Account Standards Codification topic 820 (ASC 820) describes the rules and best practices for disclosures related to the fair value of a company’s investments. Investment funds and hedge funds have to report their performance to their own investors (a.k.a. “limited partners”), which means they need to periodically value their investments. In the United States, they have to do so according to generally accepted accounting principles (GAAP), which require that the fund plays by the same rules as everyone else when determining those investments’ fair value.
The difficulty in determining that value is that most VC funds invest in private companies, which makes them “illiquid assets”: assets which cannot be easily sold. Because there is no active market for these assets, the fund controller has to use their own judgment and usually a mix of qualitative and quantitative information about the investment’s situation to establish its value.
Why is ASC 820 important?
As of this writing, First Round Capital’s $510K investment in Uber from 2010 is worth about $2.5 BILLION, or a 5,000x return. We know this because Uber exited (and because we’re not under a rock). But what’s the value of Andreessen Horowitz's December 2017 ~$5M investment in Descript? About $5M? More? Less?
After a decade of near-zero interest rates, the search for higher yields and returns has become increasingly difficult. Over the past decade, traditional money managers, banks, insurance companies, and alternative funds (like private equity and hedge funds) have poured over $250 billions into venture capital funds—over 2,000 VC funds have formed, all in search of the next Uber. As the number of VC fund investments grows, the question for the funds’ stakeholders becomes: how are the VCs doing?
The LPs, the investors in these alternative funds and VCs, as well as shareholders and creditors of traditional money managers and insurance companies want to keep a close eye on the performance of their investments, especially to be in compliance with GAAP, including ASC 820. Further complicating matters, the specific guidance in ASC 820 has increasingly put emphasis on exit value, which means that investors can’t “keep valuations at cost basis.” Rather than pegging the asset’s value at its original cost, they have to determine what it would be worth if the company exited and became a liquid asset.
For exit value, IPOs and M&A provide some signal, but by and large, the performance of these private, illiquid holdings remains difficult to track and calculate. That’s where we come in— valuation experts, whether internal or at a valuation-focused firm like Preferred Return, do the work necessary to value each position.
How does an ASC 820 report work?
The goal of an ASC 820 report is to establish the fair value of each asset in the fund’s portfolio if the asset were to become liquid (i.e. exit) at the date of the valuation. ASC 820 is primarily concerned with describing classes of assets on a three-level liquidity scale, but that means that it includes the guidelines accountants have to abide by in valuing illiquid assets. Fund controllers have many responsibilities aside from performing these types of valuations, so they often outsource the work of determining their funds’ investments’ fair market value to analysts, who provide them with what is known as an ASC 820 report.
We’ll save the in-depth specifics for another post, but here are the basics of what goes into one. To create an ASC 820 report, the analyst takes each investment in the portfolio through three steps:
- Estimate the enterprise value of the company,
- Allocate the enterprise value to the various debt and equity holders of the company
- Adjust the allocated value by discounts, premiums, and other considerations such as secondary transactions, upcoming exits, or dissolution scenarios.
Each asset needs to be valued according to a method most appropriate to its situation. Per the guidelines of ASC 820, funds can present auditors with justification for the value of any given asset (i.e. the value of their stake in each investment) on the basis of a mix of qualitative and quantitative factors. This means that there’s some subjectivity involved—ASC 820 mostly describes the ways in which these subjective choices have to apply across the fund’s valuations of their portfolio companies.
Finally, to get from the enterprise value as allocated to the debt and equity holder of the asset to the fair value at exit of the asset, the analyst has to adjust the allocated enterprise value, based on a modeling method (typically option pricing modeling) to each class of ownership
These valuations together make up the basis for an ASC 820 valuation report, which can be translated into fund performance reporting for general partners (the VCs themselves), stakeholders like limited partners, and auditors.
For better or worse, private company stock doesn’t trade. The lack of an active market forces fund controllers, CFOs, and valuation experts to use models, ownership and performance data, and market indicators together to ascertain value to comply with ASC 820 and keep their LPs informed. Having performed over 4,000 valuations, the Preferred Return team can help you with all of these considerations and nuances, and free your time to do more high-level thinking. Reach out to us and we’ll be happy to help.