Complex Security Valuations

Complex Security Valuations

By Admin March 3, 2017

Understanding Complex Security Valuations

Many businesses use complex securities to raise capital, manage cash flow, and align performance incentives between executives and employees. Mergers, acquisitions, joint ventures, and other cross-company transactions are often optimized by using complex securities. Companies can also use complex securities to hedge across multiple types of risk.

What are some examples of Complex Securities?

Below are a few examples of common complex securities:

• Convertible securities (preferred stock, convertible debt, etc.)
• Warrants and Options (either standalone or embedded into other securities)
• Equity allocations
• Contingent considerations (earn-outs)

Although complex securities allow for flexibility when structuring financing rounds, M&A activity, and other events, the complexities embedded into these securities can also trigger the need for the work of a valuation specialist, often for either financial reporting or tax purposes.

How are the securities valued?

The more complex the security, the more difficult the analysis can become. In these cases, a firm familiar with the nuances of each security as well as the regulatory requirements surrounding their valuations can be extremely helpful. The situation is made more troublesome by the fact that (1) model selection can be difficult and (2) small fluctuations in the various inputs used in the valuation models can have substantial effects on the calculated value.

Following are brief overviews of the two most common valuation methods in use today:

• Option Pricing Model: various inputs such as most likely time to expiration/exercise, current stock value, estimated stock volatility, and exercise price are applied to an option pricing model (most commonly under “Black Scholes” assumptions).

• Monte Carlo Simulation: in situations where payouts and values are dynamic, or “path dependent”, a Monte Carlo simulation can be used to run simulation trials under various assumptions and an assumed distribution. On average, the result will converge on a reliable answer as a very large number of trials are run.

• Lattice Model: similar to a Monte Carlo model, a lattice model using probability weightings can be used to approximate value when various discrete outcomes are possible. A binary tree is created with various outcomes or value movements approximated under a given distribution and set of assumptions.

Should I value my own complex securities, or hire someone else?

In certain situations, it may be possible for the company itself to value certain simple securities, assuming it can be done by a financial professional with a working knowledge of the appropriate valuation model. However, as securities become more complex (e.g. with embedded derivatives, down-round protections, and dynamic payout features), it becomes increasingly important to hire a professional valuation firm with experience valuing complex securities. In any case, the valuation will often need to comply with financial reporting or tax requirements, and as such it will typically be more time efficient and cost effective for a company to hire a third party firm rather than attempting to perform the valuation on their own.

Additional Resources :

http://www.financierworldwide.com/valuation-of-derivatives-and-complex-securities/#.V6LZRhWAOkp

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/background/valintro.htm