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Demystifying the AICPA Audit & Accounting Guide O C T O B E R 1 0 , 2 0 1 9

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INTRODUCTIONSSal Shah Partner Asset Management BKD CPAs & Advisorskshah@bkd.com

Rand Gambrell DirectorForensics & Valuation Services BKD CPAs & Advisorsrgambrell@bkd.com

1 Measure the diverse view of investment funds, valuation experts, auditors & regulators

Describe key valuation methods & assumptions

Recognize certain industry frequently asked questions

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OUR GOALS FOR TODAY

Evaluate industry case studies

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GOAL OF THE GUIDE

• “The purpose of this guide is to provide guidance to investment companies and their advisers regarding the valuation of, and certain aspects of the accounting related to, their investments in both equity and debt instruments of privately-held enterprises and certain enterprises with traded instruments. Such investments are subsequently collectively referred to as portfolio company investments.”

• “The guidance is intended to provide assistance to management and boards of directors of investment companies; valuation specialists; auditors; and other interested parties, such as limited partners.”

• “This guide is not intended to serve as a detailed "how to" guide but, rather, to provide investment companies that invest in equity and debt instruments of portfolio companies with

(a) an overview and understanding of the valuation process and the roles and responsibilities of the parties to the process and

(b) best practice recommendations for complying with Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 946, Financial Services-Investment Companies, and applying FASB ASC 820, Fair Value Measurement.”

– AICPA Accounting and Valuation Guide

Valuation Challenges in PE/VC Industry

• U.S. GAAP requires PE/VC investments be stated at fair value • PE/VC funds invests in private securities which, by structure, are illiquid• Securities include common stock, preferred stock with important & complex economic & control

rights, warrants, compensation options, convertible or straight debt As these securities are not publicly traded, there is no Level 1 pricing to use, very limited Level 2 data & thus

most valuations require Level 3 inputs The complex structure of these securities, e.g., preferred, options, & use of Level 3 inputs, requiring the use

of complex valuation models, results in significant challenges for PE/VC • Diversity in practice contributes to fair value measurements that vary across reporting investment

companies as well as the valuation experts• “Private Equity Industry Attracts S.E.C. Scrutiny,” The New York Times, 2/12/2012,

https://dealbook.nytimes.com/2012/02/12/private-equity-industry-attracts-s-e-c-scrutiny/

• Besides complying with regulatory requirements, accurate portfolio valuations help boards make better investment decisions & accurate, transparent & timely reporting can help attract potential investors

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Valuation Challenges in PE/VC Industry

• “Valuing assets and transactions based on an observable market can be especially challenging when these entities do not trade on a regular basis. For companies that do not have an observable market, there may be a wide discrepancy between the price that a company calculates and what a third-party valuation expert believes to be the fair value of a portfolio company. In order to determine the fair value of these assets, private equity firms must rely on models that are composed of multiple data sets and numerous assumptions. These assumptions require judgment and as a result, can produce a wide range of valuations if any of the inputs are altered."

• Level 1 inputs: quoted prices for the identical assets traded in active markets

• Level 2 inputs: quoted prices for comparable assets or liabilities that can be observed directly or indirectly in active markets

• Level 3 inputs: assets that do not have an external market. They are derived by using data that is not observable & are used with valuation models that require assumptions

SCOPE OF THE GUIDE

AICPA Accounting and Valuation Guide: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies• Draft of the Guide prepared by AICPA PE/VC Task Force & released on

May 15, 2018• Final version of the Guide issued by the AICPA on August 19, 2019• The task force was formed in 2013 to assist funds, valuation specialists,

auditors & regulators with the valuation process, as well as provide guidance on best practices

• As with other AICPA accounting guide publications, this publication is also "nonauthoritative." However, these guides are typically considered "best practices" in industry

• It does not supersede any existing regulatory guidance; it is designed to improve the current valuation process by Providing an overview & understanding of the valuation process

Elaborating on roles & responsibilities

Discussing best practices

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Key Areas of Concern

Consideration in determining the assumptions of a market participant

Importance of time horizon of the investment

Complex structures – multiple securities or held across multiple related entities

Adjustments for control & marketability

Calibration of the valuation model

Performance of back testing on realized investments

Consideration of uncertainties & contingencies

Treatment of transaction costs

Major Topics • Chapter 1 – Overview of PE and VC Industry

• Chapter 3 – Market Participant Assumptions

• Chapter 4 – Determining Unit of Account

• Chapter 5 – Overview of Valuation Approaches

• Chapter 6 – Valuation of Debt Instruments

• Chapter 9 – Control and Marketability

• Chapter 10 – Calibration

• Chapter 11 – Back Testing

• Chapter 12 – Factors at or Near Transaction Date

• Chapter 14 – Frequently Asked Questions

• Appendix C – Illustrates a Broad Spectrum of Case Studies

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Mandatory Performance Framework (MPF)

• Certified in Entity and Intangible Valuations™ (CEIV™) credential

• MPF is required for holders of CEIV credentials

• MPF is considered best practice for non-CEIV credentialed holders

• MPF describes the degree & purpose of documentation

• An experienced professional must be able to Understand the purpose, nature, extent & results

Understand all approaches & methods used

Understand the inputs, judgments & assumptions

Support the conclusion of value with sufficient detail

• Requires detail surrounding appraiser qualifications, intended user(s), measurement date, citing sources & providing supporting data

Fair Value, Market Participants, & Unit of Account • Market participants would necessarily consider information specific to the company, including

information about the company's plans under current ownership, as modified by the degree of influence associated with the interest being acquired, when valuing an interest in a given company

• For the purpose of estimating the value of an interest in a business, it is appropriate to consider the value of the business from the perspective of the investors who, in aggregate, have control of the business. This value may reflect the benefits of control as well as cost of liquidity. Contrary to conventional wisdom, in the context of transactions in venture capital & private equity-backed companies, the value associated with control & the cost of liquidity are both embedded in the price paid

• Since the unit of account is defined in the context of the reporting entity's financial statements, it cannot include interests that are not owned by the reporting entity. If the reporting entity holds multiple instruments within a given portfolio company, however, the assumed transaction may consider how fair value would be maximized. Thus, the assumed transaction might be a transaction that involves the aggregate position held by the reporting entity if this is how market participants would transact, citing in their economic best interest

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Fair Value Measurement Objective

• To estimate the price at which an orderly transaction to sell the asset or to transfer a liability would take place between market participants at the measurement date under market conditions. A reporting entity must determine all of the following The asset or liability Nonfinancial asset – “highest & best use” The principal & “most advantageous market” The valuation technique appropriate for market participants

Wide Range of Value in Financial Reporting?

Inherent uncertainty in estimation

IPO at 45x revenue & traded at 120x revenue

Financial crisis debt instruments lost volume – bid in $20s, ask in $70s

Use calibration to reduce uncertainty

Key is to combat biases by having reasonable, consistent process, using available market data as of measurement date

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Market Participants

• Buyers & sellers in the principal & most advantageous market having the following characteristics Independent

Transaction at market terms

Knowledgeable about the asset or liability & the market

Able to enter into a transaction

Willing to enter into a transaction

Market Participant Risk Assumption

The risk inherent in a particular

valuation technique

The risk inherent in the inputs

The inputs may be observable or

unobservable

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The Principal & Most Advantageous Market• Reporting entity perspective• Must have access to it• Most likely to trade in• Not optimal to actively market at interim date

Consider a hypothetical sponsor to sponsor market

• Principal market re-evaluated at each measurement date• Common characteristics that prevent access

Transform asset or liability to match observation Restrictions unique to the reporting entity Marketability difference in observable market

Holding Period

• Fair value is a market-based assumption

• Entity's intention to hold or sell/settle is not relevant

• Fair value based on hypothetical transaction at measurement date

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Unit of Account

• The level at which an asset or liability is aggregated or disaggregated for recognition purposes

• The asset being measured might be a single asset or a group of assets• Measure fair value considering multiple units (debt & equity) together; or a single

unit, depending upon how market participant would transact • Level 1 securities• On condensed schedule of investment, PE/VC may report total value in a portfolio

company, then allocate to each instrument• May not report smallest value of each instrument that could theoretically be sold as

an unrelated investment• Relevant as to how market participants would transact

Valuation Methods in Stages of Enterprise Development• Stage one – no product revenue

Recent round of financing Asset accumulation

• Stage two – income approach with higher discount rate Guideline public company/transaction methods may not be reliable Difficult to obtain a reliable financial metric for which to apply multiples Intangible assets may be hard to value

• Stage three – income approach &/or multiple rounds of financing

• Stage four/five – income & market approaches are typically used Discount rates are lower than stages two/three Use market approach reflecting calibration of the multiple rounds of financing

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Calibration

• A process using observed transaction in the portfolio company's own instrument, to ensure that the valuation techniques used on subsequent measurement dates begin with the observed transaction, as well as more recent transactions Required when initial transaction is at fair value & there are observable transactions

at later dates

Unobserved inputs are used to measure fair value at subsequent periods

• The valuation technique & key Level 3 inputs are fine-tuned, i.e., calibrated, so that the model fair value equals the transaction price Helps determine if an adjustment to the valuation technique is required

Calibration

• Ensures current market conditions are reflected in the fair value measurement, capturing differences between the company & the observable guideline public companies or transactions

• The calibrated input assumptions are revisited at each measurement date to determine how they should be updated for Changes in market conditions

Performance of the portfolio company

Performance of the portfolio company vis-a-vis the selected guideline public

Companies own transactions

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Transaction Price May Not Reflect Fair Value

• Between related parties (exception arm’s length)

• Under duress

• Unit of account is different

• Transaction market is not the principal market

• Fair value is an exit price (not entrance price)

• If not at fair value, the best practice is to compare the estimated fair value with the transaction price & reconcile any differences

Recent Transactions

• Consider rights & preferences between the current financing round & the company's other classes of equity

• Evaluate changes in the value of the company, or changes in risk with planned transaction, if not yet closed

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Debt Investment

• When trade price is not available, perform a DCF analysis (cash flows are discounted at a market yield)

• Market yield can be measured relative to issuance date Change in credit quality of the company

Credit spread of comparable debt

Seniority, strength of covenants, company performance, quality of security, etc.

• For fixed-rate debt – change in reference rate matching maturity

Debt Instrument Valuation Example

• Company A issued debt on June 30, 2015 Interest = Libor + 300 bps (roughly B+)

In three years, business operations expanded, revenue grew

June 30, 2018, estimated rating BB+

Market risk premium increased

Credit spread for debt rated B+ increased to 900 bps (up by 600 bps)

Spread for BB+ increased to 700 bps (up by 500 bps)

Market yield for Company A would be Libor + 700 bps

RESULT: fair value is lower

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Calibration Equity – Market Approach • Company A acquired for $500M, $200M equity & $300M debt• Good management & rapid growth• Transaction price is 10x L TM EBITDA $50M; 8.33x forward-looking EBITDA of

$60M• Comparable public company median 8x L TM EBITDA & 7x forward-looking

EBITDA, suggesting a premium of 25% (=10/8) & 20% (8.33/7)• Six months later

LTM EBITDA is $55M & forward-looking EBITDA is $64M Comparable LTM EBITDA 9x & forward-looking EBITDA is 7.5x Assuming the same premium relative to the comps the multiples are 10.35x (9 x 1 .25) & 9x (7.5 x 1 .2) suggesting a value range of $570M (10.35 x 55) to $576M

(9 x 64 M)

Calibration Equity – Market Approach

• Company A's $500M transaction price implies an IRR of 15%; including forecasted cash flows & modeled terminal value WACC suggests 7% CSRP based upon forecast risk

• Fast forward six months Good management & rapid growth

CSRP of 6%, EV is $570M

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Calibration Equity – Income Approach

Risk-Free Rate of Return 3.0%Levered Beta 1.05Market Risk Premium 6.3%Small Stock Premium 6.0%Company-Specific Risk Premium (CSRP) 7.0%Cost of Equity 22.5%Equity Weighing 60%After-Tax Cost of Debt 4.2%Debt Weighing 40%Discount Rate (WACC) 15.0% (rounded)

Calibration Equity – Income Approach

Risk-Free Rate of Return 3.0%Levered Beta 1.1Market Risk Premium 6.0%Small Stock Premium 6.0%Company-Specific Risk Premium (CSRP) 6.0%Cost of Equity 21.3%Equity Weighing 60%After-Tax Cost of Debt 4.2%Debt Weighing 40%Discount Rate (WACC) 14.5% (rounded)

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Calibration Relevance

• Significant time lapsed & no recent transaction

• Company about to be sold – triangulation

• Bankruptcy or debt restructuring – recovery method

• Change in business model, stage of development, anticipated exit market

Secondary Market

• Secondary markets are where nonpublic debt & equity instruments may be traded Consider proper weighting between value in secondary market & fund valuation

Secondary market may not represent an orderly transaction

• Other weighting factors Timing of transaction – delay of 30 to 60 days

Sufficient sophisticated bidders – accredited investors

Sufficient financial information – reporting requirements

Pattern of trades – relationship with the exchange & nominal investor pool

Other biases & costs

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Q 14.19 Shelf Life of Value-Related Information

Q. Port Co had a new investor for $20/share on 1/31/2011. Co product, price & demand are volatile. 30% projected sales growth. Would equity transaction on 1/31/2011 reflect FV at 3/31/2011?

A. Generally no. High growth & volatile experience relative to a mature company is inversely related to the shelf life of a valuation. Look at other objective & substantive evidence indicators

Q 14.21 Differences in Fair Value Estimates

Q. Why may valuations prepared for other purposes come up with different values?

A. The unit of account & other considerations specific to the measurement may be different &, therefore, the valuations performed for these different purposes may not necessarily result in the same value

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Q 14.22 Valuation Diligence on Club Deals

Q. For an investment clubbed with investments from other unrelated funds, is it required to consider other fund’s fair value?

A. Not required but, if known, consider relevance & reliability of info. Can be a good indicator of market participant perspective

Q 14.24 Valuation of Contingent Consideration

Q. Fund contractually entitled to future payout contingent on Port Co performance. Should the contingent consideration be fair valued?

A. Yes. A contractual right to a future payment is an asset that should be fair valued & recorded

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Q 14.26 Earnings Normalization

Q. Is it OK to normalize earnings to derive a fair value indication?

A. Yes. Market participants frequently normalize earnings for one-off, nonrecurring items to reflect sustainable performance

Q 14.28 Treatment of Synergies

Q. How are synergies treated in developing fair value estimates?

A. Fair value estimate should incorporate market participant synergies that would be available to a typical market participant, but exclude buyer-specific synergies that would be available to only one buyer

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Q 14.32 Addressing the Lag in Available Financial InformationQ. In estimating market multiples for guideline companies as of 12/31, the latest info is available as of 9/30. It is reasonable to use the data?

A. Yes. Also consider industry news & analyst reports for Q4. If delay in release of financial statements & Q4 data becomes available – if major surprises only adjust for information that is known/knowable at measurement date

Q 14.42 Offer to Purchase

Q. Does an offer or a nonbinding letter of intent constitute fair value?

A. Probably not. Assess if the offer is realistic. Good data point; however, consider adjustments for closing price. Consider weighting offer price & adjusted price. Consider factors such as financing contingencies, stage of due diligence, regulatory approval, etc.

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Q 14.57 Treatment of Equity Interests with Different Liquidity Preferences Q. How should valuation capture higher (senior) & lower ranking (junior) classes of equity?

A. If profit sharing is proportionate & with preference in a waterfall, there will be no difference. But if contractual rights & preferences are different, then use appropriate waterfall or methods to reflect such rights

• Sometimes seniority will have a significant impact on the value of an equity interest, while in other situations, seniority may have little or no effect on value

• The least impact will be at the very early stages & at a very high exit value, when the proceeds to senior & junior classes are expected to be proportional

• For situations in between, the guide suggests using a valuation method that is designed to capture the contractual rights & liquidation preference differences between the classes of equity

Q 14.62 & 14.63 Control Considerations

Q. When valuing private company interests where there are no observed transactions, should the enterprise value reflect a controlling or noncontrolling interest?

A. The value of an enterprise should reflect assumptions that are consistent with company's plans under current ownership & control. It would not be appropriate to add a control premium. If investor interest is aligned & fund has information rights, adjustments for minority interest may not be necessary. If such information is not available & minority investor IRR is higher, then a discount may be necessary

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Q 14.70 Incorporating Nonpublic InformationQ. Can nonpublic (insider) information be used in a valuation?

A. Should consult with counsel. The Fund should consider the information that is known or knowable at the valuation date. Whether permissible to disclose information to market participants prior to use

Q 14.72 Post-Valuation Event

Q. At 12/31/2010, the Fund is not aware that a major customer filed for bankruptcy in late December. Fund became aware at 1/31/2011. Can this information be used in the valuation at 12/31/2010?

A. Yes. Because the filing was a matter of public record (as of late December/pre-12/31) & was known/knowable at the valuation date

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Q 14.73 Post-Valuation Event –Product Approval Q. Measurement date 12/31/2010; valuation date 2/1/2011; FDA drug approval date 1/25/2011. Should you include drug approval in stock valuation at 12/31/2010?

A. No. Drug approval in January 2011 was not known or knowable at the December 31, 2010 valuation date

Level 1 Securities

• If a reporting entity holds a position in a single asset or liability (including a position comprising a large number of identical assets or liabilities, such as holding financial instruments), & the asset or liability is traded in an active market, the fair value of the asset or liability shall be measured with Level 1 observable inputs, as the product of the quoted price (P) for the individual asset or liability & the quantity (Q) held by the reporting entity, i.e., [P*Q] Exception

• Post-market close events; does not pertain to nonpublic information

• Blockage discounts for Level 1 securities still not allowed

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Level 1 Securities with Restrictions

• Where there is a legal or contractual restriction which is deemed a characteristic of the shares & not of the holder, an adjustment to the P*Q fair value estimate may be necessary. Such a restriction would prevent the fund from accessing the public market &; therefore, the principal market would be a transfer of the interest to another market participant who typically would also be subject to the restriction

• A reporting entity holds an equity instrument (a financial asset) for which sale is legally or contractually restricted for a specified period, e.g., such a restriction could limit sale to qualifying investors, as may be the case in accordance with Rule 144 or similar rules of the SEC. The restriction is a characteristic of the instrument &, therefore, would be transferred to market participants

Level 1 Securities with Restrictions

• When evaluating an assumed transfer of a position, any buyer of the position typically would be subject to the same restrictions, either via direct transfer of the restriction (for legal or regulatory restrictions), or because the counterparty would require that the buyer accept the same restrictions (for contractual restrictions). Therefore, in such cases, the task force believes that it is appropriate to consider the restriction to be a characteristic of the asset irrespective of the form of the restriction

• The adjustment would reflect the amount market participants would demand because of the risk relating to the inability to access a public market for the instrument for the specified period The nature & duration of the restriction

The extent to which buyers are limited by the restriction, e.g., there might be a large number of qualifying investors

Qualitative & quantitative factors specific to both the instrument & the issuer

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PIPE – Similar vs. Identical Securities

• To the extent that the transaction price reflects fair value at initial recognition, the fund should calibrate the valuation model to the transaction price. In most cases, such transactions will be priced at a discount to the traded public stock price, reflecting the relative negotiating leverage between the company & the investors in situations where the company does not have access to less expensive forms of capital

• The valuation must also consider the differences between the specific instruments held & the common stock, given the unit of account & the market participants in the principal market for the instruments

• Consider Timing of the most recent transaction Differences in information available Degree of dilution Ability to exit via the public market

Pricing Services/Broker Quotes

• Management should understand how a quotation or a price provided by a third party was determined. It should understand what the source of the information was, the inputs & assumptions used & whether a quote is binding or not. In addition, management is expected to establish internal controls to determine that the pricing information received from a third-party source & used by management in the valuation process is relevant & reliable, including Whether that reflects how an orderly transaction would take place between market

participants (on the measurement date); & Whether there are a number of price indicators for a single instrument & the price

indications are widely dispersed. If so, management should consider which price(s) best represent the price at which an orderly transaction would take place between market participants on the measurement date

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Pricing Services/Broker Quotes

• When determining the relevance & reliability of pricing provided by pricing services, consider the following Whether the price provided is based on recent market information; Whether the price provided is based on transactions of similar or identical

instruments; The extent & nature of the market information on which the price was based;

& Whether price provided by the pricing service is representative of a market to

which the entity has access

Pricing Services/Broker Quotes

• When determining the relevance & reliability of pricing provided by broker quotes, consider the following Whether quote is contemporaneous & actionable, i.e., binding or not; Who, at the broker or dealer provided the quote; Is the broker or dealer active in assets of the type for which they provided the

quote; & What disclaimers from the broker or dealer accompany the quote?

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Questions?

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