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Article

Guidance for the valuation of private equity and venture-backed companies

April 28, 2020 · Authored by Fred Peterson and Michael C. Massey

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Valuation assumptions and methods require significantly different considerations for systematic risk during periods of unusual market volatility.

As COVID-19 brings disruption and uncertainty to domestic and global markets, the American Institute of Certified Public Accountants (AICPA) and the Investment in Private Equity and Venture Capital (IPEV) Board have released guidance to help businesses frame the risks in their valuation modeling.

An overview of the respective guidance — the AICPA’s Valuation Services Resource and the IPEV’s Special Valuation Guidance — follows, as well as key considerations for different investors.

Valuation basics

Despite the current disruption, it’s important not to abandon your current models quite yet.

Fair value

You should continue to follow a consistent valuation process that complies with the definition of fair value, or the price that would be received in an orderly transaction between market participants at the measurement date.

This definition relies on an orderly transaction taking place that doesn’t equate to a so-called fire sale. A fair value assessment still needs to consider how market participants would transact in the current market environment.

For further guidance and details on applying valuation methods, see the AICPA’s 2019 guide Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and other Investment Companies.

Additional risks

Keep track of where adjustments for risk are being incorporated and don’t duplicate these adjustments. If cash flow assumptions in a discounted cash flow model are moderated, additional risk reflected in the discount rate might not be appropriate because it’s already built into the cash flows.

Fred Peterson Profile Photo

Fred Peterson

Principal

Michael C. Massey profile photo

Michael C. Massey

Principal

In the application of a market approach, if financial metrics such as forward earnings metrics are risk-adjusted, then an additional subjective discount to the market multiples might not be necessary.

It’s also important to take note of when the multiples were measured and what was known in the market at the time.

Equity investments

There are several key considerations to be addressed in the valuation of equity investments.

Scenario analysis

Estimates of potential performance changes in Q1, Q2, and beyond will be necessary to fully develop a fair value estimate. Financial projections should incorporate what’s known or knowable as of the measurement date.

Consider applying scenario analyses to your valuations that account for the probability of adverse economic conditions lasting three, six, or 12 months, or even longer.

Market approach

In the application of a market approach, revenue and earnings are generally evaluated on an ongoing, sustainable level. Market participants may exclude one-time impacts to these metrics that aren’t reasonably expected to reoccur in the normal course of business.

Ultimately, you’ll need to assess whether the current negative economic environment will continue, or if a quick return to business as usual can be reasonably assumed.

Values based on recent financing rounds

If investment value is based on a financing round that took place before the current downturn, it will likely require additional consideration.

Depending on the timing of the round, this approach will require further support for the valuation or an adjustment to fair value based on current expectations differing from expectations in place at the time of the recent financing round.

Exit environments

You’ll also want to consider how the potential exit environment impacts the value of the company.

Possible acquisitions could be put on hold or fall through completely, and the initial public offering (IPO) market could be less favorable now than just a few months ago. As a result, the timing and weighting of IPO or merger and acquisition exit scenarios will likely change if a full scenario-based method is used to value the equity interest.

Liquidity

Necessary liquidity should be considered. You’ll need to assess if the company currently has, or could have, a cash flow problem that will need to be addressed.

Questions you’ll want to ask include:

  • Where will working capital be generated from to begin ramping up operations again?
  • Do debt covenants need to be reviewed for possible breaches?

Working capital short falls can be easily modeled into a discounted cash flow approach, and market approach values can be adjusted for working capital shortfalls.

When working with a discounted cash flow, the determination of an appropriate discount rate should include assessments of appropriate cost of new debt financing. To learn more about assessing your liquidity needs, read our cash-flow modeling article.

Value drivers

Continue to focus on the factors that drive company value and how they could be affected by recent events. Examples of value drivers include:

  • Revenues and customers
  • Growth prospects
  • Market conditions
  • Competitive advantages
  • Technology
  • Supply chain

Debt investments

Many funds hold debt at par value as a reasonable approximation of fair value. In a rapidly changing market, consider updating your approach to estimating fair value.

A yield analysis taking into account credit quality and a current market discount rate could result in fair value differing from par value. However, it’s important to determine if credit spreads on market participant discount rates require adjustment.

You’ll want to determine if convertible debt previously valued using conversion scenarios will need to be reassessed under updated scenarios.

Limited partners

It will be important to determine if the last reported net asset values (NAV) of underlying assets, such as real estate as of Q3 or Q4 2019, will need to be updated by general partners.

This update would be done to ensure adequate information about a fund’s NAV is timely, either for reporting to limited partners or for satisfying distribution requests.

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