Complex Structures Create Valuation Challenges

With the increase in private equity investment activity in recent years, today is an advantageous time to sell a private company. Valuation multiples are elevated, and owners are increasingly able to obtain liquidity. However, as private equity investment has grown, management and ownership structures have become more sophisticated and complex, which has made it more difficult to estimate the value of an ownership interest and created new risks for less sophisticated investors.

A private equity investment can be structured in different ways. In general, the sources of capital and forms of ownership include senior debt, mezzanine debt, preferred stock, common stock, and options and warrants. Depending on the entity’s legal form, ownership interests have different names, such as membership interests, profits interest or common stock, but the economic rights and valuation issues are essentially the same. Furthermore, an instrument can have characteristics of some or all of the different forms of ownership; yet, even seemingly straightforward investments can be complex and create challenges when attempting to value the various instruments and ownership classes.

The value of the different ownership classes matters. It can have financial reporting and tax implications, and the valuation impact of certain provisions will be important when structuring an investment’s terms. In addition, the investor should know and understand the impact that different provisions have on the interest’s value, including the rights and privileges of other securities in the capital structure.

Estimating the ownership interest of a company requires taking a variety of considerations into account. The company’s overall value is obviously important. However, economic rights and other factors must also be considered when estimating the value of different ownership classes. Key economic drivers include contractual liquidation and return rights, growth opportunities and the expected hold period. Liquidation and contractual return provisions provide an investor downside and return protections, while the investment’s growth potential can be especially attractive in the case of a high-growth company. In some instances, the hold period—often estimated as the time until a liquidation event—can be a benefit by providing more time for the investment to grow, but it can also be a marketability issue for a minority owner who wants to exit.

There are three common methods for valuing an investment in a company with a complex capital structure, and each comes with advantages and challenges. The first is known as the liquidation/waterfall method, which estimates the value of the interest based on the assumption that a sale occurs on the date of valuation. This method is relatively easy to apply, but it does not consider the hold period and may not fully reflect the investment’s growth opportunities. The other two methods are the probability of expected outcomes and option pricing, often using a Monte Carlo simulation. Both approaches consider the growth opportunities and the hold period, but they are more complex to execute and interpret than the liquidation/ waterfall method.

Owners exiting in today’s market are doing so at an opportune time. By considering the economic rights and privileges across investments tranches and using an appropriate valuation method, they’re more likely to value their ownership interest correctly and, ultimately, to achieve their desired payout.