Why was Backsolve Method used?
What is the backsolve method and why was it used?
According to the AICPA guidance for 409a valuations, the backsolve method is a market-based approach that is the most reliable indicator of fair value for companies that have had a recent arm’s length transaction. Given your Company's recent financing round, we relied on the backsolve method to ensure the valuation is completely audit defensible. The backsolve method calculates the total fair market equity value of the company by taking the most recent price paid for preferred shares and allocating that value to each share class using the Black-Scholes Option Pricing Model (OPM), which is a function of the inputs discussed below.
What is an Arm's Length transaction?
An arm's length transaction is a transaction in which the informed buyers and sellers act independently and have no relationship to each other. The concept of an arm's length transaction is to ensure that both parties in the deal are acting in their own self interest and are not subject to any pressure or duress from the other party. For 409A purposes, an arm’s length transaction indicates that the most recent round of financing either involved new investors or involved a negotiated price that a new investor would have paid to participate in the financing round.
The Common Stock price is not in line with expectations. What are the key inputs and how would they change the value?
Due to the mathematical nature of the backsolve method, there are only a few key inputs that drive the concluded common share value. The main inputs in the backsolve method are Volatility, Risk-free Rate, Discount for Lack of Marketability (DLOM), and Time to Exit. The risk-free rate is determined by the US Treasury rate as of the valuation date. You can find a discussion of the other specific inputs and how they affect the concluded share price of common stock in the below questions.
Why is the 'Time to Exit' in the OPM different than what I inputed in the request form?
The time to exit used in the OPM is a “probability-weighted time to exit” based on your expected time to a successful exit, as well as the possibility of a dissolution in the scenario where your company is unable to raise financing in the future. For companies at this stage, we typically place this at 2-3 years, depending on time to a successful liquidity event, current burn rate, and time to the next financing round. The time input in the OPM reflects an audit-defensible method to capture the fair market value for common stock that takes into account the risks and challenges that early-stage companies experience.
How are the guideline public comparable companies selected?
We leveraged the public companies provided in the Carta 409a request form, performed industry research on Standard & Poor’s Capital IQ database of more than 60,000 publicly traded companies, and relied on e' database of private companies to curate the most applicable set of comparable companies. We understand that it is almost always the case that the public comparable companies are significantly larger and more established and as a result, we do take that into account and make adjustments to the relevant inputs that are driven by the selection of the public comparable companies. Given the 100% weighting on the backsolve method for the valuation, the comparable public companies shown in the report only affect the volatility selection. Accordingly, any changes to the guideline public companies selection most likely will not materially impact the FMV.
Can any adjustments be made to the Discount for Lack of Marketability (DLOM)?
The Backsolve method assumes that your investors are rational market participants who have performed their due diligence incorporating all relevant information and risks into their pricing of the preferred financing round. This includes any lack of marketability for their investment. The AICPA guidance enforced by audit firms and the IRS indicates that using an Incremental DLOM (Variable Put Model) to calculate the DLOM on the common shares is the best practice whenever relying on the backsolve method. The Incremental DLOM method factors in the implicit DLOM already priced into the Preferred Shares, equity volatility, and liquidation waterfall.
How does the volatility selection affect the valuation?
We analyzed the range of volatilities of the guideline public companies to approximate an appropriate volatility for your Company. For companies at a similar stage, volatilities typically range from 40%-65% depending on the selected comparable companies and industry. Additionally, small changes in the volatility often have no material impact on the FMV of common stock. While an increased volatility could potentially increase the DLOM calculation, an increased volatility would potentially offset any decrease in the common share price caused by a higher DLOM because a higher volatility increases the marketable (pre-DLOM) share price due to the increased optionality in the OPM.
How does the industry classification affect the valuation?
Just as in picking a selection of similar public comparable companies, there typically isn't an exact single industry that comprehensively classifies a company; instead we often must choose from a database of industries to include in the valuation which is a requirement by IRC 409A. As part of our analysis, we review the expected growth and anticipated economic conditions for each relevant industry, and adjust our analysis in cases where future expected outcomes are either extraordinarily positive or extraordinarily negative. However, in the typical case the quantitative side of the valuation report far outweighs the qualitative industry factors, so in this case a reclassification into a new industry will not cause a material change in the valuation.