Equity-Based Compensation Valuation

Executive SummaryOver the past decade stock-based compensation (SBC) gained widespread popularity as a way to reward employees while conserving cash.Turmoil in the stock market during 2022 resulted in employees seeing diminishing value in SBC and investors questioning its aggressive use.In this article, we discuss how market volatility can affect employee, management, and investor perspectives on SBC.

Compensation models are the subject of significant handwringing for RIA principals—and for good reason. Out of all the decisions RIA principals need to make, compensation programs often have the single biggest impact on an RIA’s P&L and the financial lives of its employees and shareholders. The effects of an RIA’s compensation model are far-reaching, determining not only how compensation is allocated amongst employees but also how a firm’s earnings are split between shareholders and employees, what financial incentives employees have to grow the business, and what financial incentives are available to attract new employees and retain existing employees.Compensation models at RIAs tend to be idiosyncratic, reflecting each firm’s business model, ownership, and culture. In an ideal world, these compensation programs evolve purposefully over time in response to changes in the firm’s size, profitability, labor market conditions, and a variety of other factors. However, inertia is a powerful force: we often encounter compensation programs that made sense in the past but haven’t adapted to serve the firm’s changing needs as the business has grown in scale and complexity.Effective compensation programs need to change with the times, and the times have certainly changed. The RIA industry has seen tremendous growth over the last decade. As a result, firms today face increasingly complex compensation decisions that affect a growing list of stakeholders: outside shareholders, multiple generations of management, retiring partners, new partners, possible minority investors, and so on. On top of that, financial and labor market conditions have evolved dramatically over the last eighteen months, leading many RIAs to scrutinize their compensation models more than ever before.Introduction to RIA Compensation ModelsIt’s important to note at the outset what compensation models do and don’t do. Compensation models determine how the firm’s earnings are allocated; they don’t (directly) determine the amount of earnings to be allocated. When it comes to determining who gets what, it’s a fixed-sum game. The objective of an effective compensation policy is to allocate returns in such a way as to increase this sum over time.Compensation for RIAs can be broken down into three basic components, each of which serves different functions with respect to incentivizing, attracting, and retaining employees:Base Salary / Benefits. This is what an employee receives every two weeks or so. It’s fixed in nature and is paid regardless of firm or employee performance over the short term. On its own, base salary provides little incentive for employees to grow the value of the business over time.Variable Compensation / Bonus. In theory, variable compensation can be tied to specific metrics that the firm chooses or may be allocated on a discretionary basis. The amount of variable compensation paid to employees varies as a function of the chosen metric(s) or management’s qualitative analysis of an employee’s Variable compensation is also called at-risk compensation because all or part of it can be forfeited if target thresholds are not met. Variable compensation is most often paid out on an annual basis.Equity Compensation. Equity incentives serve an important function by aligning the interests of employees with those of the company and its shareholders. While base salary and annual variable compensation serve as shorter-term incentives, equity incentives serve to motivate employees to grow the value of the business over a longer period and play an important role in increasing an employee’s ties to the firm and promoting retention.Variable CompensationIn this blog post, we focus our attention on the variable compensation component (we’ll address the others in subsequent posts).Variable compensation plays an important role in incentivizing employees over the relatively short term (1-3 years). The evidence suggests that such incentives work, too. According to Schwab’s 2022 RIA Compensation Report, firms using performance-based incentive pay saw 28% greater AUM growth, 34% greater net asset flows, and 31% greater client growth over five years than firms without performance-based incentives.What Do You Want to Incentivize?As the name suggests, variable compensation changes as a function of some selected metric, typically revenue, profitability, or some other firm-level metric or individual-level metric, depending on the specific aspects that management intends to incentivize. Additionally, a qualitative assessment of employee performance across various areas may factor into variable compensation.In our experience, variable compensation pools tied to firm profitability and allocated amongst employees based on a combination of individual responsibilities and performance provide an effective incentive for most firms to grow the value of the business over time. Such structures tend to work well because linking variable comp to profitability creates a durable compensation mechanism that scales with the business and aligns the financial and risk management objectives of shareholders and management. Variable comp linked to profitability also promotes a cohesive team, rather than the individual silos that can arise out of revenue-based variable comp, which further helps to build the value of the enterprise.In market downturns, compensation mechanisms that directly link employee pay to firm profitability have the additional benefit of helping to blunt the impact of market conditions on firm profitability. Consider the example below, which shows the impact of a 10% AUM increase and a 10% AUM decrease for a hypothetical firm under two comp programs, one in which all compensation is fixed and the other in which there is a variable bonus pool equal to 20% of pre-bonus profitability.Click here to expand the image aboveIn this example, both compensation programs result in $4 million in EBITDA and an EBITDA margin of 24.6% in the base case scenario. In the downside scenario, however, the fixed comp structure leads to a high degree of operating leverage, and as a result, a 10% drop in AUM leads to a decline in EBITDA of over 40% and a decline in the EBITDA margin to 16.2%. Under the variable comp structure, the variable bonus pool helps to blunt the impact of declining AUM. In this example, a 10% decline in AUM results in a 32.5% decrease in EBITDA and a decline in the EBITDA margin to 18.5% under the variable comp program. In the upside scenario, the increase in EBITDA is greater under the fixed comp structure than under the variable comp structure (an increase of 40.6% vs 32.5%).From a shareholder perspective, a variable compensation program such as the one described above effectively transfers some of the risk equity holders bear to the firm’s employees. In downside scenarios, some of the decline in profitability that would otherwise accrue to shareholders is absorbed by employees. Similarly, some of the increase in profitability is allocated to employees in upside scenarios. The logic of such a compensation program is that employees are incentivized to grow and protect the same metric the shareholders care about—the firm’s profitability.ConclusionInvestment management is a talent business, and structuring an effective compensation program that allows the firm to attract, retain, and incentivize talent is critical to an RIA’s success. In future posts, we’ll address additional compensation considerations, such as equity compensation options and allocation processes.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.

Compensation models are the subject of a significant amount of hand-wringing for RIA principals, and for good reason. Out of all the decisions RIA principals need to make, compensation programs often have the single biggest impact on an RIA's P&L and the financial lives of its employees and shareholders.There are three basic components of compensation for investment management firms: Base salary/Benefits, Variable Compensation/Bonus, and Equity Compensation. We discuss these and more in this whitepaper.

Clients frequently want to know, “How long is an equity compensation valuation good for?” We get it. You want to provide employees, contractors, and other service providers who are compensated through company stock with current information about their interests, but the time and cost required to get a valuation must also be considered.Due to the natural business changes every company goes through, accounting and legal professionals often recommend updates at least annually if no significant change or financing has occurred.However, unique company or market characteristics often necessitate more frequent updates. Here are some of the factors to consider when determining the need for a valuation update:Significant changes in the company’s financial situationShift in overall strategyAchievement of business milestonesChanges in market or industry conditionsGain or loss of major customer accountsAdditional fundingIssuance of new equity compensationPotential for an upcoming IPOChanges in expectation as to the timing of an exit eventEven for companies that have fairly steady operations, the effects of small business changes accumulate over time. Companies that deal with major changes relatively infrequently may be suited to regular summary updates to supplement full comprehensive reports as a way to maximize the cost-benefit analysis of equity compensation valuation. Originally published in the Financial Reporting Update: Equity Compensation, June 2019.

Equity-based compensation has been a key part of compensation plans for years.  When the equity compensation involves a publicly traded company, the current value of the stock is known and so the valuation of share-based payments is relatively straightforward.  However, for private companies, the valuation of the enterprise and associated share-based compensation can be quite complex.The AICPA Accounting & Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, describes four criteria that should be considered when selecting a method for valuing equity securities:Going Concern.  The method should align with the going-concern status of the company, including expectations about future events and the timing of cash flows.  For example, if acquisition of the company is imminent, then expectations regarding the future of the enterprise as a going concern are not particularly relevant.Common Share Value.  The method should assign some value to the common shares, unless the company is in liquidation with no expected distributions to common shareholders.Independent Replication.  It is important that the results of the method used by a valuation specialist can be independently replicated or approximated using the same underlying data and assumptions.  When completing the valuation, proprietary practices and models should not be the primary method of determining value.Complexity and Stage of Development.  The complexity of the method selected should be appropriate to the company’s stage of development. In other words, a simpler valuation method (like an OPM) with fewer underlying assumptions may be more appropriate for an early-stage entity with few employees than a highly complex method (like a PWERM). With these considerations in mind, let’s take a closer look at the four most common methods used to value private company equity securities.Current Value Method (CVM)The Current Value Method estimates the total equity value of the company on a controlling basis (assuming an immediate sale) and subtracts the value of the preferred classes based on their liquidation preferences or conversion values.  The residual is then allocated to common shareholders. Because the CVM is concerned only with the value of the company on the valuation date, assumptions about future exit events and their timing are not needed. The advantage of this method is that it is easy to implement and does not require a significant number of assumptions or complex modeling.However, because the CVM is not forward looking and does not consider the option-like payoffs of the share classes, its use is generally limited to two circumstances. First, the CVM could be employed when a liquidity event is imminent (such as a dissolution or an acquisition). The second situation might be when an early-stage company has made no material progress on its business plan, has had no significant common equity value created above the liquidation preference of the preferred shares, and for which no reasonable basis exists to estimate the amount or timing of when such value might be created in the future.Generally speaking, once a company has raised an arm’s-length financing round (such as venture capital financing), the CVM is no longer an appropriate method.Probability-Weighted Expected Return Method (PWERM)The Probability-Weighted Expected Return Method is a multi-step process in which value is estimated based on the probability-weighted present value of various future outcomes.  First, the valuation specialist works with management to determine the range of potential future outcomes for the company, such as IPO, sale, dissolution, or continued operation until a later exit date.  Next, future equity value under each scenario is estimated and allocated to each share class.  Each outcome and its related share values are then weighted based on the probability of the outcome occurring.  The value for each share class is discounted back to the valuation date using an appropriate discount rate and divided by the number of shares outstanding in the respective class.The primary benefit of the PWERM is its ability to directly consider the various terms of shareholder agreements, rights of each class, and the timing when those rights will be exercised. The method allows the valuation specialist to make specific assumptions about the range, timing, and outcomes from specific future events, such as higher or lower values for a strategic sale versus an IPO.  The PWERM is most appropriate to use when the period of time between the valuation date and a potential liquidity event is expected to be short.Of course, the PWERM also has limitations.  PWERM models can be difficult to implement because they require detailed assumptions about future exit events and cash flows.  Such assumptions may be difficult to support objectively. Further, because it considers only a specific set of outcomes (rather than a full distribution of possible outcomes), the PWERM may not be appropriate for valuing option-like payoffs like profit interests or warrants. In certain cases, analysts may also need to consider interim cash flows or the impact of future rounds of financing.Option Pricing Model (OPM)The Option Pricing Model treats each class of shares as call options on the total equity value of the company, with exercise prices based on the liquidation preferences of the preferred stock. Under this method, common shares would have material value only to the extent that residual equity value remains after satisfaction of the preferred stock’s liquidation preference at the time of a liquidity event. The OPM typically uses the Black-Scholes Option Pricing Model to price the various call options.In contrast to the PWERM, the OPM begins with the current total equity value of the company and estimates the future distribution of outcomes using a lognormal distribution around that current value. This means that two of the critical inputs to the OPM are the current value of the firm and a volatility assumption. Current value of the firm might be estimated with a discounted cash flow method or market methods (for later-stage firms) or inferred from a recent financing transaction using the backsolve method (for early-stage firms). The volatility assumption is usually based upon the observed volatilities of comparable public companies, with potential adjustment for the subject entity’s financial leverage.The OPM is most appropriate for situations in which specific future liquidity events are difficult to forecast.  It can accommodate various terms of stockholder agreements that affect the distributions to each class of equity upon a liquidity event, such as conversion ratios, cash allocations, and dividend policy. Further, the OPM considers these factors as of the future liquidity date, rather than as of the valuation date.The primary limitations of the OPM are its assumption that future outcomes can be modeled using a lognormal distribution and its reliance on (and sensitivity to) key assumptions like assumed volatility. The OPM also does not explicitly allow for dilution caused by additional financings or the issuance of options or warrants.  The OPM can only consider a single liquidity event. As such, the method does not readily accommodate the right or ability of preferred shareholders to early-exercise (which would limit the upside for common shareholders). The potential for early-exercise might be better captured with a lattice or simulation model.  For an in-depth discussion on the OPM, see our whitepaper A Layperson’s Guide to the Option Pricing Model at mer.cr/2azLnB.Hybrid MethodThe Hybrid Method is a combination of the PWERM and the OPM.  It uses probability-weighted scenarios, but with an OPM to allocate value in one or more of the scenarios.The Hybrid Method might be employed when a company has visibility regarding a particular exit path (such as a strategic sale) but uncertainties remain if that scenario falls through. In this case, a PWERM might be used to estimate the value of the shares under the strategic sale scenario, along with a probability assumption that the sale goes through. For the scenario in which the transaction does not happen, an OPM would be used to estimate the value of the shares assuming a more uncertain liquidity event at some point in the future.The primary advantage of the Hybrid Method is that it allows for consideration of discrete future liquidity scenarios while also capturing the option-like payoffs of the various share classes. However, this method typically requires a large number of assumptions and can be difficult to implement in practice.ConclusionThe methods for valuing private company equity-based compensation range from simplistic (like the CVM) to complex (like the Hybrid Method). In addition to the factors discussed above, the facts and circumstances of a particular company’s stage of development and capital structure can influence the complexity of the valuation method selected. In certain instances, a recent financing round or secondary sale of stock becomes a datapoint that needs to be reconciled to the current valuation analysis and may even prove to be indicative of the value for a particular security in the capital stack (see “Calibrating or Reconciling Valuation Models to Transactions in a Company’s Equity” on page 6). At Mercer Capital, we recommend a conversation early in the process between company management, the company’s auditors, and the valuation specialist to discuss these issues and select an appropriate methodology. Originally published in the Financial Reporting Update: Equity Compensation, June 2019.