On-Demand: Alternative Investments Year-End Audit Planning Webinar Series Part II - Venture Capital Valuation Considerations

November 30, 2022

Join EisnerAmper and Empire Valuation Consultants as we review the key year-end audit planning strategies and take aways.


Transcript

Anthony Minnefor:Thanks Astrid. Hello everybody, and welcome to part two of our Alternative Investments Year-End Audit Planning Series.

Today's session will cover venture capital valuation considerations as we approach year-end. I'm joined today by Bill Johnson, CEO and Transaction Advisory Services Leader at Empire Valuation Consultants and Craig Ter Boss EisnerAmper Partner in our Corporate Finance Group. Both Bill and Craig help their venture capital and private equity clients and teams navigate challenging valuation issues, especially in today's turbulent market.

Today, Bill and Craig will be covering several important topics that VC managers and CFOs will need to bear in mind, including recent trends in VC markets, market participant pricing considerations, valuation considerations, allocation considerations, and key takeaways as year-end fast approaches. Bill, Craig, I'm going to kick things over to you.

Craig Ter Boss:Great. Thanks, Tony. Just want to cover some recent trends in venture capital markets. I cover a little bit on the fundraising side, some deal flow, exit activity, and a little bit with valuation. Keep in mind this data is through 9-30-2022. Anything that's happened in the last six weeks will not be reflected in these slides. In the US, the venture capital fundraising for the first three quarters of 2022 is 159.9 billion, which is higher than all of 2021. This is a new record. For the 20 months, the last 21 months through 9-30, the fundraising was 298.1 billion. But two points here to keep in mind. One is that although these are strong, 62% of that total that was raised only goes to 6% of the total funds.

Then also, just if we look at 2022, that 150.9 billion that was raised, the third quarter only raised 29.4 billion out of that number. The trend is to be seen for the fourth quarter, but obviously, the first two quarters of 2022 are much better than the third quarter. If we flip now to deal count, the estimated deal count in the third quarter of 2022 was a little over 3,000, almost 3,100, which is down about 35% from the quarter record that was in the first quarter of around 4,700 deals.

This is also, in the third quarter, it's the lowest count since the fourth quarter of 2022, where it's about 3,400, give or take. Also, keep in mind that quarter three had 43 billion invested in venture capital deals across all stages, which was a nine quarter low and off by 46% from the first quarter of 80 billion and off by 40% from second quarter of 72 billion. This year, instead of doing it by quarter, this just gives it on the annual basis. As you can see, 2021 was a record of 343.6 billion on almost 18,000 deals.

We're trending right now, clearly through the three quarters of 2022 at a much lower rate, both dollar wise and deal count wise. All right, so let's cover a little bit on the exit activity. There was only 14 billion in exit value generated across the first three quarters in 302 exits in the first three quarters of 2022, which is significantly lower than obviously 2021. Bill and I had a discussion a little bit about this, about talking a little bit about the unicorns, which it's only produced, in 2022, there's only 59 public listings. Last year in 2021, there were 303 DC back public listings, which generated 670 billion in exit value. Clearly the first three quarters of 2022 are significantly lower on the exit activity.

William Johnston:Yeah. I think it's not that the unicorns aren't there, it's just not the right market environment for them right now. There's a lot of companies, and I'm sure a lot of what I'm talking about, that are doing very well, but it's just a reflection of the market uncertainty why there haven't been a lot of IPOs.

Craig Ter Boss:Right? Yeah, I think clearly the stock market, it's much different in 2022 than it was in 2021, which has an effect. Again, this slide here is on an annual basis, and so far, it looks like 2022 will be probably a five year low, give or take, but 2021 stands out significantly more than even 2020. All right. Sorry about this slide. There's quite a bit of information, but if we just focus on the top part, the median, the impact of these exit conditions is going to soften the late stage for all of them.

But particularly if you look at the late stage VC, you can see that the median pre-money valuation is down from 100 million to 91 million. As we spoke in preparing for this, and Bill pointed out that that's through 9-30, the fourth quarter to be seen. But it's one of those things that yes, believe that the investors are a little bit less confident than they were in the market. But keep in mind that 2021 was an unusual year. If you look at the late stage VC, the average, the medium was 100 million, which is roughly 40 million above what was in 2021.

William Johnston:Yeah, I would expect there's some kind of lag effect there also with the 9-30 data. Obviously, these deals take some time to do due diligence and negotiate and things like that. Some of the more recent data probably doesn't fully reflect the lag effect of all that.

Craig Ter Boss:Yeah. Again, in this slide, whether they look at the median or the average, obviously the average pre pre-money valuations are significantly higher than the median. But again, the trend seems to be the same. All right.

William Johnston:Yeah. Just I wanted to add one or two more comments about that. I think we see a lot of market uncertainty in a lot of different ways. The markets are obviously more volatile, but there's also the issue with it can be even more challenging when you have an early stage company you're investing in, because you're trying to kind of understand how market conditions apply to your company or your investment. But some of these companies are doing very cutting edge things that the market hasn't been around for very long, and sometimes what they do is harder to understand and things like that. These trends are very useful, but then also what can be challenging is sifting through the data and finding what data's most relevant to your particular company in question.

Craig Ter Boss: Right. Yeah, good point. Thanks.

William Johnston:Then moving on, I'm going to kind of set the table here for the valuation discussion with a little framework. We're talking about, while the principles that do apply to for other purposes, generally we're talking about doing these for financial reporting purposes. The framework, fair value framework is ASC 820 and fair value is the price that would be received to sell an asset or pay you to transfer liability between market participants. A key concept, really, in general, with fair value is that you want to think about the market participants.

You want to think about, okay, there's all the fundamentals you considered, but who are the other market participants and would they consider the same things, the same? I would say most of the time you can make a strong argument that market participants would assume something similar. However, there can be exceptions to the rule. You just want to make sure that there isn't some kind of distinction between maybe some kind of intrinsic value that you see that other market participants might not.

Craig Ter Boss:Okay. Just, Bill, if you don't mind, for venture capital, do you see it more as a market participant, another fund, another venture capital fund, and less a strategic buyer than what you would see in private equity?

William Johnston:Well, yeah, that's a great question. I think there's no doubt that when you're talking about, for these kinds of businesses, it's going to be much more relevant and much more common to look at a financial buyer perspective versus an operating company or strategic buyer perspective, especially when you're at an earlier stage. Now, there can be exceptions. There are certain industries that maybe it's, I'm thinking of biotech where they might be more likely to get in at an earlier stage and all of that. But generally, I would say more financial buyers, until you get to a later stage where you're thinking about a liquidity event and everything.

Craig Ter Boss:Yeah. Okay.

William Johnston:Yeah, just continuing the point is that you want to just make sure that you're looking at it from a market participant standpoint, not anything entity specific. Most of the time you again can probably make a strong argument there, but there are times this comes up and you want to just make sure you have that squared away.

Craig Ter Boss:I guess with this one, in this slide here, when we talk about orderly markets, I guess, obviously it's very different for venture capital than say a fund that deals on level one assets or even a private equity fund. I guess the question is, what is the market here? As you pointed out, and I think it has to be kind of reinforced, is that there might be a different market for an earlier stage venture capital company than a later stage.

William Johnston:Yes.

Craig Ter Boss:Okay.

William Johnston:Yeah, yeah. I think that was a good question you had and you know, want to think about, you don't want to apply a one size fits all approach. That's a common problem we see at our firm that people do. They try to apply the same thinking, same methodology to every case, but you have to tailor it to the specific fact pattern you're dealing with.

Craig Ter Boss:All right, so let's go into valuation considerations. Obviously we just mentioned there's a big difference between an earlier stage company and a later stage company. We want to talk about that a little bit. We're going to talk about the use of the last round of financing or the most recent round as a benchmark for what something's another security may be worth, and then the concept of calibration. Just a little aside, years ago, when Tony and I were working on a client, we sat down with the GP and we talked about the difference between their perspective as an investor versus the founder of the company.

I think that what he pointed out to us at that time, and I think it probably still holds true today, is that the founders were more concerned about the valuation going up and showing to their employees for morale and other investors that it was going up where they were founder was willing up to give up control and incentives where the investor looked at it from a little bit different point of view. I think that obviously as this market appears to be cooling down, that trend will shift a little bit, where in the past I think you could argue that the investors, excuse me, that the founders had a little bit more control because they had more people chasing their companies higher valuations, where now it's probably shifting more to the investors.

I think the key point here is in this environment you have to understand what protection the investors want and what returns and what is going to be determined by that valuation. A couple things on this. Earlier stage companies, they tend to be the last round of financing because there's not really metrics, revenue might possibly not be a large number at that point. It might be building up the revenue base. They'll calibrate to each round as time goes on. For the later stage companies, we typically tend to see them start utilizing what we call the traditional valuation approaches, whether it's a guideline company approach or whether it's a transaction approach.

I think what's different in these types of valuations versus let's say a private equity is that in the precedent transaction method, that latest round is kind of a variation. It's actually in your own company. If you raise a series C round, can you calibrate what the series B and the series A round are worth compared to that C round? We get asked this quite a bit, I think Tony might want to, if you don't mind, agree or disagree, we get asked this question the most from people is, "How long can I use that latest round?" Is it nine months, is it 12 months, is it 15 months, is it three months? I think our answer is always, "It depends on facts and circumstances."

Anthony Minnefor:It depends.

Craig Ter Boss:I know Bill, that's one of the biggest valuations, right? It depends on tax and circumstances.

William Johnston: Yeah. I've seen that's something that gets punted around in the conversations and everybody probably has a good input on that. This is an area where you have to be as open-minded and as flexible as you possibly can with your thinking process. I mean, generally speaking, we don't like anything more than 12 months, but there can always be exceptions to the rule. One other thing I just wanted to say is for an earlier stage company, normally we're big fans of approaches like this kind of cash flow method and all that. We think they're very worthwhile.

But if you're an early enough stage company, the outlook is so speculative that to argue that forecast is as good or better indicator of value than a recent actual investment in the company, it's just a very difficult, I think, argument to make. For the earlier stage, why it might seem a little counterintuitive at first, we do place primary emphasis on that and not as it says here, when you're later stage, then you start becoming more of a business where it's easier to look at comps and look at forecasts, things like that. Not only is that Bill Johnston's opinion, but there's also AICPA guidance about stages of development for companies and what methods are most appropriate at what stage. Those are consistent with what we're talking about.

Craig Ter Boss:I just want to point out that when we talk about traditional valuation approaches, guideline company president transactions, I think venture capital will lose my experience. However, although it's enterprise value to revenue, that revenue is typically not a gap, what we call gap revenue. A couple things to keep in mind is if you're going to analyze recurring revenue, where some other metric, are you able to compare that to a public company, can you get the same amount of information?

I think that's why I was saying with the concept, and we'll go over a little bit more with the calibration concept is when we did our last round nine months ago or series B round and revenue was X and this is the value, or whatever revenue number metric you use, that implies some type of multiple. It may be you're just calibrating to prior rounds, calibrating to other similar companies that you can get public information on. I think it's a little bit different than private equity. I think the discounted cash flow method, I don't see as much, obviously in the earlier stage, the later stage we definitely start to see it more. But I think again, it's usually, in my experience, it's usually guideline companies in some type of transaction.

William Johnston:Yeah, that's a good point. It made me think of too, just tying together what you're saying that if you're doing valuations outside of the VC world, it's not as frequent to rely on something like a revenue multiple or thing. Sure it's something you might consider certainly, but in this world, looking at some kind of multiple of revenue can wind up being, because of the level of how speculative it is and everything, can be a key if you're looking at metrics can be one of the key things you look at.

Looking at a revenue multiple is pretty simple and easy to do. But as Craig was pointing out, if that's going to be one of the things that comes up a lot, you want to understand your company might not be following the gap. Then also within gap, there's different options you can have to report revenue, there's different income streams. Looking you have that revenue multiple, it's worth spending some more time sort of thinking about what that multiple means and how it's being looked at.

Craig Ter Boss:Sorry about that. I would say that for the last few years, the amount of fundraising, some of these companies that we looked at was pretty incredible. The latest round and some of the companies that we were looking at six to nine months prior. Two things I just want to bring up here before we really get into this is even the concept of the latest round is somewhat debatable.

What we saw were a lot of extensions of prior rounds. It was a series D round and then six months later was a D one, and then D two, D three, but in essence it was the same round just extended over possibly 18 months or 12 months or something. What we would do is say, okay, one of the biggest things is in this extension round were there any new investors? If so, what was the significance of their investment to that total round? I think that one of the biggest things that we dig in with the latest round of financing is understanding what prior investors came back, what new investors are, and the significance of everyone's investment and what is the significance of the total investment to the valuation of the company.

William Johnston:Yeah, I know I have a sigh of relief when I look through and I see there are new investors, because if you don't have that it can often just be a function of people putting more money in at the same price, because the business needs the capital and it becomes much more difficult to use that. That's definitely also one of the biggest things we look at too.

Anthony Minnefor:Yeah. We like that too on the audit side when we see the new money coming in. Otherwise, it strikes us as a stale financing when the original financing was done 18 months ago, two months, two years ago.

William Johnston: One other thing I'll just do with the existing investors, if it's just that I've found often there isn't nearly the same level of thought or due diligence or anything like that being put into that as say an initial investment. That's just another indication of what kind of process did you go through, the business needs more money and you're putting it in, or what kind of financial considerations you made and everything.

Craig Ter Boss:Right. Yeah, I think the top part of this slide says it is the latest round relevant in this environment. I think that looking at 12-31-22 valuations, obviously a couple months away, but we'll start to see a little bit if you raise money in April '22, or March, April, May, how do you calibrate that to now or can you, and so we look at that. Then the biggest thing I just want to bring up on the second part of this slide is are there different rights attached to new investments? We haven't seen it in a while, because we've been in a different market in the last several years where I would say, at least in my experience has been that every new round of financing has the same rights as the prior round. As Tony calls it, the Shark Tank method, we would see, okay, what's the fully diluted number of shares time's the latest price? That's what the company's worth.

William Johnston:That's how the media covers it too.

Craig Ter Boss:Yeah, that's how the media covers and that's the pre-money valuation. A lot of times we'll see advertisements that say, "Subscribe to our service. We do valuations of VC companies." A lot of times it's the fully diluted cap table times the latest round.

William Johnston:I actually think the media or shows like Shark Tank are good, they're entertaining, but they're actually good illustrations of some flawed valuation thinking. I've seen the show where somebody, it'll be an early startup and they'll be like, you want us to pay you two times revenue or something like that. Why would we ever do that? Well, for an earlier stage company that might actually be a pretty conservative multiple and everything. I think it's an example of applying maybe tech techniques you would apply to a traditional company that don't apply to an early stage one.

Craig Ter Boss:Right. I think what the point of this slide is going into later '22 and possibly 2023, is you possibly may see valuation flat or I don't know if you see them up per se, but I think a lot of people are expecting down rounds, and you might not see that. One of the reasons is because you can negotiate the same value as a founder of a company with a venture capital, but you might have to give up a tremendous amount of rights attached to that valuation. Valuation is one aspect of a VC audit. The other one we'll get into soon is the allocation of that value.

I think that the founders think of valuation and dilution and how it affects them and their employee morale where the investors tend to think about potential returns and how do they protect themselves on the possible downside of their investment if that happens. Again, I think you're going to see some flat valuations and I think you just have to peel back and say, "Okay, at what cost to the other investors and what cost to the founders?" All right. Again, just to talk about this concept of calibration, it's basically, again, I'm not going to read through the whole slide, but it's basically if you have a recent round, let's say nine months ago and you want to show that it's still relevant to the overall evaluation, you might use that and say, "Okay, at the time, nine months ago when we made this investment, this was the implied enterprise value to revenue multiple based on that raise."

Nine months later we still think that multiples are relevant for these reasons, but revenues increased 30%, 40%. You might be using that latest round not as your value, but a starting point to calibrate as to why you think it's worth more. Bill, just want to get your opinion on this. As far as the concept of calibration, do you see it or have you seen it used mostly in the later stage companies, and the earlier stage, just kind of keeping that last round, I guess more of a qualitative factor that affects that value?

William Johnston:Yeah, that's a great question. Personally, I think calibration done properly is useful for any kind of business. Now, it's a different exercise you're alluding to when you're talking about an early stage company. It's more challenging when you have a complex capital structure to look at market data and calibrate directly to that. But you can apply that concept to whatever the implied overall value of the company is and take a look at it that way. We feel when there's market uncertainty, it's very important to, in one shape or another, look at calibration.

One just another thing I wanted to mention about calibration is that we think it's very important to get as granular as you possibly can looking at specific... It's harder for an earlier stage company, but to the extent you're going to use this to try to look at data as relevant as you can find. It may not be a direct method, it may just be guidance that sort of assists you in kind of figuring things out.

But one example I'd just give quickly is very recently I saw two different retailers report results at the same time, and one was Lowe's and one was Target. Lowe's greatly exceeded expectations and Target greatly disappointed expectations, because they have two very totally different dynamics, which given the time we have, I won't get into here. If you just looked at a retailer's index or something like that to get an idea what happened in the market, you're probably not drilling down enough to understand what's going on.

Craig Ter Boss:Right. I would say, especially in the technology area, when you look at the different sectors, because most of the venture capital investments that we've seen the last few years have been technology, at least in my experience, and Tony can, if you've seen something different, let me know. But in the technology we have a lot of clients, what they'll do is they'll look at the overall technology area and then they'll look at, here's the comps and they'll peel it back, SaaS versus FinTech versus this, and then within that, peel it back on the size of the comparables or what they feel in the industry versus the subject company.

Because obviously, the stage of development and the size or as you point out affected the multiples considerably. I haven't seen anyone just, as you pointed out, just say, "Here's a retail index or here's an index and because it's down 40% I'm going to, or up 20% or whatever, I'm going to do that." But that's a good point, when you really get into it, there's a lot of different sectors and companies that affect that overall number.

Anthony Minnefor:And Craig, when they go through that, oftentimes we see the real applicable comps. There could be just one or two companies that when you peel back the onion.

Craig Ter Boss:Yeah, that's correct. One other thing that I have seen is kind of what someone referred to as the scorecard method, where they're looking at what other, for example with FinTech, they were looking at what other FinTech companies were raising money at the valuations, and if it was public information, what that revenue at the time, and they were kind of using that. It's a little bit different than a true public comp, but at that point, if the data's out there and it's pretty valid data, you can see that this is the implied valuation that this company and because they're in the same market space, they know possibly the revenue or they know that around the same size, service the same type of customers, and therefore they look at it as another way to, I would say, calibrate the overall market to that investment.

William Johnston:Yeah. I'm glad you brought that up because what I probably see that's more common is maybe people will look at a set and look at what the average, or the median, or anything. But one other just quick thing I wanted to mention too is remember when you go through that exercise that there's a presumption that if you identify one or two companies that those one or two companies are most applicable, then the odds are when you do something in the future, those one or two companies are going to be most applicable also. You want to just think about your current situation, but also longer term, are these the best ones to focus on?

Craig Ter Boss:Right. My experience the income approach is probably the least used, until obviously they get to a little bit of a later stage. Even then I would think that most of the times we see it's kind of as a sanity check, until the second point of the slide is that the value is also linked significantly to a possible liquidation event. We'll get into the allocation models next, but I think that that point right there, if it's linked to a possible liquidation event, we see this as not just an allocation model, but the probability weighted expected return.

If we do an IPO, it could be worth this. If it's M&A transaction, it's worth that. That liquidation event is typically a little bit difficult. The timing and the size of it's a little bit different, but quite frankly, the stock market kind of threw everyone, I think, a little bit for an unusual amount of valuation in the ideal market.

Anthony Minnefor:I think the other aspect is just sometimes financing are done, these young companies are, ideas are being financed. They don't have a built out finance team that can do real projections until the later stage. That's another element just in terms of the applicability of that method.

Craig Ter Boss: Sure. Bill, anything you want to add on the income approach or...

William Johnston:Yeah, yeah. I mean I agree with everything said, and I think the point of the earlier stage, it just frequently doesn't make any sense for many reasons, like you said. The second point, what I would just say is when you get near a liquidity event, it just requires you to put your thinking caps on more like in terms of what's going on. That could be considering other methods, but it could also be considering possible IPO or sales scenario outcomes and things like that. Whether it's a new method or something, it's really just looking at your thinking that should start changing when you get near a liquidity then.

Craig Ter Boss:Now we're just going to go into the allocation. Now, let's just take a step back. You have a value of a company, whether it's fully diluted times the last price, it's calibrated to some market comps. Now, that value has to be allocated. I would argue that the allocation of that value is probably more important than just coming up with a value, at least from an audit approach. I think that's where Tony and his team, we sit down and talk quite a bit about how that value gets allocated through the waterfall and what features in a security can affect that allocation.

William Johnston:Yeah, so I think we'll probably touch on the point a few times. I'll just quickly touch on it, but one of the most common, what I'll call misconceptions that we see is somebody looking like a, you have your value, you have your recent investment, but then looking at it's a fully diluted, everything is already converted in common. If you're in a later stage, that actually might get you near the right answer if you're later stage and everything, because the liquidation preference doesn't matter that much anymore, et cetera.

But earlier stage, you can actually do the modeling. The modeling shows that there are, besides maybe logic, the modeling shows that there is value to some of the features that the preferred get. We've seen a number of times where there can be a very large discrepancy in value, if you assume a fully diluted cap table versus actually looking at the different classes of securities. Here are some methods that one can consider. The first one is probably weighted, that's just basically a more simplistic scenario analysis where you might assume a small number of outcomes and then you apply probabilities to them.

This may be most relevant when you're very near a liquidity event and you might assume a liquidity event scenario and a non-sale, non IPO scenario and everything. But I've been doing this for a long time now, almost 30 years now, and earlier in my career, this method was much more commonly used. It's more intuitive and straightforward, but as time has gone on, it has used much less frequently than the second method, because the, and I don't know if Craig or Tony would like to comment on this, but from an audit standpoint, the probabilities are more difficult to support, don't reflect all possible outcomes.

Anthony Minnefor:Agreed. It's highly judgmental the different paths the company will take in the scenario analysis.

Craig Ter Boss:Yeah, I think that it's twofold, right? One is, if it's a transaction, what's the value obviously, and then the timing of that transaction. I think my experience has been when we sit down with clients and they say we have an offer on the table significantly higher than we have the current mark, some of that is, not to delve too much in another topic, but some of that's investment value versus fair value. It could be a strategic buyer that will pay a significant premium for that subject company that another market participant would not pay.

That's one aspect of it. The IPO market, if it's not something that's really open or happening in the next couple years, it's tough to model that factor in there. You have to look at what are your exit strategies and the timing of the strategies. Although it's not used as much, we do sit down with clients and say, "Okay, well you came up with a fair value." What is it? Most likely extra strategy and possible timing, but they may just do it overall as opposed to breaking into each component. I would say that I see this, I agree with you, I see this less, more than we saw a long time ago, but a long time ago when I saw this method personally, it wasn't as much in the venture capital, it was more in the, what I call the commercial space that we'd see it.

William Johnston:Yeah, that's true that it's more frequently used in the commercial space, but I'm probably sure it varies from case to case and everything like that. But we also use it more frequently in the financial space than we used to. But you're right that there's a difference in frequency in those two worlds and everything like that. But going to the number two here, so it's common when this concept is introduced for the first time to a client or something, there's some initial resistance, because the first approach is very intuitive and doing option modeling, it's a little less transparent in terms of basically what option modeling it's not clear, but what it does is it really projects out a very wide range of scenarios and outcomes and everything.

Then what the option modeling does is it takes those high volume of possible outcomes and it calculates when, say there's going to be a liquidity event in three years, in three years, it calculates a very, it's going to vary from case to case, but a very large volume of possible outcomes at the liquidity event date and what the payouts would be. Some of those outcomes are going to be success and some of those outcomes are going to be failure and some of those outcomes are going to be in between. This model also has its flaws and there's a cost benefit consideration and everything, but an advantage it has is that its inputs in my opinion, are more supportable in terms of the key inputs usually either through data or information from management and all. You can have some specific things to tie your assumptions to.

Then also, our observation is if you only assume a small number of outcomes, the first method does, you're setting yourself up to be much more likely to miscalculate if you only have a small number of pots. By having a larger range of outcomes of what could happen, that's another benefit of the method. Number three is something we mainly just see or use if you're very near a liquidity event. Then, that third method is just basically if you sold the business that day or near that day, what's the waterfall basically calculation? What goes to each class of securities? That's most relevant when you're very near a liquidity event. Then number four is just a combination of at least a couple of the methods above depending on what your fact pattern is.

Craig Ter Boss:Right. On number three, and correct me if I say this wrong, but the reason why it's a more appropriate use as an expected liquidity event is because in the scenario I'm giving, the valuation is significantly higher than the liquidation preferences. If it's non participating preferred, you have to make a choice, okay, do I ask for my liquidation preference or do I convert to common and cash out that way? In this scenario, I think the value of the company is so much higher than the liquidation preference, that you're obviously going to convert to common. Because it's happening soon, that waterfall is the most likely common and liquidation preference are not relevant in that. Did I say that correctly?

William Johnston:Yeah.

Craig Ter Boss:Just why I let Bill take the lead on this is, because he is better at this than I am.

William Johnston: I totally agree with you and I'm glad you said that, because it's not just being near the liquidity event date. You can do the modeling, and if you are, I don't have a magic multiplier that we use in these things, but say you're at, we do sometimes work with unicorn style ones, and say your liquidation preference, your values, what the liquidation preferences, the odds of that liquidation preference mattering is very minimal. You could probably go down lower, significantly lower on that multiple from what I said, where that would still be the case.

If you put it into the modeling, it'll also show there's only a minor, more minor difference in value and everything. On top of it being near a liquidity event, if you're not actually knowing when that's going to happen, but it's going to happen in the next year or two. If you're that what I'll call deepen the money in terms of the liquid, the value relative to the liquidation preference, then this is a method that's more... Whether you would use it or not, you'd have to think about more, but you're probably going to get a, whether it's the right method or not, would remain be seen, but you'd probably get an answer that is closer to what you'd get using the other method.

Anthony Minnefor:Right. I see it used quite frequently. The equity values determine that they'll run it through the waterfall.

Craig Ter Boss:Well, I think at that point, because the valuations are so significantly higher than when they invested, that's my experience too, that the determined equity value is so much higher that quite frankly, whether you use an option pricing model or use the current value method, the answers aren't wholly different. I think just to backtrack just the hair on the option pricing model, there's two ways that I've seen it. An example, a company raises a series C round at $10, and B was at $5, and A was at $1.

You could solve for based on everyone's liquidation preferences at that point in time, you can solve and see what solves for the price of the C at 10, and see what the B and A are worth. That was one way that we saw it. Then, another one is as the value grew of using comps or whatever, and so they would run it through an option pricing model to see what everything was worth, but you would get a different answer because it wasn't, sorry, the liquidation, the value wasn't significantly higher than the total liquidation value. It's a little bit different. Several years ago when people were interviewing Tony and I, potential clients, they would say, "What's your take on the OPM? Are you going to force us to use it?" We didn't factor.

William Johnston:I actually remember some of those conversations.

Craig Ter Boss: but it all depended on the stage of the company and how much higher the value was than the liquidation preferences.

Anthony Minnefor: Now Craig, you may recall we've seen situations where audit teams have used the OPM to audit valuation where the client may not have used the OPM, just as a sanity check in the background.

Craig Ter Boss:Sure. To see how different the current value methods are. Absolutely.

William Johnston:Yeah. I think one interesting thing about our different perspectives is, we're an independent valuation firm, we're not an accounting firm. The situations that we see are when the companies have already decided they want to use an independent valuation firm to do the work, where I'm guessing you see a mix of things and everything. There's a certain sample of ones that we're not seeing that you are.

Anthony Minnefor:Yeah.

William Johnston:It's interesting to hear what you see. I will say one other thing, talking about how great the OPM is, we see a high level of resistance from people wanting to use the OPM.

Anthony Minnefor:Sure.

William Johnston:It varies from case to case what we wind up doing there. Sometimes we do and we convince them. Other times you might have that liquidation preference issue, where the value's a lot higher and people think they can work around. Sometimes, I've heard like what you said earlier that there can be some kind of testing shadow calculations using the OPM. I do think that it's a great method, but in the daily world I live in, it's not like we just all agree that we should use it. It's just something to consider.

Anthony Minnefor:Yeah, look, you have venture capital firms with dozens of companies in their portfolio. It becomes a practical matter, I think, from their perspective.

William Johnston:Yeah.

Craig Ter Boss:Yeah.

Anthony Minnefor:It's viewed as a lot of work.

Craig Ter Boss:Yeah.

William Johnston:Yeah. I had one recently where they had only a small number of positions and they were more open to it.

Anthony Minnefor:Open to it.

William Johnston:Then once the number of positions increased significantly, then it was more, there's a practical aspect to it.

Anthony Minnefor:Right.

Craig Ter Boss: I think that as time, on this general comments, and the first one, I probably stole the thunder a little bit there, but as the value gets significantly higher than the liquidation preferences. The difference between the models is minimal. I think that we've seen clients that use an OPM to a certain point, and then they'll go to the current value method, because the equity value is significantly higher than the liquidation preferences. As Tony said, as the number increases.

You might have to bucket your investments and say, "Okay, these no longer probably need to be looked at this way for these reasons. These have to be looked at through the OPM for these reasons." Point three, no single method is superior others in all circumstances. I think that's probably the most critical thing here is you can't go in and say, "All must be looked at through an OPM or a hybrid or properly weighted or the current value method. You have to sit back and give a rationale as to what method you're using and why."

William Johnston:Yeah. One thing I will just say is I think you have to just be careful. Whether you use an OPM or not, you just have to be, when you're earlier stage, you just have to be careful that you're not looking at it too simplistically, and that the level of what you're overlooking is not too high and everything. You can get there some different ways and everything, but I think the earlier the stage, the more it comes in.

Craig Ter Boss:I think the last point on this slide is extremely important. Just want to cover it real quick, is that you have to look at the agreements and what model, is it participating versus not participating. You have capital structures where there's a mixed type of, some are structured and some are not. I think as we enter into possibly a new era, you might see more of the participating preferred investments come in and how do you model that compared to the non-participating? That may be something that we see. I think just real quick, some of the key takeaways.

Calibration, I think the venture capital world is extremely important that you are telling a story from period to period and you're linking that story based on whether it's a raise or some type of indication of value that you got and six months later, how does that tie to how you're valuing it at that point? Another thing, especially in the venture capital world, the qualitative factors, the milestones, did you hit those milestones? What were those milestones and how did you consider that in the valuation? I think it's extremely important.

The third point, just again, we hear this a lot and we get the subsequent events that help support the position at a measurement date. That could have been three months, four months earlier. Sometimes we get to minimize the event. I think all events should be taken into consideration and why you included some in may be excluded others in your analysis. Again, it's probably less relevant in the venture, but if you're using a precedent transaction and you're using comparable companies and you're getting wholly different answers, I think you need to reconcile that and address those outliers.

Then lastly, part of your valuation policies and procedures, are they clear? Are they transparent? If you diverge from those, how do you document that? I think that's extremely important in especially going into 12-31-22, where you might start to look at your comps differently, you might start to look at indication indices differently, and you might go from one method to another a little bit more. You're weighting might change, so it should all be documented.

William Johnston:Yeah. One thing I just want to, as we're getting near the end of this, it just take a step back. I think of all the different kinds of evaluations that we do, it's like I'm thinking of you're an early stage company investor and it has no revenue and there's already a high level of risk in everything and nothing's really changed specifically at the company. How do you reflect that and everything?

There's no one size fits all approach. There's a lot of reasons you could make arguments as to why some of these things aren't applicable or everything. But the one piece of advice I would give is that those are very useful to do, but whether it affects your conclusion or not, to address the fact that there's been a change in the market. What is the story here? The story might be that something's down, or it's unchanged, or it's up, but whatever your position is, you consider what's going on in the market and how you address that in what you're doing.

Craig Ter Boss: Tony, we have-

Anthony Minnefor:Yeah. Yeah. We've got some audience questions that have come through, a bunch of them, but let's at least get one addressed. I'll read it to you. It's, "How should we evaluate a company that did a large financing in 2021 has plenty of cash. It's performing very well in 2022 with solid revenue traction, but the relevant counts are down 20 to 30%. The comp analysis suggests we take a markdown, but that just seems wrong to do."

Craig Ter Boss:Well, I'll kind of just piggyback off what Bill just said. It's obviously a very pointed question and relevant, but I think that one of the things that, the first thing that we always ask, I ask a client, and Tony, you're there, you can, is, at the measurement date, would you underwrite the company at the same value that you did nine months ago, 10 months ago?

If not, how would you look at it? It might not be okay, the comps are down 20% and therefore 20. It might be that they look at it as we know that other companies in the industry are raising money at only 10% lower or flat, but the terms are different. I think you kind of just can't blindly say, "Okay, tech stocks are down 20%."

Anthony Minnefor: It's not mechanical. Yep.

Craig Ter Boss:You might refine your comps a little bit, you might look at it, but I think you have to look at the environment that you're in and what's happening generally and the exit activity in that sector. Are deals still being done in that sector at what implied values and can you get any multiples from that? Right?

William Johnston:Yeah. There's a lot of things. I don't think there's one answer to that question, but there's a lot of factors that can lead to different... If it's a unicorn or near unicorn or one of the higher end opportunities, people are going to be less impacted by short-term changes in the market and everything like that. That may be a case where you make an argument that you're not going to make an adjustment or anything for market conditions.

I think that another thing, this is a very simplistic comment, not based on complicated analysis like the other things, but my observation is, to some extent you kind of already know to some extent, from knowing the company, knowing the investment, knowing what's going on, knowing what the current market is, you already have an initial indication or thought about... To use that as your starting point and then go through the fact pattern, what's the story here and why did you assume this and that, given what's going on?

Anthony Minnefor:Guys, great discussion. I'm going to kick it back over to Astrid.

William Johnston:Great.

Craig Ter Boss:Thank you.

 

About Craig Ter Boss

Craig Ter Boss is a Partner in the Corporate Finance Group providing valuation services to public and private clients across a range of industries including consumer products, apparel, technology, business services and financial services.

About Anthony Minnefor

Anthony Minnefor is the Partner-in-Charge of the firm’s National Private Equity Services Group with experience in the alternative investment industry who leads engagement teams on audits of private equity and venture capital funds and funds of funds.

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