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

Article
Common scenarios VC managers face as they prepare their valuations for their financial statement audit and tips for approaching the valuation analysis.
10 minute read
October 26, 2023

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:

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approach rather than relying solely on the most recent financing round, especially if that round of financing is outdated.

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:

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:

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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