Valuing Complex Securities:

What makes a security complex?

Complex securities combine features that make their economic outcomes conditional on future events. Examples include convertible instruments, preferred shares, options, warrants, and financing arrangements whose settlement depends on future funding rounds or other specified conditions. Different instruments within the same business can therefore have materially different risk and return profiles.

The complexity often lies in the interaction between provisions. A preferred shareholder may have priority over ordinary shareholders but also hold an option to convert into ordinary equity. A convertible instrument may produce different outcomes depending on whether the company raises capital, is sold, or reaches a repayment date. The valuation must consider these alternative paths and the contractual entitlements associated with each.

1.   Begin with the contractual economics

The first step is to understand what the investor actually owns. Subscription agreements, shareholdersʼ agreements, instrument terms, and the capitalisation structure provide the foundation for identifying economic rights and obligations. IPEV guidance specifically highlights liquidation preferences, conversion features, anti-dilution clauses, ratchets, guaranteed returns, and funding commitments as matters requiring consideration.

The review should establish:

•      The instrumentʼs ranking relative to other claims.

•      The conditions governing conversion, repayment, or redemption.

•      How proceeds are allocated following a sale or other liquidity event.

•      Whether participation rights are capped or uncapped.

•      How future financing or contractual adjustments could affect ownership and proceeds.

These provisions should be translated into a financial model of the relevant payouts. Ambiguous contractual terms should be clarified with legal advisers rather than resolved through an unsupported modelling assumption.

2.   Distinguish company value from security value

Estimating the companyʼs value and estimating the value of a particular security are related but distinct exercises. Where share classes have different economic rights, allocating value solely by percentage ownership may fail to capture those differences. IPEV guidance recognises the need for allocation approaches that reflect complex capital structures.

Consider a simplified illustration. An investor contributes 10 million for preferred shares representing 20% ownership on an as-converted basis. The shares carry a 1.0× non-participating liquidation preference: on an exit, the investor receives either its preference amount or its proceeds on conversion, whichever is greater.

This hypothetical example assumes sufficient distributable proceeds, no competing preferences, and no other adjustments. It illustrates the contractual payout at two possible exits—not the securityʼs present fair value. A valuation must also consider the uncertainty, timing, and range of potential outcomes.

3.   Select a method that reflects the instrument

The appropriate method depends on the securityʼs contractual features, the companyʼs circumstances, and the evidence available. IPEV guidance identifies option pricing, scenario-based analysis, and combinations of these approaches as relevant techniques for complex instruments and capital structures.

Option pricing methods

An option pricing method allocates equity value across classes by considering a continuous distribution of potential outcomes and the thresholds at which different securities participate. It can capture the economic value of junior interests even where those interests would receive little or nothing in an immediate distribution at the current equity value.

Scenario-based methods

A probability-weighted expected return method, or PWERM, evaluates discrete future outcomes. The analysis estimates the proceeds attributable to each security in each scenario, applies appropriate probabilities, and discounts expected proceeds using a suitably selected rate. [1]

Hybrid approaches

A hybrid approach combines scenario analysis with option pricing within selected scenarios. This can help represent a capital structure where some outcomes are best assessed individually while others require a broader distribution of possible values. The method should follow the economic features of the investment, rather than the convenience of a particular model.

4.   Calibrate to transaction evidence

A recent financing can provide important evidence, but its price should not automatically be applied to every security class. The rights attached to the instrument purchased—and differences from the instrument being valued—must be considered.

For IFRS 13 measurements, where the initial transaction price represents fair value and subsequent valuation uses unobservable inputs, the technique must be calibrated to that transaction price. Calibration helps establish whether the modelʼs inputs are consistent with the observed transaction. It does not justify leaving assumptions unchanged indefinitely; subsequent measurements must reflect conditions at the relevant measurement date.[4] [5]

5.  Test the assumptions that matter

Complex securities can be sensitive to assumptions about company value, volatility, exit timing, financing events, and the likelihood of alternative outcomes. Sensitivity analysis helps distinguish conclusions supported by a broad range of assumptions from those dependent on a narrow set of expectations.

Where IFRS 13 applies, valuation techniques should maximise relevant observable inputs and minimise unobservable inputs. The use of significant unobservable inputs also has implications for fair value hierarchy classification and disclosures. A sophisticated model does not remove the need to explain the evidence and judgement supporting its inputs.

Closing perspective

The central challenge in valuing complex securities is translating contractual rights into financial outcomes. A defensible conclusion connects the instrumentʼs terms, the underlying business value, the distribution of possible outcomes, and appropriate market evidence.[1]

Model complexity is not an end in itself. The objective is an analysis that faithfully represents the investment and makes the material judgements understandable.