Is there a rule of thumb for valuing common stock relative to preferred? If a new preferred round is priced at $1.00 per share, can we assume that the value of common is $0.10? No.
By now, most managers of venture-backed companies understand that the old 10% rule is dead. The AICPA Practice Aid (Valuation of Privately-Held-Company Equity Securities Issued as Compensation) states “The use of ‘rules of thumb’ is not (and never has been) an appropriate method for estimating the fair value of a company’s common stock.” Nevertheless, many managers still want to get a sense of the common stock’s value before engaging a valuation specialist. Once the draft appraisal is completed, managers often respond by saying it doesn’t “feel” right.
The guidance is the guidance, but that doesn’t prevent us from at least asking the question: mathematically, is there a way we can reliably estimate the value of common relative to preferred?
For an early stage company, many valuation specialists use the “backsolve” method under the OPM framework to determine the value of the common. If the specialist knows the price paid for Series A preferred, it’s possible to use the option-pricing method (OPM) to solve for an equity value which corresponds to this price. Not only that, the OPM allocates this equity value among the company’s equity securities. Since the analysis relies on a mathematical model, the answer is unambiguous. If we understand the company’s equity capital structure, we can calculate a strike price, or breakpoint, for each iteration of the OPM. At a given level of volatility and with a given time to liquidity, the model will always generate the same value for common relative to preferred.
To illustrate, let’s assume that a company issues 5 million Series A preferred shares priced at $1.00 per share. The Series A preferred converts to common on a one-for-one basis. There are 10 million common shares outstanding and no options. We’ll assume that the time to liquidity is 2 years and volatility is 60 percent.
We know that the value of Series A has to be the amount invested, $5 million. We know that the first breakpoint in the OPM is the liquidation preference on Series A, which is also $5 million. The second breakpoint is the equity value at which the Series A holder elects to convert to common. This is $15 million, which is the product of the number of fully-diluted shares times the Series A price. If the company is sold for less than $5 million, all of the proceeds are paid to Series A. If the company is sold for more than $5 million but less than $15 million, the payout to Series A is fixed at $5 million, and common is paid the remainder. If the company is sold for more than $15 million, one-third of the proceeds are paid to Series A and two-thirds are paid to common.
Once we load these assumptions into the OPM, it provides us with a value for the equity of $10,292,933. The Series A has to be worth $5 million, so the common is worth $5,292,933. How’s that for precision? The common is worth $0.53 per share before applying a discount for lack of marketability (DLOM). The DLOM is beyond the scope of this discussion, but it should be apparent that, even if we apply a very big DLOM, the value of common is going to be well north of 10% of the Series A price.
We may not like the answer (53% “feels” high), but at least it’s an answer. Can we rely on our new rule of thumb? Before doing so, it’s worth considering how changes in the features of the preferred can affect the outcome. For example, the preferred may be entitled to a cumulative dividend or no dividend at all. Sometimes, preferred “participates” in distributions to common after the liquidation preference has been paid. This participation may be capped or uncapped. How do these features affect our rule of thumb? The following table provides the answer:
| Preferred feature |
Value of common / preferred |
| Plain vanilla |
53% |
| 8% cumulative dividend |
37% |
| Participation capped at 3X |
24% |
| Participation with no cap |
23% |
In each case, the value of the preferred is the same, but the equity value varies. Each concession to the venture investor is a reduction in equity value. What’s the difference in participating and non-participating preferred? In our example, the equity value indicated by participating preferred is $7,307,406, which is 29 percent lower than the value indicated by non-participating preferred.
All of the variation in equity value is absorbed by the common. Common value is leveraged in a venture-backed company. A change in the equity value results in a disproportionate change in the value of the common. In our example, a 29% decrease in equity value corresponds to a 57% decrease in the value of the common.
Bear in mind that this table, which shows wide swings in the value of common, relies on a number of simplifying assumptions. Is it safe to assume the time to liquidity is two years, or should a longer life be assumed? Is the volatility of an early stage company higher or lower than sixty percent? What happens to the value of common if the preferred is priced at a premium or a discount, or if the mix of preferred and common shares is changed?
Rules of thumb never have been a good way of valuing common relative to preferred. The features of preferred are too varied. The value of common is too volatile.