“A rising tide lifts all boats” – Credited to John F. Kennedy
A corollary to this metaphor may be that a falling tide sinks all ships. Observance of daily high and low tides would prove this corollary incorrect, as ships do not sink at low tide and the sinking of a ship may be caused by a multitude of factors and circumstances. It may also be observed that a rising tide does not lift all boats to the same height. While the above-cited metaphor is commonly referenced in investment valuations, the impact of a low tide should additionally be considered.
The current environment in the financial markets compels the consideration of low tide in the valuation of private equity and venture capital investments as the funding landscape has experienced a shift in financing conditions and outlook over the past year. Venture Capital deal value in Q3 2023 fell to the lowest level since Q2 2018.[1] More companies are raising funds through bridge, continuation and down rounds, and there has been an increase in insider capital raises and a decrease in financing rounds with new lead investors obtaining a board seat.[2] This trend has been echoed in the private equity space with value through exits in US investments falling 26.4% and the realization of a decrease from peak value in 2021 of 73%.[3] For 2023, deal value decreased to the lowest point since 2017, outside of the COVID lockdown in 2020.[4]
PE and VC Fund management and the board of directors reporting their financial statements under Generally Accepted Accounting Principles (GAAP) may face unique issues in reporting the fair value of their investments in the context of these dynamics. Under GAAP, certain fair value determinations may be subject to audit review and potentially, review by the Securities Exchange Commission. The determinations of the fair value of many private equity and venture capital fund investments require Level 3 inputs, defined as unobservable inputs (FASB 820-20 Glossary), due to limited market information.[5] The Financial Accounting Standard Board’s Accounting Standards Codification Topic 820 Fair Value Measurement (hereinafter “FASB 820”) sets the stage for the determination of the fair value of these assets, commonly referred to as hard to value assets. FASB 820 establishes the definition of fair value as:
- Fair Value: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. (FASB 820-20 Glossary)
The element of “an orderly transaction between market participants” is essential to the definition of fair value with the following set forth definitions:
- Orderly Transaction: A transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale). (FASB 820-20 Glossary)
- Market Participants: Buyers and sellers in the principal (or most advantageous) market for the asset or liability that have all of the following characteristics:
- They are independent of each other, that is, they are not related parties, although the price in a related-party transaction may be used as an input to a fair value measurement if the reporting entity has evidence that the transaction was entered into at market terms;
- They are knowledgeable, having a reasonable understanding about the asset or liability and the transaction using all available information, including information that might be obtained through due diligence efforts that are usual and customary;
- They are able to enter into a transaction for the asset or liability; and
- They are willing to enter into a transaction for the asset or liability, that is, they are motivated but not forced or otherwise compelled to do so.
Fund Management Considerations
To secure a supportable fair value determinations as set forth in FASB 820, below are some relevant factors and issues fund management should consider and address in the valuation analyses of portfolio companies and their underlying investments.
- Capital structure changes and the impact on stakeholders throughout the capital stack, including equity capital raises at higher liquidation preferences, convertible and straight debt financings and additional SAFE note issuances.
- Pricing of secondary transactions. Secondary market activity has increased in 2023 as exit opportunities for private equity and venture capital investments through the public markets have lessened. Any secondary transactions for instruments identical or similar to the fund’s investment should be considered in fair value determinations.
- Bids, offers or letters of intent for the acquisition of the portfolio company and/or investment positions in the entity. This includes any bids or offers which the fund has received or solicited for the fund’s investment.
- Level of liquidity and capital available to execute the portfolio company’s business plan.
- Company financial and operational performance as compared to forecasted performance and as compared to industry peers.
- Projected investment exit path and timeline and changes since the investment origination and the prior valuation date.
- Projected timeline to the next capital raise and expected implied valuation.
- Evidence of new investor interest in the next capital raise or if it is expected that the next funding will be executed as an insider round.
- The impact of increased interest rates on the company’s cost of capital and henceforth, viable financing options.
- Trends in the market multiples of comparable publicly traded companies and merger and acquisition multiples in the company’s industry space as well as the level of M&A activity.
Each valuation situation is unique and while there are generally accepted valuation approaches and methodologies, each analysis and inputs to that analysis are bespoke and must be supported with quantitative and qualitative evidence. Fair value should be measured by a “valuation technique that maximize the use of relevant observable inputs and minimize the use of unobservable inputs.” [6]
[1] Pitchbook NCVA Venture Monitor Q32023, p.6.
[2] Ibid, p.3.
[3] Pitchbook 2023 Annual US PE Breakdown, p.4.
[4] Ibid, p. 8.
[5] AICPA Accounting and Valuation Guide, Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies, Section 1.8, p. 18 (2019).
[6] Ibid, Section 2.21 citing FASB 820-10-05-IC.