Q4 2020 - Addressing Venture Capital Valuation Challenges

December 14, 2020

By Gautham Deshpande

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There is very little need to emphasize the importance of valuations: Investors need to know the fair value of their investment; fund managers need to demonstrate their internal rate of returns (IRRs) and calculate accrued carried interest for financial reporting. If for some reason a venture fund operates under a regulated regime (advisor registered with the SEC), then they have the added obligation to comply with the custody rule. If a fund relies on distributing GAAP-based financial statements to investors to comply with the custody rule, incorrect valuations could potentially trigger non-compliance, as the financial statements would not be prepared in accordance with GAAP.

What Is Valuation Risk?

Simply put, it is the risk of incorrectly valuing an asset. Fair value under U.S. GAAP represents an exit price that would be exchanged between market participants (willing knowledgeable buyers and sellers). It is possible for market participants to have diverse opinions of fair value. However, such opinions tend to be within a stated range based on access to information. Practical challenges in valuation arise from: (i) lack of available information for a particular investment; (ii) using significant inputs or assumptions that are not supportable; or (iii) uncertainty relating to either the portfolio company or the macro-economic conditions in general.

Valuation challenges are unique to each investment firm and represent a combination of factors specific to the portfolio company being valued and macro-economic factors that impact the industry and the economy in general that affect the portfolio company. Entity specific factors include the type of investment (equity, preferred, debt), stage of investment (early stage, growth, mature), product lifecycle, revenue and profitability considerations. Macro-economic factors are related to the spending patterns and availability, total addressable market, and technological developments in the industry. Such factors are partly captured by recent transaction activity in the space and are represented by revenue, EBITDA and other common multiples. Venture capital valuations present unique challenges as the investments tend to be in early or pre-revenue stage enterprises (with limited information/data available) or the product/service that the enterprise is bringing to market could be a disruptive concept with very little or no precedent.

Addressing Valuation Challenges:

  1. Set up a consistent valuation framework: A robust valuation framework includes (i) adopting a well thought out set of valuation policies and procedures; (ii) establishing an internal valuation or pricing committee; (iii) maintaining good governance and transparency by involving a limited partner advisory committee (LPAC); and (iv) continuously monitoring the investment resulting in the availability of information to calibrate the valuation. Factors funds should consider while setting up or reviewing their existing valuation framework are investor and market expectations and trends and the commitments made to investors (through the limited partnership agreement, private placement or offering memorandum or investor letters).
  2. Obtaining information used in valuations: Revisit investment documents (share purchase agreements, convertible note agreements) and pay close attention to the information rights in there. Hopefully, firms have a clear path to obtaining information on a periodic basis from their investees. Obtain all relevant information required for valuation. If an investor is sizeable, then the agreements provide for information rights. If the fund is a minority investor, one can still ASK for rights. If such rights are not available, build a relationship with the lead investor or the individual who introduced the deal. Do it before investing.
  3. Valuation is an art and not a science: Everyone has heard this before!! Once information has been obtained, consider, assess and conclude on valuation and more importantly DOCUMENT the valuation rationale in a memo. A good memo provides both quantitative and qualitative information about the portfolio company and includes a discussion about the portfolio company’s background, initial valuation thesis, changes in fair value since the investment was made, and calibration based on the latest information available. It also discusses the valuation technique used and supports the key inputs that go into the valuation technique.
  4. Avoid extreme volatility. A portfolio company doesn’t go from cost to being valued 2X in a single day and similarly doesn’t go down to zero in a day/quarter. A venture capital fund manager knows if their portfolio company is a winner, and when it’s not. Most valuation challenges relate to portfolio companies that fall somewhere in between and where the path to exit is unclear. Fund managers can identify the trajectory and the trend of the portfolio companies to avoid extreme volatility. Calibrating the information obtained to evaluate the valuation and back-testing the accuracy to subsequent exits and/or funding rounds is a good validation of the valuation mark.
  5. Rely on knowledge from the last round of financing: The valuation challenge becomes relatively simpler if a portfolio company had a sizeable recent round of financing that was subscribed to by external investors. Obtain the details of the last round of financing from the portfolio company, including the share purchase agreement, the latest cap table and the most recent certificate of incorporation that provides information about liquidation and conversion rights, preferences and restrictions. Also, if a reasonable amount of time has elapsed since the last round, gather qualitative and quantitative information on the company’s progress compared to the investors’ expectations set prior to such funding.
  6. Should we use an Option Pricing Model (OPM) or the Probability-Weighted Expected Return Method (PWERM) to allocate fair value? Fund managers bring different perspectives. Some like the use of a quantitative model and will employ an OPM or PWERM to allocate the fair value amongst different classes of the capital stack and others like to use more qualitative inputs coupled with other data points. We believe that the answer depends on the facts and circumstances of each situation. If funds have the sophistication to use an OPM or a PWERM, or prefer to work with qualitative inputs along with other data points, they are encouraged to partner with an advisor who has expertise in assisting with these valuations.
  7. Collaborate: Funds should get a head start by identifying and discussing issues with their accountants early on. A first-year audit is more challenging than a regular audit. They should ask their auditors to review Q3 valuations as if they were the final year-end valuation and provide their comments. Accounting firms generally try to move work up from the typical busy season and will be more than willing to undertake valuation reviews before January. This makes it easier for all parties to update valuations.

To conclude, valuations depend on both qualitative and quantitative factors. Such information can be gathered from multiple sources. Once such information is obtained from a reliable source, using the data to calibrate valuations is the easy part.


OUR CURRENT ISSUE: Q4 2020

About Gautham Deshpande

Mr. Deshpande practice focuses on financial services, including audits of hedge funds, private equity and venture capital funds, commodity pools, real estate partnerships and REITS, alternate investment vehicles, and investment advisors.