Overview

Some forms of debt, equity, and other financial interests in private equity portfolio companies can get classified as complex securities and need to comply with special accounting and valuation requirements.

This can be a surprise that causes problems getting audited financial statements issued, with add-on acquisitions, or in due diligence.

Have accounting requirements changed? Not really. Rather, these situations often result from the increasing complexity of financing structures used in private equity transactions.

Further, special methods are required to value complex securities for financial reporting that are different than management typically uses for other purposes.

What Are Complex Securities?

Complex securities are corporate financial interests that are, as the name suggests, not simple.

For example, a simple form of debt is a traditional bank loan such as a line of credit or term note. Complex forms of debt are convertible loans or subordinated debt with warrants.

A simple form of equity is a common share. Complex forms of equity include preferred shares, options, profits interests, and warrants. 

Other types of complex securities include rollover, earnouts, phantom shares, SAFEs, and hybrid financial interests.

Complex securities have certain features that, when compared to other financial interests, can result in different payouts. Examples include preference, participation, return, conversion, thresholds, exercise, and vesting.

These characteristics are generally referred to as option conditions – a situation where features, events, or choices can result in different financial outcomes.

Further, a capital structure with multiple classes of equity or a waterfall that governs distributions can create option conditions and turn what otherwise might be simple financial interests into complex ones.

Fair Value: How Financial Reporting for GAAP Is Different

Complex securities are recorded in audited financial statements in accordance with a specific standard referred to as fair value.  Fair value is generally defined under US GAAP in ASC 820, as “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

Using the accounting standard of fair value can result in differences when compared to how management determines value for other purposes. This is particularly true for complex securities.

For example, consider a portfolio company where investors have preferred shares with control rights, a liquidation preference, and a preferred rate of return. The company may also have common shares and management incentive units issued as profits interests. Perhaps there is convertible debt, warrants, rollover, or an earnout. The shareholder agreement has a waterfall provision that establishes the order of distributions.

In this situation, a common valuation approach for management reporting is to start by estimating the total company (enterprise) value. This might be developed using an EBITDA multiple, comparable transactions, or a discounted cash flow analysis. This enterprise value is then run through the waterfall and the payout to each financial interest determines its value.

This approach is straight forward, rather easy to apply, and widely used in private equity for purposes of management reporting. It is referred to as a current value (or liquidation) method. This is how private equity funds often look at the value of investment holdings. It captures the economics of financial interests on a practical basis.

However, let’s assume the fair value of a complex security such as rollover, earnout, warrants, or incentive units needs to be determined for financial reporting purposes. The individual complex security is referred to as the subject interest or unit of account.

The perspective is no longer a liquidity event for the entire company. Rather, fair value assumes a hypothetical transaction takes place at the valuation date involving only the subject interest on a stand-alone basis.

As unrealistic as this concept might seem, it applies even when there is no intent to sell, a buyer cannot be readily identified, there are restrictions, or the value is not what the seller wants. Fair value adopts the premise there is a hypothetical market and buyer for the subject interest, even if such a transaction is unlikely to actually occur.

Further, fair value adopts the forward-looking perspective that a buyer of a stand-alone complex security would consider, including:

• A liquidity event and payout might still be years down the road;
• Value of the company and equity could change over time;
• Ability to control if, when, or at what price liquidity will occur;
• Option conditions, waterfall, and the possibility of different payouts;
• Risk and the expected rate of return for such an investment.

Methods to Value Complex Securities For Financial Reporting

To meet fair value requirements, complex securities in privately owned companies are valued using special methods and follow a three-step process.

The first step is to develop an enterprise value for the company. This is often done the same way as in the current value method described above. The objective of step one is to determine a value for total equity, or in some situations, an enterprise or investment value.

The second step is to allocate that value to all financial interests and the subject interest.  As discussed above, fair  value requires a forward-looking perspective that considers risks, expected returns, changes in company value, option conditions, and the possibility of different payouts. Because the current value method does not address these areas it won’t work for step two.

This means special valuation methods, known as option methods, are required. Option methods are designed to handle the characteristics of complex securities in the way needed to comply with fair value. Examples of option methods include scenario and expected return analysis, calculations based on the Black Scholes equation, and a technique known as Monte Carlo simulation.

A basic purpose of an option method is simply to evaluate future value: if, when, and how much the value of a financial interest could fluctuate over time.  Option methods use readily available information, basic assumptions, standard calculations, and take the uncertainty out of how to determine the fair value of a complex security.

Option methods may be unfamiliar or seem unnecessarily complicated. However, option methods actually make things easier in the financial statement audit process. This is because they can readily be reviewed, tested, and confirmed.

This does not mean management needs to be an expert in financial options or do complex mathematical calculations. The wide availability of resources such as web-based applications, models and templates, AICPA practice aids, training, and expert assistance make it easy to successfully use option methods.

Finally, the third step in the process is to consider any additional factors required for the fair value of the subject interest not addressed in the prior steps. These adjustments are specific to fair value and not typically used in  management reporting.

For example, there could be adjustments relating to the nature of the subject interest on a stand-alone basis such as control rights, marketability, liquidity, discounts, and premiums. Methods used to determine these adjustments could include published data, general benchmarks, and additional calculations.

In addition, the third step will include any adjustments needed to record values on the financial statements. For example, these could include determining classification (debt, equity, asset), hybrid components, vesting conditions, footnote disclosures, and journal entries.

Final Thoughts

Although perhaps unexpected, it is likely option methods will be required to value complex securities for financial reporting.

Understanding fair value standards, the capital structure, option conditions, and resources available will help you get ahead of any issues.