Privately held and venture backed companies frequently enter into complex fundraising situations or compensation arrangements in order to maximize growth and financing opportunities. In some instances companies hastily negotiate terms in various fundraising transactions or issue equity to their employees without considering some of the costs or complexities of the ensuing financial reporting requirements that these transactions can trigger.
These cases often require significantly more complex valuations in order to ensure that companies are properly complying with U.S. generally accepted accounting principles (GAAP). Although complex valuation techniques may not always be applicable, it important to have an understanding of what type of events can necessitate the use of more sophisticated valuation modeling.
Introducing More Complex Valuation Techniques
When is a more complex valuation technique appropriate? The situations below describe examples of when traditional valuation methods may fall short:
- Equity awards with market conditions. Employee stock compensation that is issued with market-based vesting provisions instead of more traditional time-based vesting can make it difficult to use a standard Black-Scholes option pricing model to determine your stock compensation expense. Often times a binomial lattice or Monte Carlo simulation model is required to properly account for this type of compensation. FASB Accounting Standards Codification (ASC) 718 Compensation – Stock Compensation.
- Convertible debt. When a company issues convertible debt, the debt instrument often needs to be bifurcated on the company’s balance sheet. In the event that the conversion feature qualifies as an embedded derivative, the cost of the debt includes the interest plus the beneficial conversion feature (BCF). In order for this BCF to be properly valued, the valuation technique may need to account for various future scenarios which can require sophisticated valuation modeling. ASC 470-20 Debt – Debt with Conversion and Other Options
- Debt issuance with warrant coverage or other sweeteners. Whenever a debt instrument is issued in conjunction with another security such as warrants, there may be a need to examine whether or not an embedded derivative exists. Whenever there is possible variability in the host instrument, in this example, the debt itself, an embedded derivative may exist and the need for a complex valuation model is required in order to conform with U.S. GAAP. ASC 470-20 Debt – Debt with Conversion and Other Options.
- Anti-dilution features on any equity issuance. When a capital raise requires anti-dilution provisions to protect investors in the event of a down round or additional capital raises, the anti-dilution feature often times needs to be accounted for under U.S. GAAP. It is typically necessary to develop some form of Monte Carlo simulation model in order to properly account for the value of this type of instrument. ASC 815-40 Derivatives and Hedging – Contracts in Entity’s Own Equity.
- Hedging instruments. This example would include various hedging instruments such as foreign exchange swaps (FX), credit default swaps or interest rate swaps. When a company purchases or issues these types of instruments to manage risk, it can often trigger the need for valuation models that include forecasting interest rate curves, currency trends and commodity forecasting. ASC 815 Derivatives and Hedging.
- Earnouts. When a company is growing through acquisition, a great way to get a deal done is to offer a conditional payment to the seller, also known as an earnout. Earnouts are traditionally structured to be paid upon the achievement of various post-transaction milestones which can be financial or event-driven in nature (i.e., the successful completion of a prototype by a certain date). Under U.S. GAAP, earnouts need to be fair valued at each reporting period and may require significant analysis due to their derivative nature. ASC 805-30 Business Combinations – Goodwill or Gain from Bargain Purchase, Including Consideration Transferred.
How to Ensure Your Company Meets Its Financial Reporting and SEC Compliance Requirements
The scenarios above typically render valuation models such as Black-Scholes or basic amortization schedules inappropriate. These traditional models would not be sufficient to capture the full breadth of some of the financial implications of the newly negotiated terms and instruments. Rather, companies will need to explore more complex modeling such as Monte Carlo simulation or binomial and trinomial lattice models. These methods may be more appropriate to ensure that your company meets its financial reporting and SEC compliance requirements.
Some of these methods are complex and involve a great deal of modeling and analytics expertise that is often outside the capability of most audit firms. For these reasons, many companies find it crucial to work with experienced valuation professionals to help with the determination of their derivative valuation needs. If you would like to discuss these concepts further please feel free to reach out to myself or any member of our valuation team.