The teams that manage the finance function of an investment fund have a lot on their plate. And that is especially true around the quarter- and year-end stretch.
It is enough of a challenge to monitor and communicate with portfolio companies, to prepare for partner meetings, and to properly close-out the books. Adding the task of valuing every portfolio company can create an unnecessary workload and undue amount of exposure.
That’s because valuation best practices change regularly, auditors increase their scrutiny, and limited partners and auditors need to be properly informed of the valuation methodologies and end-results being selected by the finance team.
For these reasons, valuation experts like our team at Redwood Valuation are often called upon to do much of the heavy lifting. A seasoned appraiser will work in concert with finance team to ensure the approach to valuation is in sync with the perspective of your leadership group.
Introduction to ASC 820
Let’s step back for a minute and revisit why it’s critical to value your portfolio on a regular basis in the first place.
The relevant guidance for portfolio valuation is found in the Accounting Standards Codification (ASC) section 820, which is part of the Financial Accounting Standards Board’s (FASB) Generally Accepted Accounting Principles (GAAP). Those acronyms may or may not be familiar (we don’t blame you). Here’s the long and short of it:
Investment funds turn to GAAP because it provides a widely-accepted standard of reporting quality for their investors (often limited partners). That level of rigor and transparency is important to both parties. Within GAAP, ASC 820 is specifically relevant because it deals with valuing the illiquid assets that are commonly held by private equity or venture capital funds.
ASC 820 is, in short, our north star in portfolio valuations. From there, a reporting entity then must decide which type of asset it is looking for guidance on. ASC 820 provides perspective here by distinguishing between assets based on the level of their liquidity.
In general, the higher the liquidity level the easier it is to find a quoted price on an asset, and the lower the liquidity level the more difficult. A publicly-traded stock would be highly liquid, and ASC 820 categorizes this as a Level 1 asset. At the other end of the spectrum would be preferred shares in a private company, which constitute a typical investment for a venture capital fund. The preferred shares would be a Level 3 asset, indicating that they are a highly illiquid holding with no readily retrievable price.
It is not a stretch to say that Level 3 assets are nearly always the most difficult ones to value in practice. Without a quoted price on an exchange, the determination of valuation instead rests on the finance team responsible for the fund’s reporting. This is a tough place to be: While it provides leeway in assigning a value, the expectations of investors and perspectives of regulators can present challenging constraints.
As a result, it is common for a fund’s CFO or controller to seek input from valuation specialists. These types of appraisers are specifically trained in valuing early-stage companies with complex capital structures. On top of that, they provide a level of independence that is viewed favorably by the fund’s investors and auditors.
What approaches are discussed in ASC 820?
The first step in assessing the value of a fund’s holdings in a portfolio company is to calculate an enterprise value for a specific company. The next step is allocate that value across all of the share classes held by the various investors in that company. The final step is to take the resulting per share value and multiply it by the specific shares held by the fund.
We often get asked what approach we use to arrive at enterprise value.
The short answer is that we utilize one of three approaches that are widely accepted in the valuation field and specifically called for in ASC 820. Those are the Income Approach, the Market Approach, and the Asset Approach. Here is a high-level overview of what each approach looks like in practice:
This approach will take the company’s expected stream of future cash flows and discounts those cash flows to the present-day (i.e. as of the valuation date) to arrive at the enterprise value.
When it’s used: Startups rarely have positive and predictable cash flow, so the Income Approach is less often relied upon for venture-backed companies. However, for later-stage profitable companies and established private equity-backed companies the Income Approach becomes more relevant.
This approach employs market indications to arrive at a value for the company, most often relying upon the option pricing model (OPM) backsolve (the “Backsolve Method”) or comparing multiples for comparable publicly-traded companies (the “Public Company Method”).
When it’s used: The Backsolve Method within the Market Approach is commonly used when a company has conducted an arms-length financing round within the last 12-18 months. The Public Company Method is used for companies that are generating revenue (or EBITDA) that results in a meaningful indication of value when the comparable multiples are applied.
This approach values the company’s underlying assets at cost.
When it’s used: The Asset Approach is rarely used for a going concern business because it provides a floor value for the enterprise and does not adequately capture the value of intangible assets or goodwill of the business.
A note on the “backsolve”
Of the above approaches, the Backsolve Method within the Market Approach is the most commonly relied upon (in our experience) for early-stage companies that are consistently raising a new financing round. Observers often view the backsolve analysis as a simple one: The appraiser utilizes the pricing of the last financing round to “backsolve” to the total equity value. A thorough analysis, however, would be incomplete if the appraiser stopped there. Other factors that need to be considered in a “simple” backsolve include the following:
- How much time has transpired since the financing round being considered?
A more recent round – within 6 months, for example – is more likely to represent a reliable value. The older the round, however, the more an appraiser should look to weight an additional approach to arrive at a more robust and defensible valuation.
- How has the company and/or market performed since the last financing round?
This is a consideration – similar to the one above – that becomes more critical as you move further from the last transaction. A hypothetical scenario would be where the company has outperformed the investors (VC’s or PE’s) expectations, and the industry to which it belongs has similarly experienced strong momentum. In this scenario, would the value indicated as of the transaction date be representative of the value at the more recent valuation date? It’s highly unlikely. A thoughtful analysis would take into account these contextual developments to arrive at a more accurate valuation for reporting purposes.
- How do you allocate the enterprise value once it’s calculated via the backsolve?
Within the Backsolve Method, the pricing of the specific shares in the most recent transaction are known – and that shouldn’t change. However, what about the other classes of shares, including various preferred rounds, common, convertible notes, options, and warrants. To arrive at a specific price for each, a sophisticated waterfall analysis needs to be performed. This, of course, further complicates what began as a simple “backsolve” analysis but also further enhances the quality of the valuation for the fund and its investors.
You’ve determined the fair value at the enterprise level. How do you allocate according to ASC 820?
The next significant exercise in an ASC 820 valuation is to allocate the enterprise value to the various share classes. The allocation is sometimes referred to as the “waterfall” calculation, but that can be misleading.
Yes, a waterfall technique can be used where the capitalization table is not highly complex and where there is visibility to a near-term exit event. In those cases, the waterfall will take into consideration the rights and preferences of the different equity classes, but it will not take into consideration the behavior over time of different share classes.
For instance, certain share classes will possess attributes of “optionality” which will vary based on the payout hierarchy, volatility, and the time to exit. Value should be attributed to the share classes based on this option-like behavior.
As a result, the most common exercise for allocation is the option pricing model (OPM). The OPM considers the volatility and time to exit and also accounts for the rights and preferences of the different share classes. Given its more complex nature, the option pricing model requires careful construction and fine-tuning over time. Ideally, a fund would prefer to have the valuations of its companies run through an option pricing model that’s been tested extensively – not just dozens, but hundreds of times – and vetted by experienced auditors.
The final method of allocation that we’ll discuss is the commons stock equivalent (CSE) method. This method will perform a straight-line allocation to the different classes as though converted and without taking into account the rights and preferences. Its shortfall is evident: It doesn’t properly account for the value inherent in priority payouts, unique conversion ratios, or the optionality inherent in the various share classes. In practice, we rarely find that the CSE method is the most suitable.
Are valuation experts always necessary?
In this article, we’ve presented an introduction to the guidance in ASC 820, including insight on some specific valuation and allocation techniques.
Are these approaches complicated in and of themselves? Not necessarily. Can the capitalization table and fact pattern of a particularly unique company create complexity in the valuation? Absolutely.
Valuation experts will be your best bet in these complex cases. Or where sensitivity to the outcome is high. The following circumstances lead fund CFOs and controllers to reach out to Redwood Valuation for assistance in their valuation process:
- New and evolving auditing standards
- Complex cap tables, rights, and preferences
- Deals and rounds that aren’t uniform
- Auditors that require guidance-driven approaches and ample documentation
- The lack of a one-size-fits-all model
- Investors that are sensitive to valuation outcome
- Turnaround time is crucial ahead of reporting of board-related events
Guarantee your valuations are done the right way the first time. Each successive year will be that much easier to comply with ASC 820 across your portfolio.
You can get in touch with our experienced portfolio valuation (ASC 820) experts by sending an email to firstname.lastname@example.org. We’ll get back to you in a hurry.