Recently, the Private Equity and Venture Capital Taskforce of the AICPA published an Accounting and Valuation Guide entitled, ‘Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies’. The purpose of this Guide is to help investment companies estimate the fair value of their portfolio company investments, consistent with market participant assumptions. Specific to venture capital and early-stage investors, the Guide addresses selection of valuation methodologies and assumptions, since “traditional” approaches may not be appropriate for the valuation of these early stage entities.
The Guide indicates that planning for, and performing valuations for venture capital and early-stage investments includes (but is not limited to), the following key considerations:
1. If there is a recent outside financing round, when is it considered reasonable to price all share classes at the same price per share?
This approach, based upon post-money valuation, assumes that the various classes of equity have the same value, and generally, that the expected distribution of performance outcomes of the portfolio company is bimodal. It is most commonly used with a simplified scenario analysis, where market participants would assume that the liquidation preferences have little to no value. However, in some cases, liquidation preferences matter, and the values of different classes of equity may vary significantly.
2. If a portfolio company isn’t generating revenue yet, is it considered reasonable to leave the value at cost, since I don’t know how the next round is going to price?
The objective of the fair value measurement is to reflect the exit price a market participant would pay, for the investment at the measurement date. Holding investments at cost may not be appropriate. A methodology based on calibration, using a valuation model consistent with the investment’s entry price, is used to update inputs reflecting company-specific progress and current market conditions, at subsequent valuation dates.
3. What methodologies should management consider when there has not been a recent financing round, relative to the current valuation date?
For early stage companies without a recent financing round, valuation methodology would involve a technique that calibrates the value obtained from a previous financing round that reflected fair value. Each valuation will depend on specific facts and circumstances. Several key considerations related to the selection and application of appropriate valuation methodology and assumptions include:
4. Is a ‘waterfall’ method of equity allocation, also known as the current value method, considered reasonable in all circumstances, regardless of the complexity of a portfolio company’s capital structure?
If the fund’s interests have seniority over the other interests in the capital structure, and these rights include the right to effectuate a sale of the company on the measurement date, then the current value method may be considered reasonable. For complex capital structures, where market participants would assume that liquidation preferences would not have a material impact on the ultimate payoffs received, it also would be reasonable to allocate the equity value through a current value method. In cases where the distribution of potential outcomes includes scenarios in which the senior classes of equity will benefit from contractual rights and preferences that are superior to those of the junior classes of equity, it would be appropriate to use a valuation method that is designed to capture such differences, such as an analysis through an option pricing model or a lattice model.
Author: Michelle Keyes, ASA | firstname.lastname@example.org