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Option-pricing method of valuing multiple classes of shares

option pricing method equity allocationI was wondering if anyone out there has recent experience using the Option-pricing method (OPM) for valuing multiple classes of stock.  My company has common and series A preferred.  I use DCF to arrive at an enterprise value and I have my Black-Scholes assumptions (risk free rate, volatility, etc.)  Where I'm getting stuck is setting up the options for the Black-Scholes call option values.  Our preferred series A has a preference, cumulative dividend, and 1:1 conversion to common (plus unpaid dividends).  No double dip. 
Option 1 is easy - it's the company's enterprise value.  Option 2 exercise price is the amount of series A raise plus dividend, basically the amount of capital that gets paid before the common gets anything.  I have Option 3 exercise price as the enterprise value that the company needs to have in order for the preferred series A holders to be enticed to convert to common stock.  This number is the total number of common and preferred shares outstanding times the price paid per share of series A.  Working under the assumption that once the fully diluted value of stock exceeds the price paid, preferred stock holders are going to convert to common.
Any thoughts on whether I've set this up right?
Thanks for any input.
 

Answers

Topic Expert
John Kogan
Title: CEO/CFO
Company: Proformative, Inc.
(CEO/CFO, Proformative, Inc.) |

This one comes courtesy of a guy I've used for valuations before, Jim Timmins of Teknos:

One, the starting value in the Black Scholes option pricing model used for allocation should be equity value, not enterprise value. Fortunately, it is easy to get from enterprise value to equity value: add cash and subtract debt.

Two, I believe that what he or she is calling “Option 1,” “Option 2,” and “Option 3” are really breakpoints. A breakpoint is an equity value at which the allocation of proceeds changes. For example, if a company has a preferred stock liquidation preference of $10 million, we would set the first breakpoint at $10 million (i.e. all proceeds from $0 to $10 million would be allocated to preferred).

In this case, the breakpoints are:
1. $0 to amount of Series A liquidation preference plus cumulative dividend (dividend calculated for a period set to match the time used in the B-S calculation, e.g. both might be five years) – all proceeds flow to Series A
2. Amount of series A liquidation preference plus cumulative dividend to point of Series A conversion – all proceeds flow to Common
3. Point of Series A conversion to infinity – all proceeds split between Series A (converted to Common) and Common, pro rata in accordance with relative ownership

It rapidly gets more complicated than this example. In a typical situation, we have two to five series of preferred, one or two series of warrants, three to six series of options, and common. Plus, one series of preferred may be senior and/or have a more than 1x liquidation preference – and about 40% of all series of preferred are participating (sometimes with a cap, sometimes without a cap) – all of which creates more breakpoints. We have created models with more than 40 breakpoints and most have 10 to 20 breakpoints.

Feel free to put the person in touch with us directly. We’ll be happy to offer some free advice, even without an engagement for a project.

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