For startups and pre-revenue companies, the most accepted means to estimate business enterprise value is known as the back-solve method. This approach satisfies the IRS requirement for valuing common stock, as part of the issuance of stock options under Section 409A. It also often comports with the accounting requirements of ASC 718.
The back-solve technique is used when preferred shares are issued as part of a financing round with an outside investor. For example, if the investor participates in a preferred stock in a recently completed round at $2.00 per share, this is considered sound valuation evidence that the value of those shares is $2.00. Then, an Option Pricing Method (OPM) is used to imply (back-solve) the total equity of the company, as well as the other securities in the Capital Structure.
The back-solve obviates the need to perform fundamental valuation analysis, which for the early stage company is very complicated and subjective. The OPM is best applied on an equity basis, not to value cash pay interest bearing debt. Care must be exercised in the OPM model to ensure that the volatility input property reflects the degree of leverage in the capital structure.
The OPM required inputs are those used in Black-Scholes parameters. These include:
- Exercise Price – equity value breakpoints identified in the analysis of the capital structure.
- Time to Expiration – assumes a single point estimate for a liquidity event, either via dissolution, sale or IPO.
- Volatility – while this cannot be directly observed, a starting point is historical return volatility for a group of peer public companies. Adjustments should be made for life cycle stage, remaining milestones, and other qualitative factors.