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

December 12, 2022

By Eric MacMillin

Recent Trends in VC Markets

One year after a record amount of venture capital fundraising deals, valuations and exits in 2021, market volatility and uncertainty has led to a decline in activity through Q3 2022. According to Pitchbook’s NVCA Monitor, of the $150.9 billion year-to-date (“YTD”) venture capital fundraising deals through Q3 2022, the majority occurred in Q1 and Q2, with only $29.4 billion of the total taking place in Q3. The average and median pre-money venture capital valuations have declined through Q3 2022 and are expected to continue to decrease through the end of 2022. Exit activity through Q3 2022 is significantly lower than 2021, and the expectation is that the amount of 2022 venture capital exits will be near a five-year low.[1]

In light of these trends, the following topics were discussed in a recent webinar titled “Alternative Investments Year-End Planning Webinar Series Part II – Venture Capital Valuation Considerations” by the following panelists:

  • Craig Ter Boss, Partner, EisnerAmper;
  • William Johnston, CEO, Empire Valuation Consultants; and
  • Anthony Minnefor, Partner, EisnerAmper

Market Participant Pricing

ASC 820-10-20 defines fair value as “the price that would be received to sell an asset… in an orderly transaction between market participants at the measurement date.” Fair value is based on an “exit price,” not the transaction or entry price. The panelists discussed the exercise of identifying who the most likely market participants in venture capital are. A common issue in performing this analysis is the use of a “one-size-fits-all” approach to determine market participants, whereas the exercise should be tailored specifically to each fact pattern. The panelists also agreed that this exercise is typically more relevant to perform from a financial buyer perspective versus an operating company or strategic buyer perspective, especially when evaluating an earlier-stage venture capital-backed company. Generally, there will be more financial buyers until a venture capital-backed company is in its later stages and looking at a liquidity event.

Valuation Considerations

In the case of an earlier-stage venture capital-backed company that hasn’t yet developed financial metrics such as revenue or EBITDA, valuations tend to be based on the last round of financing, and as time passes, the calibration to each round. When using the latest round, the panelists discussed the importance of considering if the round is still relevant in the current environment, who is investing in the round and determining if there are any different rights or preferences attached to it.

As companies mature into their later stages and begin to develop metrics, it is at this point when more “traditional” valuation approaches begin to be utilized, such as a guideline company or transaction approach or a discounted cash flow method. A question the panelists noted they often receive is “how long can the latest round be used?” They discussed the importance of being open-minded and as flexible as possible in the thinking process around this. For example, the outlook of an earlier-stage venture capital-backed company could be so speculative that it may be difficult to argue that a discounted cash flow model’s forecast is a good or better indicator of value than an actual recent investment in the company. As companies mature, it becomes easier to look at comparable public companies and forecasts and to utilize a more “traditional” valuation approach.

Calibration is a process that uses observed transactions in a company’s own stock to ensure that the valuation techniques used to value the investment on subsequent measurement dates begin with assumptions that are consistent with the more recent observed transactions. At subsequent measurement dates, these input assumptions, multiples of revenue or EBITDA, discounted cash flows or nonfinancial metrics are updated to reflect changes in the investment based on the company’s performance and market considerations. The panelists discussed the importance of being as granular as possible and obtaining relevant data to analyze when performing the calibration process.

Allocation Considerations

Once the valuation of a company has been determined, it must be allocated through the company’s equity waterfall, considering features of a security that could affect the allocation. The panelists discussed a common allocation misconception that could lead to an unreliable estimate: calculating the equity allocation on a fully diluted basis without considering the different classes of securities and their features. The panelists continued their discussion of four methods used to allocate enterprise value, including the advantages and disadvantages of each: (1) the probability weighted expected return method (“PWERM”), (2) option-pricing method (“OPM”), (3) current value method, and (4) a hybrid mix. No single method is superior to the others in all circumstances, and in every case the specific facts and circumstances surrounding the company in selecting the most appropriate method(s) should be considered.

Key Takeaways

The discussion concluded with four key considerations: (1) re-emphasizing the concept of calibration to link the current valuation to prior analyses and the initial investment thesis; (2) considering qualitative factors, not just quantitative analysis, in determining the fair value of the investment; (3) being able to reconcile the levels of values from multiple approaches, including addressing any outliers that would result in a vast range of values and (4) stressing the need for transparency of valuation policies and procedures, consistency in the their application and documentation of any divergence from them. There is no “one-size fits all” approach for a company or industry; each valuation has its own unique circumstances to consider.

The webinar can be viewed here.

[1] https://pitchbook.com/news/reports/q3-2022-pitchbook-nvca-venture-monitor?utm_source=google&utm_medium=cpc&utm_campaign=Library-Download-US&adgroup=Library-Download-VC&utm_term=nvca%20venture%20monitor&device=c&utm_content=&_bk=nvca%20venture%20monitor&_bt=476109960438&_bm=p&_bn=g&_bg=111954882653&kwdaud=kwd-1023760333171&sfid=mfVRPQZ4-dc_pcrid_476109960438_pkw_nvca%20venture%20monitor_pmt_p_slid__productid__pgrid_111954882653_ptaid_kwd-1023760333171&gclid=EAIaIQobChMIw-e93qTl-wIVluDICh3MjQL6EAAYASAAEgJ8cfD_BwE

About Eric MacMillin

Eric MacMillin is a Financial Services Group Audit Manager focusing on private equity, venture capital hedge funds and broker-dealers.