Four Key Considerations to Valuing Investments of Venture Capital and Private Equity Funds

Recently the American Institute of Certified Public Accountants’ private equity/venture capital task force issued Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (the guide). It provides practical recommendations and items to be considered by investment companies when estimating the fair value of their investments in portfolio companies.

The guide was issued to assist with the preparation and audit of financial statements in accordance with U.S. generally accepted accounting principals (GAAP), but it offers recommendations that could be applied to other financial reporting standards, such as international financial reporting standards (IFRS).

Among the items the guide suggests investment companies consider in the context of venture capital and private equity investments are:

• The importance of valuing investments from the viewpoint of a market participant;
• Matching the valuation methodology with the type of investment;
• Matching the valuation assumptions with the stage of development of the portfolio company; and
• Calibrating the conclusion to previous transactions.

Market Participants

The fair value definition prompts investment companies to consider the price another market participant would be willing to pay for the investment. Market participants in the principal market are independent, have a reasonable understanding of the investment and are able and willing to enter into a transaction. The guide suggests that in valuing the portfolio investment from the viewpoint of market participants, the investment company consider the following questions:

• What characteristics are important, from a market participant perspective, when pricing portfolio investments and companies? (e.g. What sector is the company in? What is the company’s stage of development? What experience does the management team have?);
• What is the required return on investment for market participants for portfolio investments with characteristics matching those of the holding?
• How long do market participants expect to hold comparable investments?
• Do recent transactions in securities of the portfolio company or similar companies offer relevant benchmarking information?

Types of Securities

Investment companies make their investments in different forms including debt, preferred shares, common shares, options and warrants.

It is typical for start-up companies to issue different classes of preferred shares, many with conversion features, to venture capital investors through multiple rounds of financing. The rights, privileges and preferences of each share type will influence the choice of the most appropriate valuation method. Typical rights, privileges and preferences that are considered when selecting the valuation method include preferred dividends, liquidation preferences, mandatory redemptions, conversion features, conversion ratios and participation rights.

Many of the securities in the capital structure of venture capital- or private equity-backed portfolio companies will exhibit non-linear payouts. In these more complicated capital structures, the risk of the business is allocated between the various investors according to their risk appetites (e.g. debt-like instruments to the most risk-averse and option-like instruments to those with the least risk aversion).

There are multiple methods available to value the securities and the enterprise as a whole for portfolio companies with complex capital structures. The methods include scenario-based methods, option pricing methods, the current value method and the hybrid method. The choice of method depends on, among other factors, the timing of the next liquidity event, the types of securities in the capital structure, and the likelihood of conversion for convertible securities such as preferred shares, options and warrants.

Life Cycle of Company

The guide also outlined the stage of a portfolio company’s life cycle as a key factor in determining the approach to estimating its fair value. For example, for a pre-revenue start-up company, a market participant may consider valuation methods that deal with the high level of uncertainty of the outcomes and the optionality of the securities in the capital structure such as scenario- or option-based methods. Whereas, for a mature profitable business for which an exit seems imminent, there may be much less uncertainty and a methodology reflecting higher certainty, such as the current value method, may be more appropriate.

Calibration

When transactions in the private portfolio company have occurred in the recent past, they often offer the best evidence of the value market participants place on an enterprise. If an investment company decides a transaction is relevant to the value of the portfolio company and/or the securities in its capital structure, a process of calibration would be undertaken to reconcile the transaction value with the concluded fair value. Considerations in reconciling the two values may include a comparison of:

• The rights and preferences of the investment company’s investment and the securities involved in the transaction;
• Any changes in the value of the underlying enterprise value, whether it be from changes in the economy, the industry or the business itself from the transaction date to the valuation date; and
• The assumptions used in estimating the fair value including timing, projections, discount rates and volatility.

To calculate the fair value of an investment for financial statement purposes, investment companies need to understand the characteristics and attributes of their portfolio company investments, as each situation is unique. A valuation professional experienced with portfolio company investments, such as a Chartered Business Valuator (CBV), will help navigate the complexities of determining the fair value for financial reporting purposes and bring efficiencies to the process.

For more information, contact Amanda Salvatori, Partner, Valuation Services, at 416.515.3852 or [email protected] or Quinn McDermid, Senior Manager, Valuation Services, at 416.613.3155 or [email protected].

AICPA Accounting and Valuation Guide; Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies; Released June 1, 2019; Prepared by the PE/VC Task Force

This article was co-authored by Quinn McDermid, Senior Manager, Valuation Services.