Venture Capital Valuations: Tips for Preparing Valuations for Your Annual Audit

In volatile economic times, venture capital fund managers (VC managers), especially emerging managers, often ask us how to properly value the investments held in their portfolio in preparation for their annual audits. When interest rates keep rising and the economic outlook is so uncertain, what are the factors that could make this year’s valuation so different from the past few years? Should the performance of the public markets factor into the valuations of private companies? How should VC managers value investments that are stale (older than 12 months) or that have raised a round of financing at a lower valuation than previous rounds? How should non-equity financing rounds or down rounds be incorporated into the analysis?

We will discuss some of the most common scenarios that VC managers face as they prepare their valuations for their financial statement audit and provide some tips for approaching the valuation analysis.

Re-Evaluating Stale Investments

With the rapid rise in interest rates, volatility and uncertainty in the market, portfolio companies are trying to stretch their runway, if possible, to avoid down rounds. Managers will need to analyze each portfolio company to determine whether the latest round of financing is still a reasonable fair value indication or whether mark ups or mark downs are warranted. Managers should discuss the status of investments with the portfolio company management for indicators of mark ups or mark downs by asking these questions:

• Have there been any recent rounds of financing or has there been any announcements of new rounds of financing that would affect the valuation? At times, portfolio companies do not notify existing investors of new fundraising rounds, which leads to fund managers having outdated information that is utilized in their valuations. 
• Ask management questions to determine if the company is performing either better or worse than anticipated. Indicators of impairment may include: significant layoffs, the divestiture of certain components, the loss of a large account or contract, the failure of a trial phase, known instances of fraud, or involvement in a commercial dispute or other legal proceedings. Indicators of the company’s improved performance include: acquisitions or product announcements, patent or regulatory approval, positive operational results. Ask for revenue information if you have information rights so you can see how the current revenue compares to the revenue at the time of the original investment.
• Does the company have enough cash on hand or sufficient cash flows to continue operating for the next year? Lack of cash could indicate potential impairment if the company is no longer able to continue operations. If the company is struggling with cash flows, it is important to get information about its plan to secure additional financing to continue its operations.
• Is the company meeting its operating milestones? Generally, when a company raises financing, it sets out operational goals and milestones that it will use the financing for. It is important to understand if the company is on track to meet those goals and milestones. If all milestones are on track and being met, it is unlikely that a significant impairment is present. However, if the company is pivoting or failing to meet its milestones, management should consider whether the latest valuation remains reasonable in light of the company’s updated status.
• Evaluate the industry the portfolio company operates in and understand/inquire if there have been any significant changes in that industry, either positive or negative, that can have a significant impact on your portfolio company’s operations. For instance, has there been a significant IPO or acquisition in the industry or have there been any regulatory changes that negatively impact a particular industry resulting in a major impact on your portfolio company’s operations.

If the company is meeting milestones, has significant increase in revenue or is in a positive earnings scenario, management should consider whether other valuation approaches are more reasonable. Significant revenue and earnings may indicate it is time to evaluate the fair value using a market comparable approach rather than relying solely on the most recent financing round, especially if that round of financing is outdated.

• Managers should look to find significant changes in the valuations implied by the market sector (e.g. for SaaS companies look at SaaS multiples published by the Software Equity Group). Identify publicly traded companies that are similar to your portfolio company in terms of industry, business model, market positioning, and growth prospects. While not perfect, these proxy companies can serve as rough comparable guideline public companies for valuation analyses and will assist in identifying trends in the overall market. Analyze the financial ratios, valuation multiples (such as revenue multiples) and other relevant metrics of these companies. Consider calibrating the metrics to your portfolio company using high-level figures (if available) while adjusting for differences in size, growth prospects, and risk factors. If high-level figures are not available, consider comparing the metrics as of the valuation date to the metrics at the time of the last round of financing and applying a discount or premium based on the change.
• If you have any information about the company’s business model or growth initiatives, you can create different scenarios for valuations based on overall impressions (optimistic, moderate, pessimistic) and adjust valuation multiples or other metrics accordingly.

Estimating Fair Value Without Information Rights

Estimating fair value without comprehensive information rights involves a high level of uncertainty. Without information rights, it can be challenging to access information about new financing rounds or updated company status, as well as detailed financials. When managers are without information rights, valuations are difficult, but not impossible, and it is important to be transparent about the limitations of your analysis and the potential variability in your estimates.

Even if you do not have rights to all the information you need to estimate a company’s fair value, you can still identify publicly available data that may provide insights into fair value changes by following these steps:

• Search for public information about significant changes in the global economy, the market or the industry sector for the portfolio company or its products or potential products (e.g. for IT company – how S&P500 changed, or S&P500 IT index). Fund managers should evaluate how these changes would impact the fund’s portfolio companies’ valuations.
• Engage in limited communication with management of the portfolio company. Companies have an incentive to keep their investors happy, and sometimes will provide limited information despite not having information rights. Managers should ask for less sensitive financial and operational information, such as high-level revenue figures, growth trends, cash flow situation, milestone progress and strategic initiatives.
• Search through publicly available information, such as press releases, regulatory filings, industry reports, and news articles to obtain indicators on how the company is performing. These sources can provide insights into the company’s recent developments, partnerships, market positioning, and potential financial performance.
• Consider acquisitions or other transactions involving competitors or other comparable companies which may provide relevant indicators of value.

Rather than trying to derive an exact valuation, fund managers should focus on understanding where your portfolio company might stand in terms of quality and growth potential compared to publicly traded peers and evaluate how the trends in the public companies line up in comparison to the portfolio company being valued. This can help you assess whether the latest valuation mark is reasonable or if the company is potentially over or undervalued.

Non-equity Financing Rounds

Given the uncertainty in the market, early-stage companies may seek to raise fundraising rounds that are not priced equity to continue operations until the economic environment is more conducive to fundraising. These non-equity rounds, such as convertible notes or simple agreements for future equity (SAFEs), can be a valuable tool for portfolio companies to obtain the capital necessary to perform. These non-equity financing rounds are becoming more common in the marketplace and will often have contractual obligations to convert to equity at a future date when an equity financing round is completed.

Commonly, these instruments are valued at par value until conversion. However, given existing venture debt is unlikely to convert if companies are not raising equity rounds, fund managers may need to consider if the par value of these instruments is still the most reasonable fair value metric.

If convertible note or SAFE investments have not converted and the original maturity date has passed, fund managers should consider the likelihood that these investments will eventually convert or if the investment is even recoverable. Analyzing the company’s financial statements if available or making inquiries with management of the portfolio company as outlined above can assist in determining if the company has the ability to repay or if there are enough assets on hand to fully recover the fund’s investment. If the investments are determined to be recoverable fully, then no further action is likely necessary.

If the company does not have the ability to repay the debt and interest fully, management should evaluate how much would be recovered and impair the investment to the expected recoverable amount. Any accrued interest receivable that is determined to be no longer collectible should be written off and management should cease accrual of interest income.

Down Rounds

For those portfolio companies that are raising equity rounds, the occurrence of lower valuations is not uncommon. In the past, managers often assumed that the investments would increase in value to a point that all shares would convert and participate pro-rata on a fully diluted basis. Now, as down rounds have increased in frequency, it is no longer safe to assume that all investments will convert to common shares if the company raised a round at a lower valuation. Most recent rounds may have liquidation preferences that would be more advantageous than converting to common, and thus, would reduce the proceeds in liquidation to earlier investors. If managers are invested into a company that has a down round, managers should calculate a hypothetical liquidation waterfall and analyze whether all series would convert on an equal basis into common shares.

What Support Do Fund Managers Need?

As managers prepare for their annual audits, certain documents and items of support should be obtained from the underlying portfolio companies to support the assumptions used in the valuation analyses. Managers should work with their portfolio companies in the lead up to year end to obtain the following support items that audit teams may need:

• Annual financial statements from the portfolio company as of year-end, to the extent available
• Board deck presentations showing an update on the company including changes in projections or budgets and an update on significant events that have occurred

• Latest articles of incorporation showing the round of financing and the rights and preferences associated with the various equity rounds.
• Updated company capitalization table as of year end
• In the absence of information rights, make inquiries about the cash flow situation and progress towards milestones as very often, the portfolio companies are willing to share such high-level information.

The valuation of investments is a significant estimate which requires careful attention on the part of VC fund managers. The annual audit will be focused around this estimate so it is important to devote careful consideration to the valuation of each portfolio company prior to closing your books.

Weaver’s valuation professionals can assist VC fund management with your valuation analyses in preparing for annual audits. Contact us for information.

Authored by Matt Higginbotham, Elena Mavliev and Danielle Darley.

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