Can PWERM Be Effectively Applied in Early Stage Company Valuations?
Published on 30 Sep, 2015
Valuing early stage companies is an inherently challenging exercise. What is even more challenging for appraisers is to apply an appropriate methodology that allocates the company’s enterprise value (EV) fairly among multiple classes of shareholders. When conducting common stock valuations, appraisers have the difficult task not only of ensuring that the allocation method applied is auditable and can withstand the scrutiny of auditors, but also of convincing the management team and the board that allocation of value among various classes of securities makes business sense.
Of the three methodologies prescribed by AICPA1 for allocating a firm’s value, the option pricing model is a widely accepted methodology among both appraisers and the audit fraternity. OPM has gained wide acceptance, in part, at least, because of its formulistic approach and its relatively less subjective inputs. However, as noted in several insightful articles2 published recently, there is a growing faction of valuation professionals who recognize several fundamental limitations of the OPM model and seriously question its applicability to early stage companies. It has been argued that OPM works on a key underlying assumption that distribution of future equity values is log-normally distributed (between success and failure). However, research suggests that the exit values for venture-backed investments are highly skewed toward failure. This generally results in the OPM model overstating the common stock value for early stage companies.
Many of these limitations have been already discussed thoroughly in various professional forums and are well supported by research into distribution of exit values of venture-backed investments in certain industry sectors. In this article, we present why indiscriminate application of the OPM methodology could be counterproductive in certain cases, and why appraisers should consider the probability-weighted expected return method for early stage companies. Given OPM’s potential limitations, there’s a debate as to whether PWERM can be more effectively applied to early stage company valuations.
- AICPA Practice Aid, “Valuation of Privately Held Company Equity Securities Issued as Compensation,” Para141-154.
- Article titled “Does Black Scholes Overvalue Early Stage Company Allocations?” by James Walling and Cindy Moore published in BVR’s Business Valuation UpdateTM Vol. 16, No. 1, January 2010.
Challenges in Application of PWERM to Early Stage Companies
Unlike in the OPM methodology which relies on a black box approach in terms of inputs, using PWERM is fraught with complex challenges, such as:
- It is highly complex to model and requires a lot of assumptions on potential future outcomes, notably:
- It is difficult to estimate for start-ups and early stage companies where an exit is at least three to four years in the future. Further, a favorable exit event is dependent upon achievement of several operational milestones, success or failure of which are uncertain.
- Estimates of time to exit, nature of exit events, future enterprise values and probabilities are difficult to support objectively.
- Capturing the potential impact of future financing rounds before an exit in the current valuation is tough.
- Measuring the potential impact of dilutive instruments like convertible debt, options, and preferred warrants in a current valuation is subjective.
- Given these issues, appraisers mostly prefer PWERM for companies in later stages of development that are nearing an exit event or at least have reasonable visibility about exit events in the foreseeable future.
Understanding PWERM’s Applicability in Early Stage Companies
PWERM is rarely applied to early stage companies since an exit event is seldom a foreseeable event for at least three to four years. Apart from dealing with limited availability of data, an appraiser also needs to weigh incremental benefits in quality of analysis versus incremental efforts and associated costs of doing rigorous PWERM analysis.
Having said that, our experience indicates that PWERM can be appropriately applied to early stage companies to produce a defensible opinion when attention is paid to some critical aspects of the approach and analysis.
Let us illustrate how this can be done with an example. Sunsolar Power Technologies (SPT) is an early stage company engaged in developing manufacturing solutions for photovoltaic cells with the aim to bring the cost of solar power on par with coal power.
We will demonstrate how OPM and PWERM treat allocation for a company engaged in a sunrise sector such as solar power technology. The illustration highlights what steps we can follow in a PWERM analysis to produce appraisal results that make business sense as well as being defensible from an audit standpoint.
Why PWERM-Derived Results Better Reflect Value Distribution Among Stakeholders
While application of OPM is relatively simple and auditable with respect to key assumptions, it is also important to note that the hypothesis of distribution of exit values in the industry is log-normally distributed.
However, a careful analysis of the subject company and the industry indicates otherwise:
- The product or technology development lifecycle for solar startups is quite long. Significant challenges exist during the lab-to-pilot- to-commercialization cycle, with each stage having a significant risk of failure.
- The solar technology marketplace has been flooded with over 250 venture-backed companies, each promising to revolutionize the marketplace with innovative concepts. However, only a handful of them have demonstrated the viability of their offerings, while most of the others have gone bust.
- The company has developed a mere lab scale prototype of its product and is yet to achieve critical milestone such as demonstrating its commercial viability, raising $80 million, building a demonstration plant, securing customer orders, and so on.
Given the competitive landscape, high technology and intellectual property barriers, and low success ratio in the industry, it is reasonable to assume that the future outcome of the venture is more skewed toward failure than success.
Under the Black and Scholes option pricing model, the hypothesis of log-normal distribution does not hold in this case, and would tend to overvalue the common stock. Further, the other underlying assumptions of the BSOP model such as single point estimate of time to liquidation, proxy volatility from guideline public companies, and so on, do not work for most of the early stage companies.
On the other hand, a PWERM analysis is based on more grounded assumptions that are closer to reality. The expected future outcomes of the company seem more plausible as PWERM factors the risks associated with such outcomes dependent upon success or failure of each business milestone in a clearly understandable manner. Further, it provides the flexibility to factor company-specific extreme-exit scenarios that could trigger at multiple points of time in the future instead of relying upon a single-point-intime exit event.
Application of PWERM to Early Stage Companies: Best Practices
Although developing objectively supportable inputs for the analysis remains a key challenge when applying PWERM, it can be addressed to a great extent by following these best practices:
- Gain a thorough understanding of the key business milestones. Following the basics, such as detailed management discussions and thorough industry research, are key.
- Integrate potential exit outcomes with achievability of such milestones; all possible future outcomes are ultimately the function of how successfully the company achieves such milestones.
- Analyze market data for determining success and failure probabilities. Historical industry trends and averages are good proxies of the underlying risk faced by the company.
- Estimation of equity value should only be based on projected business fundamentals existing on the exit date. The underlying risks of reaching there are factored in the probabilities and must not be factored twice.
- For building probabilities for outcomes of various milestones, focus should be more on direction of the milestones and the degree of their occurrence in terms of certainty. Management guidance such as “unlikely,” “uncertain,” ”likely,” ”very likely,” and so on, are good indicators of success or failure of the timeline of each milestone. Future events cannot be measured exactly, so emphasis should be on fair estimation.
- Put strong narrative in the appraisal report, clearly explaining risks associated with various milestones.
In the inherently subjective domain of private company valuation, no single approach can be considered as the last word. However, appraisers and the audit fraternity would do well to keep an open mind on the relevance and application of various valuation methodologies for a given context. While there is no debating the relevance of PWERM for more established companies, our own experience indicates that PWERM can be justifiably applied to early stage companies in certain situations. However, it is our hope that the application of PWERM will be more thoroughly debated. Free exchange of ideas will help to arrive at some level of consensus on sticky issues and go a long way in establishing industry accepted “best practices.”