Valuation Best Practices for Venture Capital Funds

Mercer Capital assists a range of alternative investment funds, including Venture Capital firms, in periodically measuring the fair value of portfolio assets for financial reporting purposes to the satisfaction of the general partners and fund auditors.

The National Venture Capital Association (NVCA) published the 2014 Venture Capital Yearbook in May 2014. This blog post summarizes Appendix I of the 2014 Yearbook, which includes comments on valuation guidelines and best practices for venture capital investments and funds.

Valuation Challenge

Valuation of private equity investments can be difficult because of their illiquid nature. Portfolio companies are generally not publicly traded, and holding periods are usually long. The valuation challenge is usually compounded in the case of VC funds because they invest in young companies with uncertain technical and/or economic prospects. Since startup investees need to develop viable products and marketing strategies, holding periods can be even longer for VC funds compared to other PE funds that invest in mature companies.

Nevertheless, VC investors (limited partners) rely on marks provided by the VC firms (general partners) in order to assess performance (or track progress), review allocations to the asset class, determine compensation and fulfill their own reporting requirements. Over time, VC fund valuation practices have engendered a greater degree of scrutiny from LPs, who are increasingly willing to institute or review existing valuation policies and processes as well as ask detailed questions of GPs. Valuations of VC investments generally need to conform to accounting standards (US GAAP or IFRS) in order to provide useful information for the investors.

Valuation Best Practices

Against this backdrop of the inherent difficulties in measuring the fair value of investments on the one hand and investors’ need for meaningful information on the other, in May 2013 NVCA endorsed the Valuation Guidelines published by the International Private Equity and Venture Capital Association (December 2012 edition). Salient elements of the IPEV Valuation Guidelines are summarized in this Mercer Capital presentation. In practice, GPs at VC funds should heed the following when measuring the fair value of their investments and portfolios.

• The fair value of a VC portfolio is the sum of the fair values of the constituent investments. Techniques that attempt to estimate or make adjustments to the portfolio in aggregate generally do not comply with accounting standards.
• The definitions of fair value under US GAAP and IFRS have largely converged. ASC Topic 820 defines 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.”
• In the past, many professionals relied on the marks implied by the last funding round to estimate value of the VC portfolio investments. While such information may indeed be useful, especially within short periods of the funding rounds, these marks do become stale over time as the investee companies make progress in achieving technical or market milestones, and/or as broader market conditions change.
• Accordingly, periodic fair value assessments should acknowledge and reflect the progress at the investee startup companies relative to the prior measurement dates.
• While valuation requires a considerable amount of judgment, consistent application of assumptions across measurement dates and use of the same data that the GPs employ in evaluating progress and managing their portfolio can go a long way towards making the fair value marks reliable and relevant.

With increasing activity and interest from investors, valuation guidance for VC investments and funds continues to be more clearly defined. Mercer Capital will continue to present periodic updates on the evolving fair value landscape here at the Financial Reporting Blog and other forums.

Related Links

• Portfolio Valuation Can Be Complex, Risky
• Best Practices: Fair Value Measurement
• Glossary to ASC Topic 820 Fair Value Measurement (subscription required)