Josh Schaeffer, PhD
Managing Director, Valuation & HR Advisory Services
articleClient Story
Equity Methods Delivers Integrated Equity Award Valuation and Reporting for a Real Estate Fund Manager with a Complex Payout Structure
Our client, a private equity-backed real estate investment fund manager, had equity programs with a complex payout structure. One complicating factor was that awards had idiosyncratic terms that differed by grantee, including a promote fee resulting in a second class of shares to ensure that employees and other holders were paid returns based on the returns of the overall fund. Several other complicating factors were present as well. Values differed between units based on when an employee joined the company. Some awards had time vesting provisions, while others vested only in the event of an IPO. Finally, non-employees received awards as well, necessitating mark-to-market valuations. In short, there were a lot of moving parts to this firm’s equity award valuation and reporting.
The Challenge
Three different parties managed our client’s valuation and reporting process. The accounting department handled financial reporting. Outside legal counsel housed the award agreements. Finally, an external vendor provided valuations of the equity awards. The handoff between parties was an issue, placing the accounting department at a constant information and transparency disadvantage. Not all awards were tracked in a timely fashion. Retention-driven sweeteners resulted in numerous award modifications, which also were not discovered until the eleventh hour. The existing valuation model omitted basic elements of the company’s business, including key features of its class B shares. This forced the accounting department to repeatedly make ad-hoc adjustments for external reporting purposes, resulting in painful spreadsheet dependence. In short, our client was dealing with a disjointed process that required too much intervention – and still had controls problems. Our client needed a solution that simplified the reporting process across functions.
The Equity Methods Solution
Equity Methods worked closely with the company to overhaul the valuation and reporting of its equity awards. First, for the multiple classes of equity ownership, we developed a valuation model that allowed for adjustments to different equity grantees based on individual award terms. Next, we performed valuations for non-employee awards and set up a way to handle the ongoing mark-to-market requirements. We also calculated an appropriate discount for lack of marketability to adjust the award value based on the fact that holders were unable to sell. To eliminate the need for ad-hoc and on-top adjustments, we incorporated all award features into the valuations. For better clarity and auditability, we introduced a granular, bottom-up approach that tracked awards at the person level. We created various custom reports, such as one that illustrates the terms and status of every award issued within the numerous funds. Then we created a controlled means to capture award modifications and apply the incremental cost over the remaining vesting period.
With the upgraded reporting approach in place, we looked at ways to eliminate ongoing manual work. Commercial off-the-shelf applications turned out to be ill-suited for our client’s complex profits interest framework and periodic modifications. So, to enhance repeatability, we automated the process in our own technology environment. Finally, we worked with our client to communicate the underlying methodologies and controls framework to the external auditor.
The Equity Methods Impact
Because of these efforts, our client was able to:
- Free senior resources for higher-value work
- Take a more proactive approach toward reporting via heightened visibility into the terms and events affecting awards
- Eliminate spreadsheets and ad-hoc adjustments, which in prior periods had led to errors and costly fire drills during the audit process
- Strengthen internal control over financial reporting, thereby reducing risk during a key period of IPO readiness preparation
- Gain expertise and exposure to common industry practices during a time of rapid growth and change at the company
Today, our client continues to benefit from a modern equity award valuation and reporting process that provides integration, automation, and accountability from one end to the other.
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