Valuing Early Stage and Venture Backed Companies

CHAPTER 5

Application of the Probability-Weighted Expected Returns Method in Allocating Enterprise Value

The probability-weighted expected returns method (PWERM), also known as the scenario method, is rooted in decision-tree analysis. In implementing the PWERM, potential future outcomes such as sale or merger, initial public offering (IPO), dissolution, or continuation as a private company are modeled and probability weighted. The PWERM is the most appropriate allocation method to use when management can reasonably predict potential future outcomes or returns are expected to include large “spikes” as value-creating events occur.

As an allocation model, the PWERM also has conceptual merit and has greater transparency than the option-pricing method (OPM), in that the consideration of the proceeds of each equity class at the date in the future those rights are expected to be exercised or abandoned is observable. Similar to the OPM, the PWERM is forward looking; it incorporates potential future economic events and outcomes into the determination of value as of the valuation date.

The PWERM, however, also has several weaknesses. This methodology can be complex and costly to implement. Whereas the OPM requires only five inputs (many of which are arguably merely “best guess” assumptions), a PWERM requires a number of assumptions about future outcomes that, realistically, are simply unknowable as of the valuation date. These assumptions are often based only on management estimates and, ...