Equity Valuation: Post-Money Versus an Option Pricing Model Backsolve

In the reporting of venture capital (VC) companies, many news outlets will make statements such as “VC Company A just raised $30 million, and the post-money value of the company is $100 million.” If you dig deeper into this statement, what is being said is that the security that was just sold represents all securities in the company regardless of preferences and rights.  

We will discuss the meaning of post-money value compared with other valuation techniques, and how that distributable equity value is allocated to the various securities in the capitalization table. 

What Is Post-Money Valuation? 

When a company raises a new round of financing, post-money valuation is the equity value derived as the multiple of the price per share of the recent round of financing and the fully diluted shares (post financing) for the company. It is generally considered to be the ceiling for valuation as it does not consider the differences in rights and preferences for different shares of the company. Post-money valuation is considered a good benchmark for valuation of mature companies that are close to an IPO. 

Example 1: Company A is an early-stage company which has recently closed a Series C round of financing at a price of $1.25 per share. The financing round is an arm’s length transaction, with Company A issuing 6.0 million Series C preferred shares in exchange for $7.50 million financing. The capitalization table (post financing transaction) for Company A is as follows: 

The post-money value for the Company A is $31.3 million (i.e., $1.25 price per share for recent Series C preferred times 25.0 million fully diluted shares). 

Example 2: Company B is a mature company (close to an IPO) which has recently closed a Series H round of financing at a price of $30.0 per share. The financing round is an arm’s-length transaction, with Company B issuing 1.0 million Series H preferred shares in exchange for $30.0 million financing. The capitalization table (post financing transaction) for Company B is as follows: 

The post-money value for Company B is $1.2 billion (i.e., $30.0 price per share for recent Series H preferred times 40.0 million fully diluted shares). 

What Is an Option Pricing Model (OPM)? 

An OPM is an equity allocation method used for companies with complex capital structure. The equity value for a company can be determined using the fundamental valuation approaches including income approach (discounted cash flow or capitalized cash flow methods), market approach (guideline public company or guideline transaction method), or cost approach. The equity value is then allocated to the different shareholders using an OPM. The model treats ordinary shares and preferred shares as call options on the company’s equity value, with exercise prices based on the liquidation preferences of the preferred stock. Under this allocation method, the ordinary share has value only if the funds available for distribution to shareholders exceed the value of the liquidation preferences at the time of a liquidity event (e.g., a merger or sale, or IPO), assuming the company has funds available to make a liquidation preference meaningful and collectible by the shareholders. The OPM begins with the current equity or enterprise value and estimates the future distribution of outcomes using a lognormal distribution around that current value. 

What Is an OPM Backsolve? 

According to the AICPA Guidebook section 8.40, “In an OPM framework, calibration may be used to infer the equity value implied by a recent financing transaction by making assumptions for the expected time to liquidity, volatility, and risk-free rate and then solving for the value of equity such that value for the most recent financing equals the amount paid. This method is most appropriate when the financing transaction is an arm’s-length transaction and pari-passu with previous rounds.”  

This method is called an OPM backsolve. The OPM backsolve method is superior to a simple pre-money or post-money calculation because it considers the economic rights of such recently issued security relative to the rights of other equity holders within the company’s capitalization table. 

Example 1A: Building on the information from our earlier Example 1, the detailed capitalization table (including rights and preferences for shareholders) for Company A is as follows: 

The total equity value for Company A derived using the OPM backsolve method for the Series C financing price of $1.25 per share is $21.1 million. The key assumptions for the OPM backsolve of Company A are time to liquidity (three years), volatility (60.0%), discount rate or risk-free rate (4.01%), and annual dividend rate (0.0%). The equity value is allocated to the different shareholders as per the below table:  

Example 2A: Building on the information from our earlier Example 2, the detailed capitalization table (including rights and preferences for shareholders) for Company B is as follows: 

The total equity value for Company B derived using the OPM backsolve method for the Series H financing price of $30.0 per share is $1.0 billion. The key assumptions for the OPM backsolve for Company B are time to liquidity (0.25 years), volatility (30.0%), discount rate or risk-free rate (5.4%), and annual dividend rate (0.0%). A mature company would have lower volatility than an early-stage company. The equity value is allocated to the different shareholders as per the below table:  

OPM Backsolve Versus Post-Money Valuation 

A comparison of the equity value of Company A and B derived using post-money and OPM backsolve valuation methods is presented in the below table: 

Equity value implied using an OPM backsolve framework for an early-stage company (like Company A) will typically be significantly lower than the post-money equity value, since the OPM framework considers the full value of the downside protection associated with the preferred stocks’ liquidation preferences using a lognormal distribution, whereas the post-money value calculation assumes that all equity interests in the capital structure have the same pro rata value. As discussed in our example for Company A, the equity value derived using OPM backsolve ($21.1 million) is 32.5% lower than the post-money value ($31.3 million). The equity value allocation using the OPM framework results in different per share value of different classes of shares, depending on the differences in their rights and preferences compared to the recent round. Refer to the below table to understand the difference in the resultant per share values of different classes of shares for Company A: 

For companies that are mature and close to IPO (like Company B), the difference in the rights and preferences of different classes of shareholders is not that relevant and therefore the values derived from post-money valuation and OPM backsolve methods are more in line. As discussed in our example for Company B, the equity value derived using OPM backsolve ($1.0 billion) is only 14.1% lower than the post-money valuation ($1.2 billion). The difference in per share value of different classes of shares is also not that significant in this case; i.e., the effect of differences in rights and preferences for the different classes of shareholders, compared to the recent round, are not that relevant in such scenarios. Refer to the below table to understand the difference in the resultant per share values of different classes of shares of Company B: 

Conclusion 

Each valuation method has its advantages and disadvantages. The post-money valuation ignores the differences in rights and preferences of different classes of shares but is easy to understand and apply by alternative asset managers. The OPM framework is more complex, but it appropriately captures the difference in the value associated with difference in the rights and preferences of different shareholders of a company. Even though both post-money valuation and OPM backsolve take a recent transaction as the base, the results arrived at can be very different. It is imperative that, while selecting the valuation methodology and equity allocation method, the valuation professional takes into consideration the stage of development of the company, industry that the company operates in, complexity of the capital structure and differences in the rights and preferences of the shares of the company.