Valuation Concepts: AICPA Issues Updated “Cheap Stock Guide”

In 2012, the AICPA’s Financial Reporting Executive Committee released for comment an updated working draft of its practice aid titled “Valuation of Privately Held Company Equity Securities Issued as Compensation.”

Also known as the “Cheap Stock Guide,” it is of particular interest to those who value, audit, manage or invest in early stage companies that have issued both preferred and common stock, resulting in a complex capital structure. The guide describes methods that can be used to allocate value to a company’s common stock when its total equity value is less than the liquidation preference of its preferred stock.

Why the Update?

Since the original guide was issued in 2004, there have been many changes in generally accepted accounting principles (GAAP) related to valuation. These include ASC 718 (formerly FAS 123R), which requires fair value-based valuation for share-based payments, and ASC 820 (formerly FAS 157), which standardizes fair value measurement across GAAP.

Changes in the tax code such as IRC 409A have also focused more attention on “cheap stock” valuations. Further, valuation practice has advanced significantly. The goal of the update is to reflect and clarify how these changes and advancements impact these specific types of valuations.

What’s New?

Key changes to the guide include:

   Discussions regarding the treatment of debt and the effects of leverage.

   The relevance of ASC 820 and AICPA valuation standard SSVS 1.

   How to apply SEC and FASB guidance.

   New cost of capital tables and studies.

In addition, the updated guide has new chapters that address:

   Adjustments for lack of control and marketability.

   How to infer value across the capital structure from transactions in only one part of the capital structure.

   Common valuation questions.

These changes and advancements impact all three equity value allocation methods described in the guide: the current value method (CVM), the option pricing method (OPM) and the probability weighted expected return method (PWERM).

Which Is Most Appropriate?

The updated guide clarifies that while the CVM may be the most obvious equity value allocation method, it is often not the most appropriate. This is because managers and investors base their decisions on the company’s expected future equity value, but the CVM allocates the company’s current equity value. For early stage companies with complex capital structures, this frequently implies (incorrectly) that the company’s common equity has no value.

To address this problem, the guide describes the PWERM and OPM valuation methods. PWERM estimates stock value based on an analysis of a variety of future exit scenarios — including an IPO, merger, sale, dissolution or continued operation — weighted by their probability of occurrence. The OPM treats securities as call options on the company’s equity value, with strike prices determined by the characteristics of the various classes of securities.

The updated guide also describes a new hybrid method that adds OPM calculations to the PWERM method when exit scenarios include significant risks of an inability to achieve an IPO or obtain additional financing.

While this guide is “non-authoritative,” it is an important resource for valuation analysts, auditors, managers and investors involved with privately held, early-stage companies. Because these valuations are complex, it’s important to work with a valuation analyst who is well versed in the nuances of the updated guide.