Option Methods to Value Profits Interests for Financial Reporting

So Scary❗ How Do They Work ❓

Relax. This Will Be Super Easy To Understand. No Complex Math.  Promise🤞

Information for CFOs and accountants in private equity.

Profits interests are the #1 equity-based incentive compensation in private equity.

To comply with GAAP, profits interests must be valued using special, complex, option methods.

These have ominous names like Black Scholes, Monte Carlo, and OPM Backsolve. Run away!!!

Ugh. Management is rarely familiar with these. Also why they need my help 😊.

But the real question is WHY are the results of these methods not the $0 basis management has for tax, cash, and 83(b) elections? What is going on here?

This definitely deserves an explanation.  Please - one that someone who is not a valuation expert can understand.

Read On

Take the example of any company in private equity that issues profits interests as incentive compensation to employees in exchange for services, designed to comply with safe harbor tax provisions.

Assume that if the company sold when the units were granted . . . under the capital structure and waterfall  . . . there would be no cash payout to the profits interests.

That’s the standard cash, tax, and 83(b) election basis for profits interests.

It’s an easy approach everyone likely understands. This is referred to as a “current value” method.

Sorry if I’m explaining what you already know. Had to set the stage.   

But An Option Method Is Different

An option method results in a value for profits interests that is NOT $0.😈

The difference is an option method considers:

>>> Possible increases in value of the company IN THE FUTURE.

>>> RISK AND UNCERTAINTY on the potential payout to the profits interests.

Ok, let’s see how this works . . . go hands on. Do an actual option valuation method.

Right here. Now.

Excited? Terrified? Unsure? Panic?

Stay with me. Breathe. You can do it. I believe in you.

Let’s Go!🚦

Take any typical private equity portfolio company. . .

1. Pick a time period to a potential exit. For example: 5 years.

2. Create any number of possible exit scenarios. Perhaps: High, Mid, Low.

3. Estimate an exit value (for total equity) of the company for each scenario. This is a little tricky. No right or wrong answer. Just hypothetical here.

4. Run the exit value through the waterfall to get the payout to the profits interests for each scenario. You know, after debt, preferences, things that would come first in a future exit.

5. Estimate the probability (a/k/a chance, possibility, risk) of each scenario. Yeah . . . I know, how can anyone do that? Just make it as sensible as you can. Maybe: High 75%, Mid 20%, Low 5%. Total of all probabilities must equal 100%.

6. Multiply the projected payout to the profits interest times the probability of each scenario. That’s #4 times #5 above. Call those “outcomes.”

7. Add up the outcomes from all the scenarios.  Done! 

An example of the calculation could look something like this:

The estimated value of the profits interests using this approach is the total of all the outcomes.

In the snip above, this is $2,450,000.

That's the estimate of the possible cash payout for the profits interests down the road.

You can change assumptions for scenarios, exit values, probability, or other items.

Agreed, no one can predict the future. The actual result is most certainly going to be different. This is just a way to come up with an estimate. Imagine the possibilities.

Congrats! 👏🏆

You’ve successfully completed an option valuation method. All it required was basic math – addition, subtraction, multiplication, percents, some assumptions. If you just pretended and followed along, that’s okay too.

BTW – the method we just went through is an actual legit option valuation method. It goes by a couple of mumbo jumbo names like . . . "PWERM" (Probability Weighted Expected Return Method) or "SBM" (Scenario Based Method).

Hold your horses though. This method was to demonstrate how option methods work.  Unfortunately, the GAAP police (apologies to accountants) won’t allow this as an acceptable option method for estimating the fair value of profits interests for financial reporting. Why that is . . it's a discussion for another day.⏲️

Hope this gave you a better understanding of how option methods capture the “potential” for future value of profits interests.

Will Drop With This

Hey, what would be different using one of the best practices option methods like Black Scholes, Monte Carlo, or OPM Backsolve?

Might not believe it, but it actually makes any nerve-wracking aspects of what you just went through way easier.

That’s in part because all the difficult guessing on things like future exit values, probability, or choosing scenarios is automatically taken care of and baked into the methods themselves.

And also way better because accounts will like it so much more.

Best, David          

For more than a decade, I'm the only expert I know 😊specializing in valuation and financial reporting for profits interests in private equity.

Follow, connect, DM, or “Request Services” to keep learning from me about the value of profits interests in private equity.

P.S. Tried to keep things simple here. This discussion is not intended to be comprehensive and cover all the details of a professionally recognized option method to estimate the fair value of profits interests for financial reporting. That's another conversation.