Company Valuation & Securities Pricing

Preamble

 

This section is conceptual in nature and is dedicated to helping you further develop a clear understanding of the nature of company capitalization, as well as how the issuance of different types of securities relate to that effort. We created CapPro™, available to you in the Corporate Engineering Conservatory™ at no charge, to help you get the job done quickly and accurately, so no need to be too concerned about the details and the possibilities of what follows. You need to understand a few basic concepts to frame your thoughts around this task.

 

Due to the changing nature of the securities markets, financial reporting, and disclosure requirements, we have provided a set of pro forma financial projections in the CapPro™ program and securities-offering-document templates in the Financial Architect System™ that are designed to be timeless in nature. These are the fundamental elements of deal structuring and securities-offering-document production, which probably will not change much. However, from time to time, we do update the entire Financial Architect® family of programs; changes occur, concerning federal and state tax and securities laws, rules, and regulations and GAAP standard changes. To be safe, we suggest that every time you prepare a securities-offering document, re-work a new set of pro forma financial projections from the CapPro™ programs and securities-offering-documents in the Financial Architect® program modules, which are continually updated to be the latest edition. (Complete instructions are included with each program.)

 

Some projects may require 7–10 years to realize their maximum net operating margins; this is especially true for real estate or oil and gas projects. However, we have designed CapPro™ and CapPro for Funds™ to project only over a 5-year time horizon because it is very difficult to project revenues and expenses beyond a 5-year time period. As long your pro forma financial projections show a breakeven by year 3, you should be able to illustrate a decent IRR on the securities being issued using CapPro™ 5-year time horizon.

 

The CapPro™ programs and securities-offering-documents in the Financial Architect® program modules have a fictitious company XYZ, Inc. or LLC, for you to work from, with default figures and assumptions (with notes to pro formas) so you can see how the fictitious company was properly engineered. You simply replace each defaulted figure in each item to coincide with your company and desired deal structure. In those default examples, we have used 100,000 Common Class A voting shares as the common denominator for the total (100%) authorized Common Class A voting shares in a corporation. One share, therefore, represents 0.001 (or 1/1000th) of 1%. One would need to own 1,000 shares of Common Class A voting stock to own 1% of the company. If your Company is an LLC, we suggest amending your Company’s Operating Agreement (or use the Operating Agreement templates within the Financial Architect® program modules) to reflect that percentage as well (i.e., one membership interest share represents 0.001 (or 1/1000th) of 1%. We do not reference any Common Class B non-voting stock in the illustration or in the templates. You could use Common Class B non-voting stock, but just realize it is treated, for dilution purposes, the same as the Common Class A voting stock. For ease of illustration in regard to this instructional course—not because we are lazy—the terms “common stock” and “shares” equate to “Common Class A voting stock” for corporation and “membership units” for LLCs or “partnership interests” for limited partnerships.

 

For early or later-stage companies that already have investors and established total authorized shares, we realize these changes may not be possible without obtaining a majority of ownership vote, which could be difficult as it may produce dilution. Simply keep in mind that we have used an easy way to calculate the percentage of ownership one would have by purchasing a certain amount of shares for illustrative purposed. If you feel that making changes to the total authorized shares or interests would cause you political problems throughout your Company’s current investor base, use your current total authorized shares or interests as the base point of your calculations in CapPro™. You will enter that number into various areas within the pro forma financial projections worksheets and the notes, to arrive at the proper calculations. If you are using a partnership as your organizational form, use the LLC templates and make terminology adjustments that coincide with your partnership agreement.

 

The Process

 

It seems to us, when it comes to start-ups, the number-one question most folks have is “With little or no assets and in the pre-revenue stage, how does one value a start-up company?” The answer is easy…it’s only worth what someone else will pay for it, so it’s probably worth zero. That’s probably not the answer you’re looking for, but it’s the truth. A better question may be…“how does one assign a value to a start-up company, with little or no assets and in the pre-revenue stage, so it can raise capital?” It depends on how one wants to raise capital. If you want to produce a business plan and submit it to financial institutions for funding, good luck.

Here are a few fundamental pricing models that are used in the securities industry. The first two, in an ad hoc manner.

 

  1. The Book Value model. This model simply states that the company is worth X times “book.” This means that the value of a start-up at the pre-revenue stage is multiplied by the Net Equity on the balance sheet, which means “book.” XYZ, Inc. has $140,000 in equity and $50,000 in debt for Net Equity of $90,000. Let’s assume that the companies in that industry, geographic location, etc. sell at 6 times book. That would place this company’s value at $540,000.
  2. The Annual Sales model. This model simply states that the company is worth X times “Annual Sales.” This means that the value of a start-up at the pre-revenue stage is multiplied by the gross revenue or sales over the last 12 months. XYZ, Inc. has gross sales $650,000 for the last 12 months. Let’s assume that the companies in that industry, geographic location, etc. sell at 1.2 times Sales. That would place this company’s value at $780,000. There are renditions of this model based on the trajectory of year-to-year sales and other esoteric measurements, but anyone can complicate painting a fence.
  3. Net Present Value model. This model simply states that the company is worth X amount of future cash flows discounted to net present value. Normally, used to value commercial real estate against future rents. Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting to analyze the profitability of a projected investment or project.[1]
  4. The Price / Earnings Ratio model. This model simply states that the company is worth X times “Earnings per Share.” Well since the start-up (defined as pre-revenue) or even the early stage (defined as pre-earnings) company has no earnings yet, defined by its stage, how can one use this model? One cannot, unless one uses a Net Present Value model discounted to future earnings per share in combination with the Price / Earnings Ratio model.

 

Some “experts” state that you cannot truly valuate a start-up at the pre-revenue stage with any reasonable model. We disagree, as long as one produces conservative GAAP-compliant pro forma financial projections to combine the Price / Earnings Ratio model (future earnings) with the Net Present Value model, (discounted to a net present value) our experience has shown that one can properly valuate a start-up or an early stage company accurately through a process of pricing the securities first, which leads to company valuation second, through reverse engineering.

 

Not to belabor the point, but one creates securities borne from those GAAP-compliant pro forma financial projections, calculates the potential future value of the company and the IRRs on the securities issued to raise capital—post money (capital attainment).

 

This procedure involves some fairly sophisticated calculations, mind framing, and thought protocols for determining reasonableness of future assumptions. One would be wise to be eminently practical in this approach and seek either qualified advisors or more importantly learn these skill sets to provide a framework for the proper valuation of a start-up company’s securities. By doing so, you’ll learn to create what is known as a “marketable deal structure” that leads to the types of securities most passive investors would like to buy. If this interests you, we’ll start with the fundamentals and lead to the practical application of the process.


The Fundamentals of Pricing Securities – the Wall Street way.

 

The most frequently used method of determining a company’s current value is based on a P/E Ratio (Price-Earnings Ratio). To arrive at a value, simply multiply the earnings per share by the P/E Ratio to determine the value of a single share. If your Company has 100,000 shares outstanding and the total net earnings are $200,000, the earnings per share equates to $2.00. If you establish a P/E Ratio of five (5), the earnings per share ($2.00) is multiplied by five (5) to arrive at the price for the common stock. In this case, you would price the common stock at $10.00 per share. With a 100,000 shares currently outstanding (not the total authorized amount) multiplied by $10.00 per share, the company valuation would be $1,000,000 less any debt, secured or unsecured.

 

The P/E Ratio is very important when conducting a securities offering because it is the way Wall Street valuates companies. Although there are many ways to valuate a company, we believe most would agree the value of anything is what someone would actually pay for it. That is why the auction markets of publicly traded securities, which represent the liquid markets, are the purest and most correct company valuation and securities-pricing method available. This type of valuation is known as the “Efficient Market Model”—it assumes all buyers and sellers know the same facts about the company (its outstanding securities, its liabilities, its underlying assets, the industry risks, geopolitical forces, etc.) and are inherently establishing the price of a security based on supply and demand of that security. The buy and sell decisions are based on the best available information, making this pricing model as good as any may ever be. There are a handful of valuation models, and some do have solid meaning in niche industries, such as; real estate, but those models cannot be applied universally.  Some valuation experts may disagree with the P/E Ratio valuation model, but until they can convince the publicly traded securities markets (Wall Street) of a better way, it’s all academic. That is why we only use the Wall Street company-valuation-and-securities pricing model—because it is based on reality.

 

Using the Wall Street pricing model, the valuation of your Company utilizes the P/E Ratio as its core-pricing component. That component is determined primarily by the estimated annual-earnings growth rate. Once again, although illustrating a healthy annual-earnings growth rate is important, it is more important that the growth rate be as realistic and conservative as possible. You should not be concerned when calculating the revenue growth rate—which would ultimately lead to the net-earnings growth rate—about how a slow, conservative, growth rate may relate to the estimated IRR of a particular security. Remember, the IRRs and ROI of hybrid securities rely primarily on the attributes they carry, as opposed to the actual underlying growth of the company, which is secondary.

 

Although the dynamics of the various, publicly traded securities markets are far more complicated than the examples given in this lesson, we are pricing privately held securities, which is relatively easy. These pricing models are acceptable, from the private and public markets’ standpoint, which is important when comparing IRRs on exit strategies, as you will soon note.

 

The previous example is for a company with current earnings per share. But what about the start-up or an early stage company that has yet to provide earnings per share to calculate from?

We use the combination of the NPV and PE Ratio models to arrive at a reasonable valuation of the securities first, then reverse engineer into the company valuation, as you will realize as you work through CapPro™.

 

Let’s now review some different types of securities that can be used for capitalizing start-up, early stage, or seasoned companies. Let’s assume a company-valuation exercise and the pricing of common stock included selling 40% of the company (40,000 shares from the 100,000 total authorized shares). Actually, conducting an offering of that nature may not be wise unless your capitalization effort is project specific. In other words, you may be developing a real estate or oil & gas project, which may only need a one-time capitalization effort. In addition, if you are building an operating company, you should consider giving up as little common-stock equity in the first couple of rounds, as you would need that equity for further rounds and possibly for an IPO in the future. We like to keep the amount of relinquishing common equity through conversion only, down to a total of 30% before an IPO. Simply keep that in mind as you develop your capitalization plan.

Using CapPro™, available to you in the Corporate Engineering Conservatory™ you’ll get the job done quickly and accurately. What used to take weeks, now only takes hours and what used to take hours, now only takes seconds.
The Common Stock

 

When pricing Common Stock, one analyzes 3 components:

  • The price of its original or discounted issuance.
  • The cumulative cash (dividend) distributions over a specified period, say at the end of the five years.
  • The principal of the Note or Bond to be received by the investor at maturity.

 

Common stock is the only security that is priced primarily on its future potential value.

For instance, let’s say you are using a P/E Ratio (a “multiple”) in a private market of five (5). You estimate your Company earning $20.00 per share at the end of the 5th year. With a multiple of five, you would price the common stock at $100.00 per share at the end of fifth year. Incidentally, a P/E Ratio of five (5) is a reasonable earnings multiple for a privately held company.

 

You would then price the common stock, currently, to reflect a reasonable return for the risk involved in owning that security over that period. If you priced the common stock at $10.00 per share now and it is conservatively estimated to be worth $100 per share at the end of the 5th year, you could illustrate a 58.49% Internal Rate of Return (IRR) for an investment in the common stock. (The IRR calculation formula is automatically calculating with CapPro™.)

 

If you established the current price of the stock at $20.00 per share, as opposed to the $10.00, the IRR would be 37.97% with the common share estimated to be worth $100 per share at the end of the 5th year. If the given price and rate of return were acceptable to your private capital market, based on the risk profile of your company, and the securities offered (dilution factor), that would constitute the current value of the stock.

 

If you established the current price of the stock at $30.00 per share, as opposed to the $10.00, the IRR would be 27.23% with the common share estimated to be worth $100 per share at the end of the 5th year. If the given price and rate of return were acceptable to your private capital market, based on the risk profile of your company and the securities offered (dilution factor), that would constitute the current value of the stock.

 

See how we backed into the current company valuation based on the IRR of the common equity at the end of a 5 year time frame? To use the final example, you use reasonable GAAP compliant pro forma financial projections to price the company’s common equity end valuation to be $100 (X) at the end of year 5 and reverse engineer the current price $30.00 (Y) based on the IRR of 27.23% (Z). We used both the NPV and PE Ratio Model to valuate the company by pricing its common equity, through reverse engineering.

 

Are you beginning to understand the fundamentals of pricing the common stock? One bases its current value on its potential future value. After having conservatively estimated the future value of the common-stock shares at the end of a period, one simply adjusts the current price to reflect an acceptable rate of return to one’s private-capital contacts. This is the basis of a pre-revenue company valuation and on the pricing of, but not engaging in, a common-stock securities offering.

 

Remember, you base the value of anything on what someone else is willing to pay for it. You determine the preceding by testing the waters for an indication of interest. You could test the price of the common stock at any one of the estimated IRR scenarios as described above. Certainly, in this example, an investor would rather pay $10 per share than $30 per share. Therefore, you should consider a common-stock offering of maybe $20 per share—as well as two other deal structures that would provide a similar or greater-estimated IRR—along with more protections for the investor.

 

Note or Bonds.

 

When pricing Notes or Bonds, one analyzes 3 components:

  • The price of its original or discounted issuance.
  • The cumulative coupon or annual interest rate over a specified period, say at the end of the five years.
  • The principal of the Note or Bond to be received by the investor at maturity.

 

Commercial (as opposed to government) Notes and Bonds are typically priced at $1,000 each. However, one could price at any denomination for instance one bond for $10,000, $50,000 or a $100,000. Normally, one would issue 10 Notes or Bonds at a price of $1,000 for a $10,000 investment.

 

The difference between the term “Bonds” versus “Notes” is the length of its maturity date from their issuance date. One would generally issue Corporate Notes with maturity dates ranging from ninety days to five years—corporate bonds 5–30 years (5, 10, & 30 year Bonds are most common).

 

Notes and Bonds are normally priced by the “current yield” or the annual interest or “coupon” rate. For instance, one would normally sell and issue $1,000 Notes with a coupon rate of 7%, 8% or 9% in today’s market to raise seed capital. Due to the aspect of inflationary and interest rate risk, the short-term nature of a Note, compared to a longer term maturity of a Bond allows the Note to carry a lower coupon rate. In this event, only the current yield can be stated in a tombstone ad for advertising.

 

Just as a notation, and not germane to raising capital for start-up or early stage companies, Notes and Bonds can be discounted from “face value” of the original issue price. For instance, a $10,000, 5-year Note can be discounted to any percentage, but let’s say 10% for this example.  Let’s say its coupon is 7%. At a 10% discount the current yield would increase to 7.78% ($10,000-$1,000 (10% discount) = $9,000 / $700(the interest coupon) = 7.78%.  The “yield to maturity” over five years would be 7% (the interest coupon) + 2% (10% / 5 years) = 9%.  If one were to issue a Note or a Bond at a discount the term used is an “Original Issue Discount” Note or Bond. In this event, both the current yield and the yield to maturity can be stated in a tombstone ad for advertising when soliciting Notes or Bonds.

 

Convertible Notes or Bonds:

 

When pricing the Convertible Notes or Bonds, one analyzes 4 components:

  • The price of its original or discounted issuance.
  • The cumulative coupon or annual interest rate over a specified period, say at the end of the five years.
  • The principal of the Note or Bond to be received by the investor at maturity.
  • The value of the equity upon conversion into common equity —at the end of the conversion period, to arrive at a total, cumulative, aggregate end-value for conversion under 2 scenarios, staying private or going public.

 

To calculate the IRR, one would compare with the beginning price at “face value” or a discount from face, of the Note or Bond, plus the total, cumulative, aggregate cash received from all interest payments, plus end-value of the Note or Bond, to determine the estimated IRR. For instance, if you priced and issued the notes at $10,000 face value and the aggregate value per Note was estimated to be worth $20,000 (equity-conversion value plus cumulative interest) at the end of the 5th year, the estimated IRR would be 13.99%. If the 13.99% return is acceptable to your private-capital contacts based on the risk profile of your company and for the risk involved in holding that type of security over the specified time period, the $10,0,00 face value would constitute the price.

 

To “fine tune” this IRR scenario, one would change the conversion rate as opposed to the price of the note, maturity date or the interest rate, as small adjustments to the conversion rate will have a greater impact on the IRR than small adjustments to the price of the note, maturity date or the interest rate. You will learn much more on fine tuning and market positioning when working within CapPro.™

 

Only the current yield (or if discounted the yield to maturity) can be stated in a tombstone ad for advertising when soliciting Convertible Notes or Bonds, not the IRR.

 

The Preferred Stock:

 

When pricing the Participating Preferred Stock or Units, one analyzes 3 components:

  • The price of its original or discounted issuance.
  • The cumulative stated dividend rate over a specified period, say at the end of the five years.
  • The return of principal by the investor if “Called.”

 

You price the preferred stock somewhat like a Note or Bond. It has a par or face value upon its issuance, which matters very little when you analyze the Internal Rate of Return (IRR). There is not much difference between a par value (original issue price) of $10, $100, or $1,000 when it comes down to pricing this type of security. What matters most is the stated dividend. Let’s just focus on a regular preferred stock scenario for now. You simply price the stated dividend as an annual yield or rate-of-return component not the share price of the preferred share.

 

If you decide 11% is the annual yield or rate of return that is acceptable to your private capital market, it would establish the stated dividend of the preferred stock. A stated annual dividend of $11.00 on a preferred stock with a $100 par value and issuance price represents a 11% annual yield or rate of return. Most preferred stock is priced at $100 per share—also known as “par” value. In this case, you would need to establish a stated dividend of $11.00 per share to arrive at the 11% annual yield. Par value has very little meaning because you price the stated dividend not necessarily the par or face value of the preferred stock shares. However, like a Note or Bond, a preferred share can be issued at a discount to par value.

 

It is very much the same way when pricing a Note or Bond. The difference between the preferred stock and the bond (or note) is generally the safety’s function. With a bond or note, you own a debt instrument with a Security Agreement and pre-defined maturity date (see the template) as opposed to owning a security that represents a permanent or temporary form of equity capital—as with a preferred stock. The Note or Bond is a security with less risk than a preferred stock, which has less risk than a common stock. Therefore, when pricing securities, you can provide a lower rate of return on the safer security being considered for issuance, relative to all other securities under consideration. By the way, the shorter the maturity date, the less risk for the Note or Bond. In any event, with both types of securities, you price the annual return not the price of the security itself. In the case of a preferred stock, stated dividend and debt instrument—such as a Note or Bond —the annual interest rate is known as the “coupon.”

 

Preferred equity can be discounted from “par value” of the original issue price. For instance, preferred stock with a par value of $100, can be discounted to any percentage, but let’s say 20% for this example.  Let’s say its stated dividend is 8% which would equate to an 8% current yield at par value. At a 20% discount the current yield would increase to 10% ($100-$20 (20% discount) = $80 / $8(the stated dividend) = 10.00%.  The “Yield to Call” over five years would be 8% (the stated dividend) + 4% (20% / 5 years) = 12%, assuming there’s no Call Premium.  If one were to issue a Preferred stock at a discount the term used is an “Original Issue Discount” Preferred stock. In this event, both the “current yield” and the “yield to call” can be stated in a tombstone ad for advertising when soliciting Preferred stock.

 

The Participating Preferred Stock:

 

When pricing the Participating Preferred Stock or Units, one analyzes 4 components:

  • The price of its original or discounted issuance.
  • The cumulative stated dividend rate over a specified period, say at the end of the five years.
  • The cumulative participative dividend rate over a specified period, say at the end of the five years.
  • The return of principal by the investor if “Called.”

 

When pricing the participating preferred stock, one analyzes the stated dividend and participation cash flow over a specified period—say at the end of the fifth year—to arrive at total, cumulative cash flow. That total, cumulative cash flow plus the par value of the participating preferred stock would produce an “aggregate end-value.” That aggregate end value—compared with the beginning value or original issue price—will determine the IRR if you priced and issued the preferred stock at a $100 par value per share and the aggregate end-value per share was $1,000, which included the principal paid back to the investors. By the exercise of a call-feature provision at the end of five years, the estimated IRR would be 58.49%. If the given rate of return was acceptable to the management team’s private-capital contacts for the risk involved in holding that illiquid security over that period, that would constitute the price. Since there is less risk with the ownership of a preferred stock than a common stock, maybe a participation and/or lower-stated percentage that illustrate an estimated IRR of 37.97% would be acceptable.

 

You can only estimate the IRR using the above formula if the participating preferred stock has a call date at the end of the period and your pro forma financial projections illustrate buying back those shares by exercising the call feature. You need to disclose that the exercise of the call provision is “planned” by the company, as the call provision of the preferred stock is the option of the issuer not the shareholder. (The preferred shareholder cannot assume that the principal will be returned.)

 

If you do not exercise the call feature, you would only use the total cumulative cash flow—leaving out the return-of-principal amount—to arrive at the aggregate end value, which would greatly reduce the estimated “realized” IRR figure. If you do not illustrate a call date in the pro forma financial projections, part of the IRR technically becomes “unrealized,” which gets confusing to investors. Remember, you can “Call” the preferred shares any time after the call date, as the call provision is at the pleasure of the issuing company. Technically speaking, the call date is known as the “call-protection date,” as it protects the investor from being forced to sell his/her preferred shares back to the company in the case of falling interest rates. If the call date is five years out, the investor knows they have locked in a certain rate-of-return expectation for five years. This is because the issuing company cannot force the investor to sell their preferred shares back to the company for five years.

 

The Convertible Participating Preferred Stock

 

When pricing Convertible Participating Preferred Stock or Units, one analyzes 5 components:

  • The price of its original or discounted issuance.
  • The cumulative stated dividend rate over a specified period, say at the end of the five years.
  • The cumulative participative dividend rate over a specified period, say at the end of the five years.
  • The return of principal by the investor if “Called.”
  • The value of the equity upon conversion into common equity—at the end of the conversion period, to arrive at a total, cumulative, aggregate end-value for conversion under 2 scenarios, staying private or going public.

 

To calculate the IRR, one would compare with the beginning price or “par value” or a discount from par, of the preferred equity, plus the total, cumulative, aggregate cash received from all dividend payments, plus end-value of the preferred equity, to determine the estimated IRR. For instance, if you priced and issued the preferred equity at $100 par value per share and the aggregate value per preferred share was estimated to be worth $200 (equity-conversion value plus cumulative dividends) at the end of the 5th year, the estimated IRR would be 13.99%. If that is acceptable to your private-capital contacts based on the risk profile of your company and for the risk involved in holding that type of security over that period, that would constitute the price.

 

To “fine tune” this IRR scenario, one would change the conversion rate as opposed to the price of the note, maturity date or the interest rate, as small adjustments to the conversion rate will have a greater impact on the IRR than small adjustments to the price of the note, maturity date or the interest rate. You will learn much more on fine tuning and market positioning when working within CapPro.™

 

Only the current yield (or if discounted the yield to call) can be stated in a tombstone ad for advertising when soliciting Convertible Preferred Equity, not the IRR.

 

Relax. Using CapPro™, available to you in the Corporate Engineering Conservatory™ you’ll get the job done quickly and accurately. What used to take weeks, now only takes hours and what used to take hours, now only takes seconds.

[1] https://www.investopedia.com/terms/n/npv.asp