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Breakpoints: the map behind equity valuation

A breakpoint is a company value at which the split of each additional dollar changes. Lay them end to end and you have a map of the whole waterfall. The same map is the starting point of the option pricing method used to value private-company equity.

What a breakpoint is

Imagine the company's equity value rising from zero. At first every dollar goes to the most senior preferred class, until its preference is covered. That is a breakpoint: from there, the next dollar goes to the next class. Further up, a non-participating class finds converting pays more, and joins the common. Later, options come into the money. Between any two breakpoints, every extra dollar is shared in fixed proportions.

That is the whole waterfall of the small company in our first guide, written as three tiers.

Why valuation professionals care

When a company has several classes of equity with different rights, one valuation of the whole company does not tell you what each class is worth. A share of preferred and a share of common are different claims. The option pricing method (OPM) treats the equity as a series of call options on the company's value, with the breakpoints as the strike prices:

• Each tier between two breakpoints is a call spread: the right to the value between the lower and the upper breakpoint.
• Each class's value is the sum of its share of each tier, using the percentages from the table above, with each call spread priced using an option pricing model such as Black-Scholes, given a volatility and a time to a liquidity event.
• The classes' values add up to the value of the equity.

Back-solving from a transaction

The method is often used in reverse. A recent round of preferred stock at a known price gives one observation. The valuer finds the total equity value that makes the model's value of the preferred class equal the price actually paid, a back-solve. That calibrated equity value is then used, with the model, to value other classes, including common stock, at a later date. Because the model's class values depend on the breakpoints, getting them right is the foundation of the whole exercise.

What can go wrong

• Missing a class. Leaving out a warrant or a SAFE changes the tiers and every class's value.
• Wrong preferences. Dividends that accrue, or a multiple above 1x, move the breakpoints.
• Interacting terms. A capped participating class has two breakpoints (where it reaches its cap, and where it converts). A warrant exercisable into a preferred series can come into the money inside that series' preference tier.
• SAFEs and notes. Their conversion depends on the price, so the tiers they create shift with the exit.

This guide is a general introduction, not a valuation methodology or advice. Valuation assumptions such as volatility and time to liquidity require professional judgement.