Venture Capital Review Fair Value

7/31/2019 Venture Capital Review Fair Value

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VENTURE CAPITAL REVIEIssue 27 2

produced by the NatioNal VeNture capital associatioN aNd erNst & youNg llp


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National Venture Capital Association (NVCA)As the voice of the U.S. venture capital community, the National Venture Capital Association

(NVCA) empowers its members and the entrepreneurs they fund by advocating for policies

that encourage innovation and reward long-term investment. As the venture communitys

preeminent trade association, NVCA serves as the definitive resource for venture capital dataand unites its 400 plus members through a full range of professional services. Learn more at

www.nvca.org.

National Venture Capital Association1655 Fort Myer Drive Phone: 703.524.2549

Suite 850 Fax: 703.524.3940

Arlington, VA 22209 Web site: www.nvca.org


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By stvn Nbb, CFA, Dirctor, and David L. Larn, CPA, Managing Dirctor, of Dff & Phlp LLC

Primarily because of historical bias, during the past

decade and especially during the past several years,

venture capitalists have repeatedly been heard toay: Fair val rporting for th Vntr Capital (VC)

indtry i maningl; LP dont nd it; GP dont

want it; regulators dont understand it. However, a

more critical examination of a wide range of reporting

and governance issues demonstrates that fair value

is not only required by most LPs, but provides key

bnfit to both LP and GP.

Part of the stigma associated with fair value is a lack

of understanding of what fair value means for the VC

indtry. som incorrctly bliv that FAsB intittd

fair val rl for th VC indtry in 2006 with thianc of th mch-malignd sFAs 157. Yt sFAs

157 (now AsC Topic 820) do not rqir any at

or any liability to be measured at fair value. Fair value,

for the investment industry, has its origins with the

1940 Invtmnt Company Act. Frthr, invtmnt

company accounting,1

which originated with the AICPA

Audit and Accounting Guide for Investment Companies

in th 1960/70 rqir invtmnt to b rportd

at fair value.

Wh i Fr V?Most discussions about fair value still begin witha description of what fair value represents. With

liquid securities, fair value is a concept that is much

easier to understand since the definition becomes

somewhat formulaic: market price times number of

1 US investment company accounting requirements are now promulgated byFASB Accounting Standards Codification (ASC) Topic 946.

Fair Value, Who Cares?and Why They Should!


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shares owned, or a value that has direct benchmark

indications from other market transactions. However,

when considering illiquid investments, fair value

represents a more qualitative and ambiguous

concept. Even in such instances, fair value is still

strictly defined. Accounting guidance establishes the

definition of fair value as the price that would be

received to sell an asset or paid to transfer a liability

in an orderly transaction between market participants

at the measurement date.2

The guidance adds that

to the greatest extent possible, valuations should be

based upon observable market data from reliable

sources. For VC investments, there is often limited or

no rliabl markt data. each invtmnt i niq (no

comparabl compani or tranaction) and involv

sensitive details that many times would be harmful to

the investor if disclosed. As a result, VC investors must

use supportable unobservable inputs, often using a

managers own assumptions, about how a market

participant would transact.

Historically, VC fund managers have reluctantly

embraced fair value concepts, using cost or the value

of the last round of financing as their best estimate of

fair value in between financing events. The use of cost

to estimate fair value was driven by three key factors:

1. A hitorical convntion that idntifid conrvatim

as a positive attribute;

2. Draft 1989 NVCA gidlin (which wr nvr

ratifid or adoptd), which ncoragd th of

cost; and

3. An invtor (LP) ba mad p of individal rathr

than entities that had less strict fair value reporting

requirements.

Furthermore, because the development of an

emerging business or technology requires financings

more frequently, investors attempt to manage their

exposures to certain risks by funding development

at discrete points in time. Multiple financing events

potentially generate an opportunity to assess implied

val in Lat Rond of Financing (LRF) tranaction.

However, caution should be applied when considering

LRF as indications of fair value since implying value

for existing investments using LRF requires material

assumptions that may or may not be appropriate.

Bca of thi, th ability to LRF a an indicator

2 FASB ASC Topic 820-10-35-1

of value does not mitigate the need for alternative

methods and procedures for estimating a robust

fair value.

Why Fr V?Bca many VC fnd managr hav partially

convinced themselves that fair value is not

estimable, is not cost-effective to estimate or is not

needed by their investors, it is important to dispel

such myths and once and for all acknowledge that

while imperfect, estimating fair value is not only

possible, but necessary for most investors and

helpful to most managers.

Our experience with our VC clientele is that while a

current period valuation of a VC investment requires

significant judgment, the focus on a valuation

framework that considers the analysis of all meaningful

factors and inputs beyond LRF, and the effort to

document these considerations, does indeed help the

fund in its strategic planning and in communication

with its investors. It also provides a meaningful method

for monitoring its investments and satisfying the funds

governance requirements. Additionally, we find that

most of our clients are already doing what is

necessary in some form to satisfy these goals, but

the lack of a formalized process or documented

methodology has not allowed them to take full credit

for the work performed.

One other important consideration that should not

be ignored is the fact that investment companies are

not required to consolidate underlying investments

because they report fair values. However, if a fund

did not report its investments at fair value, arguably,

from an accounting point of view, underlying control

investments would be required to be consolidated,

making internal and external reporting significantly

more complex and less meaningful.

evn of Fr V

If there are real difficulties in estimating the value of anemerging company, how then do venture capitalists

determine the valuation at which they will invest at

various points in time? Many valuation practitioners

and auditors like to refer to market studies that have

been conducted over the past couple of decades

as support for indications of value. These studies

demonstrate the step-up in value between major

rond of financing typically coniting of 25% to


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100%+ incra in val a compani progr

through the stages of development. However, this is

only true for investments at specific points of time thatsuccessfully secure financing and is only meaningful

on an aggregate level, not necessarily applicable to

a single investment.

In working with our VC clients, we have observed

numerous examples of a portfolio company being

able to meet significant milestones only to have forced

recapitalizations or down-round financing available to

it. The question then becomes, why does this happen?

The illiquid nature of the VC market sustains pricing

inefficiencies. Ultimately, the supply and demand of

VC capital and the bargaining power of entrepreneursand ownership syndicates does change, and at times

will not be correlated with the performance of the

underlying company. This environment clearly muddies

the waters for determining values. However, what this

truly means is that when estimating the fair value of an

investment, considerations beyond LRF or company

performance are meaningful.

The assessment of what could be termed non-

performance risk is the risk that a portfolio company

with negative cash flow will be unable to raise

additional capital when needed. This factor is materialfor VC investments that are capital intensive in one

form or another, and are expected to generate

negative cash flow over the development period of

two to five years. In situations where capital becomes

unavailable, the company is typically sold, possibly at a

loss, recapitalized at a valuation significantly lower than

the post-money valuation implied by the progress of

the firm or is shut down.

Ultimately valuations should consider the inputs used

to derive value, the intangible assets of the business.

These intangibles include intellectual property andknow-how, long-term growth potential, management

team talent, financial strength of existing investors,

perception of VC market interest, progress toward

milestones and competitive landscape. For early-

stage, venture capital-backed companies that require

additional capital, these intangibles may impact

positively or negatively their ability to raise capital in

the current venture capital environment. The resulting

non-performance risk for companies that need to raise

money to reach cash flow breakeven or a successful

exit continues to be substantial, and may outweigh

many or all other valuation considerations.

While changes in value are certainly not linear, it

should be clear that value does not magically increase

or decrease on the day a new financing event takes

place. Since VC investors are instrumentally involved

with their portfolio companies, they likely are aware of

how a company is progressing toward its milestones,

and they typically have timely knowledge of trends in

the VC capital market that lead to an understanding

of the willingness and ability of the market to fund the

next stage of development for a company. Therefore,

while significant judgment is required, it should be

evident that an estimate of value can be derived at

times other than on the day of a financing event.

Why invor (lp) n Fr VOn of th mot trobling fatr of th GP/LP

interactions is the seeming inability of both sides to

fully understand the needs of the other. This failure to

One other important consideration that should not be

ignored is the fact that investment companies are not

required to consolidate underlying investments because

they report fair values. However, if a fund did not report itsinvestments at fair value, arguably, from an accounting point

of view, underlying control investments would be required to

be consolidated, making internal and external reporting

significantly more complex and less meaningful.


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communicate has given rise to more specific Limited

Partner Agreements, requests for side letters, ad hoc

data requests and LP initiatives such as the ILPA

Privat eqity Principl. Any intittional LP (LP

that prodc GAAP-bad financial tatmnt and

invest on behalf of others fund of funds, pensionfnd, ndowmnt, tc.) ha nd for timly, priodic,

robtly timatd nt at val (NAV) pportd

by a rigorous measurement of the fair value of

underlying investments. LPs dont always articulate

the reasons they need fair value reporting. LP needs

include, but are not limited to, the following:

Fair val i th bai invtor (LP) to rport

priodic (qartrly/yarly) prformanc to thir

investors, beneficiaries, boards, etc.

Fair val i th bt bai for LP to mak

apples to apples asset allocation decisions.

Fair val i an important data point in making

intrim invtmnt (managr lction) dciion

on a comparable basis.

Fair val i oftn ncary a a bai to

make incentive compensation decisions at the

investor level.

Limitd partnr nd conitnt, tranparnt

information to exercise their fiduciary duty.

fair value provides such information on a

comparable basis for monitoring interim

performance. An arbitrary reporting basis such

as cost does not allow comparability. Mot invtor ar rqird by rlvant GAAP to

report their investments on a fair value basis.

Not all LPs articulate their needs as described above.

som may vn tll GP that thy prfr cot.

In many cases, this failure to communicate occurs

because deal team members of LPs speak with

dal tam mmbr at th GP and may not flly

articulate all of the needs of the investor.

Additionally, reporting fair value for financial

instruments is required to be consistent with otherfinancial reporting requirements. In particular, the

recognition of the fair value of contractual rights for

future cash flows typically resulting from earn-outs or

contingent considerations at fair value is required.3

3 Established by FASB Statement 141 (revised 2007), Business Combinations(FASB Accounting Standards Codification (ASC or Codification) 805,Business Combinations.


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Bad on th ncrtainty mbddd in many arly-

stage companies, it is not suppressing that many

M&A transactions increasingly include earn-outs

or some form of future consideration. Since other

rporting ntiti (byr) mt rport th contractal

payments at fair value, it is logical that the seller should

also recognize this contractual asset at fair valueas well. LPs must have fair value-based NAV and,

therefore, managers need to include the fair value of

all investments, including contractual payments, in

their calculation of NAV. Determining the acquisition-

dat fair val of contractal right (contingnt

conidration) may ntail th timation of th

likelihood and timing of achieving relevant milestones

and/or th dvlopmnt of xpctd or cnario-

based projections relevant to sales- or profitability-

based payments. The good news is that these types

of assumptions and inputs are the same details that

are considered by the manager in making the decision

to ll it invtmnt in th firt plac (and only nd

to b adjtd for byr/ngotiation conidration).

Essentially, the reporting of fair value for contractual

rights becomes an extension of the processes already

performed by fund managers.

lm prnr Von NAs noted above, limited partner investors have a

number of reasons for needing and using fair value

derived NAV. LPs must value their interest in an

underlying fund at regular intervals to support theirfinancial reporting process. The recent accounting

gidanc (Asu 2009-12) otlin whn and how an

LP may estimate the fair value of an interest in a fund

ing th rportd fnd NAV. Bad on th gidanc,

reliance on a reported NAV is only appropriate to the

extent that the investor has evidence that the reported

NAV is appropriately derived using proper fair value

principles as part of a robust process. In order to do

this, the most frequent ways to assess the robustness

of reported NAV are:

1. To condct thorogh pr-invtmnt d diligncand to leverage this diligence in ongoing monitoring

procedures;

2. To assess the funds fair value estimation processes

and control environment, and to monitor any

periodic changes; and

3. To rviw th fnd polici and procdr for

estimating fair value, including considering factors

such as the use of independent third-party valuation

experts to augment and validate the investee funds

procedures for estimating fair value.

Ultimately, the investor is required to assess,

ndrtand and concld that th GP ha dlivrd

a NAV derived from a rigorous estimate of the fair valueof underlying investments.

Why Fr V Mnngf?Whthr it i from th GP prpctiv, or an

LPs requirement, fair value is ultimately the

contemporaneous measurement basis that allows

the VC industry to deliver on its obligation to be

fair, ethical and to effectively communicate critical

information needed by multiple interested parties.

Arbitrary valuations, such as cost, or inaccurate

valuations can undermine effective asset allocationfor investors, resulting in the inability of an investor

to properly manage its investment strategy or

possibly increasing the risk of fulfilling its fiduciary duty

to its beneficiaries.

Industry best practices centered around robust fair

val dtrmination provid GP with ffctiv

strategic tools for making appropriate comparisons

and for monitoring interim performance of their

investments, in addition to satisfying fiduciary

obligation. Bca fair val rqir a ytmatic

approach for estimating value and supporting

assumptions, appropriate procedures that generate fair

value will provide additional focused information

to monitor portfolios regularly.

An incomplete development of policies, procedures

and processes that measure fair value may expose

fund managers to significant reputational and legal

risks and, ultimately may adversely affect their

marketing and fund-raising efforts. In the current

market environment, fund managers must now be

aware that investors should, both in their initial due

diligence process and in periodic reviews, discount

managers that have not adopted appropriate valuation

practices that generate robust indications of fair value.

Additionally, auditors and regulators will scrutinize

funds that dont have well-defined and documented

valuation process and governance policies.


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Wh Vc o do?The determination of fair value, for VC investments,

requires a significant level of informed judgment,

rather than a rigid application of a mechanical process.

Therefore, fair value requires thoughtful involvement

from all stakeholders, including fund managers,institutional investors, auditors, valuation experts

and regulators.

The valuation process should not be a make work

xrci. Bt practic dictat that th information

needed to make, monitor and improve investments

is the same information used to value investments

on an intrim bai. Gnrally, thr i no nd for

a fund manager to develop extensive policies, but

leveraging or enhancing existing processes to develop

and use a comprehensive and integrated valuation

framework that is clear, consistent and pragmatic willprovide effective documentation and communicate

the funds efforts in monitoring its investments and

reporting fair value robustly. This typically means that

the valuation process is an extension of the funds,

already developed, diligence, monitoring and strategic

decision-making processes.

A well-developed and documented valuation

process can provide the basis for demonstrating to

investors that the fund manager is compliant with

fair value measurement principles. The specific

components of a thorough process should includea governance structure, well-documented valuation

policy and clearly defined roles and responsibilities,

including independent personnel who are extremely

knowledgeable about valuation methodologies. The

elements of the valuation policy should cover specific

approaches and valuation methodologies appropriate

for various types of investments at various stages of

development, and should include details regarding

typical assumptions and sources of data that would

be part of each valuation methodology. Additionally

the policy should address the internal documentationprocdr to pport valation (modl and

tmplat) and a dlination of circmtanc that

permit a manager to rely upon specific or different

models. The valuation policy and supporting

documentation should be periodically reviewed and

updated. Having established valuation policies and

procedures will allow a manager to communicate

and discuss its approach to fair value and satisfy an

investors need to understand the processes and

controls related to deriving value.

It should be emphasized that fair value does not

represent what a fund manager ultimately expects

to receive for exiting an investment, but the amount

that would be received in an orderly transaction asof the valuation date. This concept troubles some VC

managers because they would not, and likely could

not, sell the investment at an interim date. The orderly

transaction price determination is hypothetical and

requires the exercise of informed judgment. This

means that fair value does not have to assume that

the underlying business or investment is saleable, the

investor or shareholders intend to sell in the near future

or the likely transaction would have to be a forced sale

or liquidation. In assessing fair value, fund managers

should be able to answer the following questions in

a consistent manner to explain how the investment isbeing valued.

1. How corrlatd i th invtmnt to pblic markt

data? What objective data may indicate whether

value is moving in a logical direction? This should be

from a perspective that adjusts for outliers that may

significantly impact reported trends.

2. What other recent transactions has the fund been

involvd with (or know th dtail of) that pport

the current fair value of an investment? Are there

similar deals that provide an indication of the fair

value of the subject investment? This may include

transactions of the subject company securities,

comparable company transactions, or sector and

industry transactions involving companies in similar

stages of development.

3. Ar thr any potntial i with obtaining th

nxt rond of financing for an invtmnt (compard

to original xpctation)? What th likly impact of

l/mor dmand to fnd th portfolio company?

4. Do th fair val indication rprnt a pric [a

of the valuation date] that you would be willing toinvt in th am portfolio company (with th am

xiting trm)? Wold mor invtmnt for a highr

or lower percentage interest be appropriate? Does

it make sense to invest less money for the same

percentage interest because the company has

atifid om dvlopmnt hrdl (milton)

and has less need for capital at the current stage?

Will the company need more capital than originally


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expected because the burn rate is higher, more

uncertainty developed in the market or negative

results require more development effort?

5. I it poibl to ll an intrt in an xiting portfolio

company at the same price as you could have

sold it previously? This question may help limit thehypothetical nature of a fair value transaction since

it contemplates the comparison of a hypothetical

transaction in the past to a current hypothetical

transaction.

6. What ha changd with th portfolio company in

relation to the companys position at entry, during

the LRF and with the expectations of the business

over the holding period? Its more important to

understand why things have changed than to simply

recognize that things are different. An understanding

of why changes have occurred should be helpful in

assessing the potential impact the changes will have

on the success of the business, which is the key

to assessing the progress of value during the

holding period of an investment.

7. Have the current market and economic conditions

affected the underlying opportunities, risks orprobability of success of the portfolio company?

Considering these questions and documenting the

answers will be a good start at a well-thought-out and

documented process for estimating the fair value of

VC investments. Again, since these considerations

are the same considerations that are used in making,

monitoring and exiting an investment, they flow

dirctly into th priodic (ally qartrly) valation

assessment. For example, a simplified way to consider

valuing VC investments is using the following decision

tr (for illtrativ prpo only):

. if no, h v of mo rn ron of fnnng my h

m of fr v.

No

5. Has there been any significant change in the results of the

investee company compared to budget, plan, etc? Has there been

any significant change in the market for the investee company or

its products or potential products? Has there been any significant

change in the global economy or the economic environment in

which the investee company operates?

. if h hng ov, hr n non h v h

nr. drmn fr v ng ojv from h

omny, nvmn rofon n ohr nvor

. if h hng ngv, hr n non h v h

r. drmn h v r o ror

on ojv mr n mngr xrn.

No

Yes

4. Does the investee company have positive sustainable

performance (for example, positive recurring EBITDA)?

Fr v my rmn ebitda m ron

mrk m for h omny.

No

Yes

Yes3. Is there a comparable company from which fair value can

be derived?

uz omr omny von hnq o rmn

fr v.

. if hr no g rron (r o h hr, no o

h hor), fr v rmn h mrk r m

h nmr of hr own. No on ow vn f h

nmr of hr own rg rv o h vrg y

rng vom.

No

No

Policy Statement:

All investments are recorded at fair value.

All relevant information is taken into account to make the fair value determination.

1. Barring contradictory information, the cost (excluding transaction

costs) of an investment is deemed the exit price on the date of

investment and is therefore used as its initial fair value.

2. Are shares publicly traded in an active market? 2a. Is there a legal restriction?

. Fr V mr h mrk r m h nmr of

hr h o on. sor for h on

gnry mo-.

Thereafter

Yes

Yes

Valuation Decision Tree


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By tilizing th implifid illtrativ dciion tr, many

arly-tag vntr invtmnt wold fall into tp 5.

Therefore, for some period of time after investment,

aming non of th chang otlind in tp 5

have occurred, fair value is often measured by using

the value of the last round of financing. However,

as knowledge is gained about the progress on ameaningful milestone, or it is clear that more or less

fnding will b ndd (brn rat) to gt to th nxt

tag (probability of cc), or that fnding i or i

not likly to occr at typical trm (prformanc rik),

fair value has diverged from the last round of financing,

and fund managers have a duty to acknowledge and

report that fact in the normal reporting process to the

funds investors.

cononsinc th ianc of th PeIGG gidlin in 2003,

th rla of th IPeV Gidlin in 2005, FAsB

ianc of statmnt 157 in 2006, th financial crii

of 2008 and bqnt rviion and application

of the preceding, fair value measurement has been

a topic of concern in the VC industry for almost a

decade. Rather than being vilified, fair value should

b mbracd a th bt (albit imprfct) bai for

measuring investments at interim periods, resulting

in the fulfillment of a multitude of needs for both

investors and managers.

About the Authors

David L. Larsenis a Member of FASBs Valuation Resource Group, a Board Member of the International Private Equity

and Venture Capital Valuations Board (IPEV), led the team that drafted the US PEIGG Valuation Guidelines, and is a Memberof the AICPA Net Asset Value (NAV) Task Force. Mr. Larsen serves a wide variety of alternative asset investors and managers

in resolving valuation and governance-related issues.

Steven Nebbserves as the project lead for numerous Alternative Asset managers and investors, including large global

private equity, venture capital, and Business Development Companies. He provides advisory support to many limited

partnerships and corporate pension plans regarding fund management, financial reporting requirements and general

valuation of investments, and has significant experience in performing valuations of intellectual property, private equity,

illiquid debt, and complex derivatives for a variety of purposes, including fairness opinions and transaction advisory,

financial reporting, tax, litigation, and strategic planning.


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ernt & Yong i a global ladr in aranc, tax, tranaction and adviory rvic. Worldwid, or141,000 popl ar nitd by or hard val and an nwavring commitmnt to qality. W maka difference by helping our people, our clients and our wider communities achieve their potential.

ernt & Yong rfr to th global organization of mmbr firm of ernt & Yong Global Limitd, achof which i a parat lgal ntity. ernt & Yong Global Limitd, a uK company limitd by garant,does not provide services to clients. For more information about our organization, please visit www.ey.com

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visit www.heidrick.com .

Th Tch Grop at Lowntin sandlr i a nationally rcognizd thoght ladr in th dvlopmnt oftchnology-bad and vntr-backd bin acro indtri. Th Tch Grop, which ha conldclint on mor than 300 vntr and angl financing in th pat two yar, rprnt th contryleading venture funds and works with technology entrepreneurs and businesses at every level from the

labs of leading universities, to start-ups, to the largest companies in information

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NYPPeX i on of th world lading vntr condary intrmdiari. W provid indpndnt adviory,xction and procing rvic for por tfolio divtitr and block tranaction (ingl companytranaction gratr than $10 million).

Gnral partnr and limitd partnr bnfit from or track rcord with nmro larg, mid-iz andmall vntr firm inc 1998, foc on achiving prior pric xction and tranaction pd, andacc to maiv liqidity worldwid providd throgh tablihd rlationhip with qalifid prcharholding privat qity at in xc of $2.3 trillion (a of Dcmbr 31, 2010). Mmbr FINRA and sIPC.

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private equity sectors and practice in strategic business centers that allow us to represent fund sponsors

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Venture Capital Review Fair Value