What is the backsolve method and when is it used?
When there is a transaction in a company’s own securities, per the Equity Task Force guidance, we set out to estimate the value of the company as a whole using this data point. If the company has a simple capital structure (only common stock, for example), and many buyers and sellers transact in the company’s common stock, the value of the company would effectively be equal to the average value at which the value of the company trades hands, multiplied by the total number of shares.
However, if the transaction takes place in a class of security that has different rights and preferences than that of the security which we are valuing, there are certain adjustments that are needed in order to assess the value of the company. In short, in order to “back into” the value of the company, we need to make adjustments.
The backsolve method is effectively a market-based approach that is a reliable indicator of fair value for companies that have had a recent arm’s length transaction.
What is an Arm’s Length Transaction?
An arm's length transaction is one in which the buyers and sellers act independently and do not have any relationship to each other. The concept of an arm's length transaction assures that both parties in the deal are acting in their own self-interest and are not subject to any pressure or duress from the other party. It also assures third parties that there is no collusion between the buyer and seller.