In our previous post we covered the basics of ASC 820, which includes the guidelines for valuing various positions in a fund portfolio. But what, exactly, is in an ASC 820 valuation report, and how do analysts produce them?
The process of valuing a portfolio of corporate debt and equity is mainly three steps repeated for every position in the fund. In this post, we’ll refer to a portfolio of corporate debt and equity and a “portfolio” (for shorthand) interchangeably.
- Estimate the enterprise value of the company,
- Allocate said 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.
The valuation analyst has a wide variety of methods available and has to decide which techniques to employ and which factors to take into account for each company. Every company in a fund is facing a unique situation, so the valuation analyst will look at (and document) many factors in each case. In any given ASC 820 valuation report, you can expect to encounter any or all of the following considerations:
- Milestones achieved by the enterprise
- State of the industry and economy
- Experience and competence of the management team and board of directors
- Marketplace and major competitors, including competitive forces
- Barriers to entry
- The company’s proprietary technology, products, or services
- Workforce and workforce skills
- Customer and vendor characteristics
- Strategic relationships with major suppliers or customers
- Major investors in the enterprise
- Enterprise cost structure and financial condition
- Risk factors faced by the enterprise
Based on these considerations, the analyst will choose a set of methods to estimate the enterprise value of the company.
As a full-service valuation firm, we are capable of deploying a wide array of valuation methodologies. When considering which methodologies to use, we consider a number of factors including the purpose of the work, the hierarchy of facts and circumstances present, and the nature of the asset, liability, or equity being considered.
While there are many options available, the IRS and the AICPA (American Institute of Certified Public Accountants) tend to prefer a handful for appropriate use under ASC 820. Here are a few of the valuation methodologies we typically use in each step of the process:
A: Estimate the Enterprise Value
As we mentioned in the previous article, ASC 820 describes the levels of liquidity of assets on a three-level scale from liquid to illiquid. This classification is based on the type of inputs available to an observer. Essentially, if you can directly see trading data about the value of the asset itself (because it has an active market) or its components, it’s a Level 1 asset. If there’s a similar asset being traded, that’s Level 2. If the asset isn’t being traded in an active market and there isn’t a similar asset that is, you have to rely on unobservable inputs and valuation models, which is Level 3. Most positions in a VC fund portfolio will be in Level 3—they’re each unique, illiquid assets and have to be valued using models and estimations.
So it’s up to us as analysts to choose appropriate tactics to determine the fair value of the enterprise. The methodologies we use fall into a few groups: market approach, i.e. comparing the enterprise to comparable assets in observable markets; income approach, i.e. evaluating the enterprise’s current and future cash flows in the context of the risk necessary to capture them; and asset approach, i.e. working from the current and future value of the enterprise’s assets. When valuing any given asset, we’ll use a mix of these tactics.
- Guideline Public Comparable Companies: compare the enterprise to publicly traded companies and adjust for size, risk, and likelihood of liquidity.
- Guideline Transaction Approach (M&A): compare the enterprise to a similar business that was sold.
- Venture Guideline Financings (also known as the “Backsolve”): extrapolate from the value of investments in the business to find the total value necessary to justify those investments.
Income Approach (Discounted Cash Flows)
- Gordon Growth Terminal Value: calculate the value of the asset based on an assumption of linear growth.
- Hybrid (“H”) Model Terminal Value: determine current value based on an assumption of steady rates of change leading to an eventual plateau.
- Multi-Year Exit-Based Model: calculate the value of the asset today based on an assumption of an exit at the end of several years.
- Single-Year Exit-Based Model: calculate the value based on an assumption of a near-term sale.
- Real Option Pricing: take into account the possibilities available to management at the company being valued, as well as the cost of taking advantage of them.
- Probability-Weighted Expected Return Method (“PWERM”): use the various exit scenarios and their likelihood to determine current fair value.
- Normalized Earnings: find the revenue streams and earnings that can reasonably be expected to continue.
- Asset Accumulation: use the current and future value of assets and liabilities to inform the enterprise value today.
- Replacement Cost New: take into account the cost of replacing the enterprise’s assets.
In addition, we’ll work with the fund and portfolio companies to analyze (and to the extent possible quantify) various qualitative factors. Because of the qualitative inputs and the many available methodologies, there’s always subjectivity involved in applying analysis choices across the portfolio companies’ valuations.
For each company in the portfolio, once we have determined the enterprise value, we have to decide how much the fund’s position is worth, which means looking at the whole ownership structure in step B.
B: Allocate said enterprise value to the various debt and equity holders of the company:
In this step, we again have a handful of methodologies available. The goal is to make the best estimate possible in the face of incomplete information (since the companies in a VC fund’s portfolio are typically not public).
- Current Value Method: where we would allocate the estimated value to all the various shares, regardless of class.
- Waterfall Method: where the value is allocated to the various share classes based on their rights and preferences. This method is especially used when an exit is near.
- Option Pricing Model: where we would consider all the rights and preferences of the capital structure, timing of possible events, and probability or risk of those events, using comparable volatility metrics.
- Probability-Weighted Expected Return Method: where we would consider unique timing, risk, and the probability of events. This method is especially useful for biotech and pharmaceutical companies.
At the end of this step, we have an estimate of the fair value of the stake, but it’s not yet ready for reporting—we still have to adjust for the likelihood of the stake becoming liquid at that value.
C: Adjust the allocated value by discounts, premiums, and other considerations such as secondary transactions, upcoming exits, or dissolution scenarios.
In this step, we have to take into account the factors that affect the stake itself. We have the value of the company and we know what portion of it the fund owns, but we still need to represent the conditions of the investment.
The most common discounts used are:
- Discount for Lack of Marketability: an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of the ownership’s marketability.
- Discount for Lack of Control: an amount of percentage deducted from the value of an ownership interest to reflect minority securities shareholders’ lack of control. This is usually calculated as 1 – (1 / (1 + control premium)). As of this writing, the thinking prevalent in the valuation industry (inclusive of the relevant auditors) is that minority investors are represented in aggregate at the board level, so applying such discount for lack of control may not be always appropriate.
The most common premiums are:
- Control Premium: which provides a group of shareholders certain influence that gives their shares a premium above and beyond the value allocated to their shares (as calculated in step B).
- Legal Premiums: Anti-dilution protection, blocking rights, and rights of first refusal ("ROFR") (to name a few) are legal rights afforded to some owners that have value above the value of their shares. In most ASC 820 valuation analyses, these legal rights are not modeled, although their value can be bifurcated and estimated using advanced modeling methodologies such as lattice models, Monte Carlo, or other simulation techniques.
In addition, we often need to include other types of considerations. One is calibration: it’s possible that private companies take investments once every 18 months (or longer), but funds still need to report on that company's value every quarter. Although the investment will be fair value at the time of investment, future valuation dates will most likely rely on unobservable techniques (i.e Level 3) to measure fair value. Fund controllers, CFOs, and valuation experts will thus calibrate (or “peg”) the initial valuation to other observable market data (revenue, market multiples, observable indexes, etc), in order to estimate the value of the investment during times when observable market data are not available.
Another common consideration is a secondary transaction, i.e. the sale of the stake in a non-exit scenario. When considering secondary transactions and their impact on the valuation, we have to consider the various value drivers or strategic components of the transaction. We usually consider the following:
- Is the transaction for an identical security on the measurement date?
- Does the transaction take place in an active market?
- To what extent does the transaction represent an orderly transaction?
Based on this analysis, we will determine to what extent (if any) weight to put on the price of the secondary transaction.
The last common consideration is for upcoming exits or dissolution. Companies (especially private companies) may face dissolution and restructuring at various parts of their lifetime. To a lesser frequency, they may also face exits. These idiosyncratic events are not always captured in the valuation analysis or the value allocation process, and so the timing, probability, and economic factors driving them will have to be captured (to the extent possible) in the ASC 820 report.
All of this information will be included in any given ASC 820 report, as provided by your analysts. But our job isn’t just to know how to value the positions in a portfolio—it’s also to know what to avoid, what documentation to include, and how to respond to your external auditors. For this type of expertise, many funds turn to external analysts, like Preferred Return. If you want to simplify your valuation and portfolio reporting policy and procedures and have more time for higher-level activities, get in touch.