New Guidance Released for Venture Capital & Private Equity Funds

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In August 2019, the American Institute of CPAs (AICPA) issued Accounting and Valuation Guide: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (the Guide). The Guide provides an overview and understanding of the valuation process and the roles and responsibilities of the parties to the process. It has various recommendations for complying with FASB Accounting Standards Codification (ASC) 946, Financial Services—Investment Companies, and applying ASC 820, Fair Value Measurement.

The Guide’s objective is to harmonize the diverse views of investment funds, valuation experts, auditors and regulators. The Guide contains various detailed valuation methods, assumptions, examples and comprehensive case studies that can help reduce the differences in valuation practices across the industry.

Valuation Challenges

The Guide addresses how the challenge in the valuation process comes from ASC 820 requiring private equity (PE) and venture capital (VC) investments to be stated at fair value, which by nature and structure generally are illiquid.

The investments include securities such as common stocks, preferred stocks with important and complex economic and control right, warrants, compensation options and convertible and straight debt. These securities aren’t publicly traded and have no Level 1 pricing data to use and very limited Level 2 data, and thus most valuations require Level 3 inputs. The complex structure of these securities, e.g., preferred or options, and use of Level 3 inputs requiring complex valuation models result in significant challenges for PE and VC groups. Diversity in practice can contribute to varying amounts of fair values reported by investment companies and valuation experts.

Scope of the Guide

The Guide doesn’t supersede any existing guidance, and it’s nonauthoritative. It’s meant to be considered as a best practice.

Key areas covered under the Guide are as follows:

  • Complex structures – Multiple securities, or held across multiple related entities
  • Adjustments for control and marketability
  • Calibration of valuation model
  • Performance of backtesting on realized investments
  • Consideration of uncertainties and contingencies
  • Treatment of transaction costs

Here are some major topics addressed in the Guide and the chapters they fall under:

  • Chapter 6 – Valuation of debt instruments
  • Chapter 10 – Calibration
  • Chapter 11 – Backtesting
  • Chapter 12 – Factors to consider at or near a transaction date
  • Chapter 14 – Frequently asked questions (FAQ)
  • Appendix C – Illustrates a broad spectrum of case studies

Here are some example best practices the Guide addresses:

In an initial public offering, a security is trading at 45 times the revenue, but subsequently it trades at 120 times the revenue. Similarly, during the financial crisis a debt instrument lost significant trade volume, increasing the bid and ask price difference significantly from $20 bid to $70 ask. The Guide suggests using calibration to reduce uncertainty. Calibration assumes that at the initial recognition date, valuation technique equals the transaction price. Then at the subsequent measurement date, unobservable inputs are used to measure fair value. It helps in adjusting the valuation technique, which would reflect observable market data at the measurement date or adjust for the characteristic of the asset or liability that isn’t captured. The key is to combat biases by having reasonable, consistent processes using available market data as of the measurement date.

In the FAQ, the Guide addresses the treatment of equity interests with different liquidity preferences and how the valuation should capture higher- and lower-ranking classes of equity. The Guide suggests that if profit-sharing is proportionate in preferences, in a waterfall there will be no difference. But if contractual rights and preferences are different, then one should use appropriate waterfall or methods to reflect such rights.

The Guide addresses control consideration in a FAQ example: When valuing private company interest where there are no observed transactions, should the enterprise value reflect a controlling or noncontrolling interest? In response, the Guide suggests the value of an enterprise should reflect assumptions that are consistent with the company’s plans under the current ownership and control. It wouldn’t be appropriate to add a control premium; if investor interest is aligned and the fund has information rights, adjustments for minority interest may not be necessary. If such information isn’t available and the minority investor internal rate of return is higher, then a discount may be necessary.

The Guide addresses a post-valuation event in a FAQ example where a fund isn’t aware at the measurement date that a major customer of the portfolio company had filed for bankruptcy. The fund becomes aware of the situation one month from the measurement date. The question is, can this information be used in the valuation at the measurement date? The Guide responds affirmatively because the bankruptcy filing was a matter of public record and was known/knowable at the valuation date.

Similarly, the Guide also addresses a post-valuation event with an example of FDA product approval being granted subsequent to the measurement date but prior to the valuation date. The question is, should one include drug approval in stock valuation at the measurement date? The Guide responds negatively because the drug approval, even though it was close to the measurement date, was subsequent and wasn’t known/knowable at the measurement date.

Appendix C in the Guide illustrates various case studies with topics including equity investments in leveraged buyouts, initial transaction and calibration, value accretion in a real estate project, value fluctuation in a real estate investment financed debt, effect of the value of senior equity interests when junior interests have control, reliability of information for an emerging market investment, subsequent rounds of financing, etc.

We would like to underscore that the Guide is a compilation and explanation of industry best practices and not meant to be an authoritative guidance. The actual guide can be obtained from the AICPA. If you have any questions, please reach out to your BKD trusted advisor or use the Contact Us form below.

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