This past weekend I watched the Sherlock Holmes movie with Robert Downey, Jr. (I realize that this is a few years old, but I hadn’t gotten around to seeing it yet). Holmes was a master of using the information around him to solve the puzzles that confronted him. This same approach is taken by valuation experts in the valuation of companies, particularly through the application of the backsolve method of valuation.
The backsolve method is a valuation approach that can be used to determine the value of common shares for companies with complex capital structures in which there have not been any recent transactions involving common shares. It considers the most recent price paid for an investment in preferred shares and uses this information to place a value on the common shares.
The backsolve method was given some attention in the AICPA’s 2004 Practice Aid – Valuation of Privately-Held Company Equity Securities Issued as Compensation. The method has continued to gain acceptance from both valuation experts and auditors over time and the AICPA’s 2011 Working Draft of revisions to the 2004 Practice Aid devoted significant attention to the backsolve method.
From a very high level, the backsolve method utilizes the Black-Scholes option model to allocate the value of a company implied by recent preferred stock investments between the preferred shareholders and common shareholders. “Breakpoints” are set based on the terms and provisions of the preferred and common stock, which allow for the allocation of value between the various share classes.
The backsolve method can be a very helpful tool in valuing early stage companies without much operating history. It can provide a reliable indication of the value of a company’s common shares even when the only recent investments have been in preferred shares.
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