The New Valuation Guidelines for Venture Capital and Private Equity
For those who missed the new IPEV Valuation Guidelines introduced in Dec 2018, here are the highlights.
The objective of these guidelines is to set out best practice where VC and PE investments are reported at ‘Fair Value’, to standardise the approach worldwide and hence to help investors make better economic decisions.
The most important change is the separation of the basis of valuation, which defines what the carrying amount purports to represent, a Valuation Technique, which details the method or technique for deriving a valuation, and inputs used in the Valuation Technique.
Most fund managers are required 1) to develop their own valuation methodology and documentation for each investment, 2) to have a valuation committee or external experts evaluating their approach, and 3) to backtest the new methods on portfolio investments.
The concept of Fair Value is an artificial construct, only developed in the context of accounting:
- it is the price that would be received to sell an asset in an Orderly Transaction between Market Participants at the Measurement Date
- it is a hypothetical transaction
- interest in the investment must be attributed correctly including options, warrants, and liquidity preferences
- it does not assume that the Shareholder want to sell the assets
- for unquoted companies, it is assumed that the returns are realised
- it is assumed that the transaction consummation starts before and finishes on the Measurement Date
- it must be broken into units of account (e.g. shares)
For PE and VC Investments, the value is generally realised through a sale or flotation of the entire Investee Company, rather than through a transfer of individual shareholder stakes. The value of the business as a whole (Enterprise Value) at the Measurement Date will often provide a key insight into the value of Investment stakes in that business.
The fact that we are dealing with an intrinsically forward-looking and subject sector makes the valuation process substantially more complex.
Change of Valuation Technique
One of the hardest tasks placed on fund managers in the VC and PE space is the integration of separate Valuation Techniques, such as DCF, DDM, Revenue, EBITDA, Net Profit multiples, or comparables analysis.
It must be applied consistently throughout the portfolio for similar investments.
It should be appropriate in light of the nature, facts and circumstances of the investment and in the expected view of Market Participants.
What should the fund manager consider when selecting a Valuation Technique?
- the relative applicability of the techniques used given the nature of the industry and current market conditions
- the quality and reliability of the data used in each Valuation Technique
- the comparability of Enterprise or transaction data
- the stage of development of the Enterprise
- the ability of the Enterprise to generate maintainable profits or positive cash flows
- any additional considerations unique to the Enterprise
- the results of testing (calibrating) techniques and inputs to replicate the entry price of the Investment
A market approach based on Revenue, EBITDA and Profit multiple techniques and benchmarks are preferred, although the comparable data may not be available.
This cannot be more obvious in the early stage portfolios, pre-series A, where comparable data is limited, nor is performance data complete or able to satisfy the intrinsic requirements of highly used techniques.
Fund managers must use one or more techniques to derive the Fair Value of each portfolio investment.
Early stage portfolios include at times pre-revenue, mostly loss-making entities, and perceived value sits somewhere outside the company, in the market. Technology is in most cases undeveloped, still in some R&D stage, thus cannot be priced in any meaningful way.
A change is justified in the following circumstances:
▪ The stage of development of the Enterprise changes (from pre-revenue to revenue to earnings)
▪ New markets develop
▪ New information becomes available
▪ Information previously used is no longer available
▪ Valuation Techniques improve
▪ Market conditions change
A Valuation Prescribed Process
Larger late-stage funds have a clear advantage, as most investments would be rationalised and valued on existing performance data as well as the forward-looking market considerations.
The early stage funds will, however, be left with more work trying to find a way to place a round shape in a square hole. Market valuations have gone up as different types of investors have flooded the market with capital. It has also led to irrational exuberance. It now leads to a wake-up call for some investors, who cannot justify their initial valuations, nor have enough data for any of the techniques presented above, now find suitable market comparables.
Price of Recent Investment is not a default
The guidelines prescribe a process for all non-believers to convert, however, there are flaws:
- Determine the Enterprise Value of the Investee Company using the Valuation Techniques
- Adjust the Enterprise Value for factors that a Market Participant would take into account such as surplus assets or excess liabilities and other contingencies and relevant factors, to derive an Adjusted Enterprise Value for the Investee Company
- Deduct from this amount the value, from a Market Participant’s perspective, of any financial instruments (venture debt) ranking ahead of the highest-ranking instrument of the Fund in a sale of the Investee Company. There are many scenarios where debt is either paid (substrated from EV) or converted.
- Take into account the effect of any instrument that may dilute the Fund’s Investment to derive the Attributable Enterprise Value
- Apportion the Attributable Enterprise Value between the Investee Company’s relevant financial instruments according to their ranking
- Allocate the amounts derived according to the Fund’s holding in each financial instrument, representing their Fair Value
A Calibration Exercise
The investor must at all times act prudently, considering the external market factors which can influence its estimation of the EV and subsequently the Fair Value. this The following are key considerations when estimating Fair Value using Market Participant perspectives:
- Fair Value should be estimated at each Measurement Date, each time Fair Value based Net Asset Value (NAV) is reported to investors
- The Price of a Recent Investment (if deemed Fair Value) should be used to calibrate inputs to the valuation models
- Calibration is required by accounting standards
- Backtest using the new valuation process and techniques
- The impact of the lack of liquidity
- Industry benchmarks for valuation
- Blockage impact and discount (significant stakes)
- the size and diversity of the entities and, therefore, the ability to withstand adverse economic conditions
- the rate of growth of the earnings
- the reliance on a small number of key employees
- the diversity of the product ranges
- the diversity and quality of the customer base
- the level of borrowing
- any other reason the quality of earnings may differ
- the risks arising from the lack of Liquidity of the shares.
- Reconcile the difference between market multiples and comparables
- Market Participant perspectives should be used to estimate Fair Value at each Measurement Date
- After considering individual facts and circumstances and applying these Guidelines, it is possible that Fair Value at a subsequent Measurement Date is the same as Fair Value as at a prior Measurement Date. This means that Fair Value may be equal to the Price of a Recent Investment; however, the Price of a Recent Investment is not automatically deemed to be Fair Value.
Guidelines for Early Stage Portfolios
The guidelines recognise the complexity of following more conventional approaches to valuing early-stage companies. They suggest the most appropriate approach measure for Fair Value may be a Valuation Technique that is based on market data.
Although the calibration exercise is required even in this scenario, where achievement of certain milestones, recent investment, current market conditions, and scenario analysis.
In the case of milestones, the guidelines generously provide suitable options:
- Financial measures: revenue growth; profitability expectations; cash burn rate; and covenant compliance.
- Technical measures: phases of development; testing cycles; patent approvals; and regulatory approvals.
- Marketing and sales measures: customer surveys; testing phases; market introduction; and market share.
As expected, there are challenges especially when two early-stage investors reach completely different valuations. This is often the case where perception trumps reliable company and market data.