For years, funds have valued their equity interests in portfolio companies using the following approach: calculate the enterprise value, subtract any debt and allocate the remainder to the equity classes in order of seniority. Regardless of whether you called this the waterfall method or the current value method (CVM), this approach had its advantages. It was transparent, relatively simple for auditors to test and document and easy for investors to understand.
So, the reader may ask, if the manner in which funds valued their equity interests isn’t broken, why fix it?
The good news is that in most cases, it isn’t broken, and, for some funds, the CVM may still be applicable. However, how do you know if it will continue to work for your fund? The American Institute of Certified Public Accountants, in its May 2018 Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies spends 700 pages covering this (and other) topics. Equity valuation is discussed in detail in chapters seven and eight, which we will summarise.
For those of you who have not read the Guide in its entirety, a few things to mention before we proceed. It is a summary of best practices and it acknowledges that the selection of an appropriate methodology is dependent on “facts and circumstances.” Further, not only do those facts and circumstances change depending on the portfolio company, but can change over time for the same portfolio company. Regarding equity allocation, the Guide does not suggest any method is superior, but rather that the fund should select the method that best captures the value accruing to equity interests depending on those facts and circumstances. While no method is universally superior, each method has strengths and weaknesses that should be considered. As such, the Guide emphasizes the importance of “stepping into the shoes” of the market participant and how a market participant would incorporate those assumptions into the valuation.
Now that we have the ground rules in place, let’s get started by asking the following question:
1. Does your portfolio company have one class of common equity? And yes, it is OK if the company also has debt-like preferred stock (ie, neither convertible nor participating) or has options and/or warrants. What you need to assess is the complexity of the equity classes. If the preferred stock is more equity-like, that may complicate things.
If the answer is yes, then your portfolio company may have a simple capital structure, and, per the Guide, any value remaining after subtracting the fair value of debt will be allocated to equity on a pro-rata basis.
Asking the questions
But what if your portfolio company has preferred stock that is convertible or participating, or multiple classes of equity (which is especially common for venture capital funds)? Your portfolio company may have a complex capital structure, which means that before we proceed, you have to ask two more questions:
2. Does your fund anticipate an imminent liquidity event for the portfolio company? (Sorry, the Guide doesn’t define imminent, but for the sake of discussion, six months may suffice as a proxy.)
3. Can you establish that you have “control” over the portfolio company, via one of the following:
- You have outright control through one or a combination of the following: majority of the voting interests, board seats, and so on (of course, control is facts and circumstances based); or
- Your interests are aligned with the controlling equity holder(s) (ie, a “club deal”), which may be demonstrated contractually or through a fund’s investing history with co-investors.
If the answer is yes to any of these questions, the CVM may still be applicable even if the capital structure is considered complex. The CVM assumes that the company could be sold at the valuation date for its enterprise value, and the proceeds are allocated based on current ownership: first to debt, then to the various series of preferred stock, and, lastly, to common equity and in-the-money convertible securities/options/warrants. However, additional considerations may be warranted. If the preferred stock is participating or convertible, and liquidity is not imminent, the CVM may not fully capture the potential for higher exit values. To answer this question, you have the option to consider other methods.
So what happens if you are unable to answer yes to any of the questions above? In such situations, the value of equity is contingent on various outcomes (or, as the Guide calls them, “scenarios”) for the portfolio company. The concern, from an economic perspective, is that because liquidation is not imminent or under the control of the investor valuing a specific equity interest, the capital structure at the time of the liquidity event may be different. The future waterfall would need to be considered, as the relative value of preferred and common shares may have shifted. In this case, what is your next step? The Guide provides several examples of scenario-based methods, all of which rely on an equity value that is calibrated from a recent round of financing. A key assumption in all scenario-based methods is determining and documenting the probability of each potential outcome. Despite this minor complexity, these are simply not all that hard to implement.
Business maturity affects approach
The Guide recommends that the complexity of the chosen method should be appropriate for the portfolio company’s stage of development. At a high level, here is what the Guide suggests:
- If your investment is in an early stage (pre-revenue) company, a Simplified Scenario analysis may be appropriate. The simplified scenario model is just a binary model with a high exit value (at which all investors would convert or participate) and a low exit value (based on liquidation of the company’s assets, which may not even generate enough proceeds to cover the first liquidation preference).
- A Relative Value Scenario analysis may be appropriate when the business has progressed beyond two potential outcomes, and there is value in a “middle” scenario. Scenarios might include:
-Upside: All classes of equity would convert or participate in a successful IPO or strategic transaction;
-Middle: Participants in the most recent capital round would receive some portion of their liquidation preference, but it is unlikely that any or all shareholders would convert to common; and
-Downside: Dissolution where liquidation of assets would not generate a meaningful return to investors.
- Lastly, a Full Scenario analysis may be appropriate when the company is close to exit and does not plan on raising additional capital. This method requires estimating the most likely potential future outcomes, the present value under each outcome and the probability associated with each potential outcome.
While the Guide does discuss the best practices for other approaches, such as the Option Pricing Method, the scenario analyses discussed above are often the most effective (and relatively easy methods) to implement for more complex capital structures.
In summary, the CVM may still be applicable; however, should the CVM fail to accurately capture an interest’s fair value, several scenario-based alternatives can be employed to better reflect the fair value of your fund’s investment.