Finance chiefs in special purpose acquisition company (SPAC) mergers can play a role in the valuation accuracy of the warrants attached to their companies' shares, a valuation specialist says.
Although warrant valuations involve modeling that tends to be too complex for many internal finance teams, CFOs can help ensure valuations provide an accurate representation of volatility risk by taking the lead on selecting the comparables used in the modeling, says Louisa Galbo, managing director of complex securities at Duff & Phelps, a Kroll company.
“If you're a company that’s about to be acquired by a SPAC, you have influence over some of the [assumptions] involved in setting the fair value of the warrants," Galbo told CFO Dive.
Warrants are fractional instruments sponsors typically attach to SPAC shares as an added inducement to investors. After the company goes public, the warrants give investors the option to exchange them for more shares.
Companies have traditionally accounted for the warrants as part of the equity investment, but earlier this year, the Securities and Exchange Commission (SEC) said they should be treated as liabilities.
New warrant rules
The SEC’s reasoning centers on the redemption risk the warrants pose. To the extent investors exercise their redemption rights, companies would be on the hook to make good on the obligation, making the warrants a liability that must be valued on a quarterly basis.
The frequent valuation requirement is considered burdensome — and expensive — because of the complexity of the modeling. Unlike valuation requirements for other types of instruments, the warrants tend to require the use of arcane simulation models, like Monte Carlo or binomial tree, that tend to be too specialized for in-house finance teams. Monte Carlo uses an element of randomness in the valuation while binomial tree sets valuation over a period of time rather than at a single point.
There’s no legal reason why a company’s own team can’t do the modeling, but with the possible exception of very large operations, most companies have little incentive to maintain such specialized expertise in-house.
“It’s so specialized that it’s not needed on a daily basis to run a business, so that’s why that skill set is usually not acquired in house,” Galbo said.
Creating a valuation roadmap
For most SPAC deals, the sponsor or the target company will contract with a specialist firm to do the valuation, putting the process outside of the finance chief’s hands. But the valuation firm can benefit from the finance chief’s input on comparables, whether the valuation looks at other warrants or publicly traded companies.
The goal is to find comparables that accurately reflect the lowest possible volatility level of the target company’s warranty valuation.
“The volatility can be looked at either by looking at publicly traded warrants or looking at the publicly traded comparable company volatility,” Galbo said. “So, for example, if you are a software company being acquired by a SPAC, you can [simulate] volatility by looking at the comparable publicly traded software company volatility and use that as an indication of the appropriate volatility assumption [of your company] as well.”
Finance chiefs can also be assertive in getting the valuation firm on board as early in the process as possible, especially given the SEC’s focus on warrant accounting. Many companies are having to go back into their books to restate the warrants as liabilities after originally treating them as equity, adding to a sense of urgency to move quickly on these valuations.
“You want to get the valuation team involved earlier so that it doesn’t become a last-minute scramble,” she said. The typical valuation time is two or three weeks, but firms have been working hard to compress that.
“Since the SEC came down, we have built an infrastructure that enables us to turn around these very fast, so it can take a week or sometimes shorter, if necessary,” she said.
