The OPM Backsolve Valuation Method for Equity Compensation

Find Out How it Works

Bonus: Get a Free OPM Backsolve Template in Microsoft Excel

Private equity and venture capital portfolio companies often provide equity-based compensation to employees. This can be in the form of profits interests, options, phantom units, restricted shares, or appreciation rights.

To comply with tax and financial reporting requirements, special valuation methods must be used for equity-based compensation. These methods are different than management uses for other purposes.

To achieve accurate results, it is important for CFOs and auditors to have a basic understanding of these methods and the information used in the analysis.

One of these methods is the OPM Backsolve.

Here is how it works.

Overview

The OPM (Option Pricing Method) Backsolve is often used to value equity compensation to comply with tax requirements of IRC 409A, safe-harbor provisions for profits interests, and in financial reporting for ASC 718, 805, and 820.

This method is based on pricing from the company’s latest transaction (such as an acquisition or latest round of financing), waterfall, and the Black Scholes option pricing equation.

This approach is required when a company has what is referred to as a “complex capital structure” - where there are multiple classes of equity such as preferred, common, convertibles, warrants, profits interests, or options.

The OPM Backsolve is professionally recognized as a best practice and recommended in AICPA published guidelines for valuation of equity compensation in privately owned companies.

This method is most often used for equity-based compensation, however it can also be applied to value other equity related interests.

Option Based Valuation Methods

Option based valuation methods are used in most situations when equity compensation has an “if : then” conditional economic feature, where a threshold must be reached before the employee shares in value.

A common example of this is a stock option, where the employee can purchase stock at a specific price and have a gain if it is redeemed when the stock is at a higher price. Profits interests, stock appreciation rights, or restricted shares with certain performance conditions are other examples of equity compensation with similar conditional economic features.

Option based valuation methods arrive at a value that differs from what the employee would receive if a liquidity event occurred, and proceeds were paid out, on the valuation date.

The difference is an option valuation method considers the potential for future changes in value. The potential to achieve increases in value over time is a fundamental component in the award of many forms of equity-based compensation, and an important part of its value to the company and employee.

OPM Backsolve – At a High Level

The OPM Backsolve is a special application of an option-based valuation method. It is based on the principal that an economic relationship exists between multiple classes of equity securities in a company with a complex capital structure. That economic relationship is based on the connection these securities share to a common factor - the total equity value of the company.

Although each type of equity security is connected with this common factor, they can individually have distinct features. Differences can include rights such as liquidation preferences, required returns, conversion options, exercise prices, thresholds, or other items. When differences in rights exist, equity interests will have different values.

Such rights will define the order, values, and amounts at which each class of security is entitled to a share of equity value. This allocation is referred to as a waterfall. Differences in the levels and participation in the various stages of the waterfall result in differences in value for each class of security.

In the OPM Backsolve the economic rights, relationships, and participation levels in the waterfall are combined with Black Scholes to create an option-based equation for the equity capital structure of the company.

This equation provides the ability, when the value of one class of equity security is known, to calculate a value for all other equity related securities, including equity compensation. The value reflected in the pricing of the latest transaction provides the benchmark data used to help solve that equation.

A basic analogy to how the backsolve works might be a simple puzzle, where when you find the right piece, all the other connected pieces will fit together and give you the whole picture.

Valuation Process

The first step in using the OPM Backsolve Method is to determine value thresholds for the company. Thresholds are the points in the waterfall distribution where there may be changes in the classes of equity that participate in value.

Thresholds are defined by shareholder agreements, the capitalization table, and rights of the various equity related securities. The equity interests that would share in value for each threshold in the waterfall are also identified, along with their corresponding participation amounts at these levels.

Next, an option-based valuation equation is constructed, using Black Scholes, based on the capital structure and waterfall of the company. At a high level, this option-based approach basically determines the chance (possibility) the company will achieve various potential equity values in an exit transaction.

Estimates are also developed regarding the expected equity risk (volatility) in the business and potential time period to an exit (or other liquidity event). Best practices suggest the volatility for privately owned companies should be developed using an index created by a group of comparable publicly traded companies.? The time to exit is usually estimated by management and may include a range.

At this point, all the connecting pieces are in place.? However, the puzzle can’t be completed yet because the key piece is missing – the pricing data for the latest transaction.

In private equity and venture capital, the latest transaction usually involves an investment in preferred shares, although it could be any equity security in the capital structure. Generally, the latest transaction data should not be more than a year old, of an adequate size, and arms-length.

In addition, no changes that could materially affect value should have occurred in the business or market since the latest transaction. In some instances, adjustments to the latest transaction pricing or an alternative basis for this component may be considered.

In the final step, a backsolve technique is used to determine the common factor - the total equity value - which connects all the different securities. A backsolve technique is simply a way to identify the input needed to an equation or process that produces a specific result, such as in reverse engineering.

For this valuation method, the backsolve technique means adjusting the implied total equity value of the company until the analysis produces a value for the selected security equal to its price in the latest transaction. At that point, the equation (puzzle) has been solved, and the analysis provides a value for all equity securities in the company, including equity compensation units.

Additional adjustments to the value of equity compensation units may then be considered for any discounts or premiums relating to control, marketability, or other factors.

Most equity compensation units in private companies are non-controlling (minority), non-marketable interests. For portfolio companies of private equity and venture capital funds, any discounts or premiums for these units will reflect the expectation for a potential exit/liquidity event and the nature of the equity security in the latest transaction.

Summary

The OPM Backsolve method captures the option features and waterfall relationship inherent in the equity ownership of many private equity and venture capital portfolio companies. In nearly all cases, it will be the required go-to method to value equity compensation for tax and financial reporting purposes.

A primary advantage of this method is it establishes a value for equity compensation based on the support of a latest round of financing or transaction. This is an important factor in situations where other valuation approaches and methods may not be as effective.

Bonus - Free Microsoft Excel OPM Backsolve Template

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Best, David