As a fund manager, one of your responsibilities is to issue regular reports to your limited partners (LPs) about your fund’s performance. Your LPs will evaluate your investment strategy, and your ability to execute it, by looking at the value of their holdings in your fund’s assets. But here’s the thing: There’s no single method that all funds use to value assets. Instead, funds choose a method that fits the type and scale of investments they hold. For this reason, funds are required to include their valuation policy in the initial offering documents they create for investors.
What is a valuation policy?
A valuation policy is an outline of the approach your fund takes to determine the fair value of its portfolio company assets for financial reporting. Rather than being hard- and- fast rules, fund valuation policies are usually flexible frameworks that VC funds create for their portfolio company investments. That said, the American Institute of Certified Public Accountants (AICPA) provides guidance to help fund managers and other stakeholders (such as auditors, investors, and valuation specialists) understand the valuation process. The guidance outlines current best practices for valuing investment assets in accordance with U.S. Generally Accepted Accounting Principles (GAAP) and the accounting standard known as ASC 820.
Typically, funds outline an initial internal valuation policy in their limited partnership agreement (LPA). Once established, a fund’s valuation policy isn’t set in stone: You can and should assess and adjust your fund’s valuation policy to be sure it’s suitable for the stage and type of investments your fund owns. Most fund managers review their fund valuation policies on an annual basis.
At Carta, we have a team of valuation experts who can provide fund managers with timely asset valuations that meet ASC 820 standards. The team can also assist fund managers with valuation policy construction.
Why funds need to develop a valuation policy
The valuation policy is an important part of your fund’s initial offering documents. It must be approved by your fund’s governing body, as well as by each of the LPs who subscribe to your fund. Ideally, you’ll secure this approval before launching the fund. In addition, a valuation policy facilitates LP reporting and the fund auditing process.
Your fund’s LPs will ultimately evaluate your performance based on the returns they get from your fund. However, typical funds have a 10-year cycle, and LPs will want to see evidence of your progress along the way. Quarterly financial reporting shows your LPs how your fund is performing.
In particular, your investors will want to know the fair value of their investment holdings. Determining an implied enterprise value for each company in the fund’s portfolio is a step towards determining the investment holdings’ value. The implied enterprise value is an estimate of a company’s valuation, taking into account its debt, and cash balances. From there, they’ll want to know how much their share of your fund’s holdings in each company is worth. Establishing portfolio company valuations and ownership allocations based on your approved valuation policy assures LPs that your reporting is reliable and reasonable.
Many LPs—in particular, larger LPs who tend to make larger commitments—will require that your fund be audited. During an audit, you’ll work with auditors to establish the fair value of your portfolio investments. Your auditors will request a copy of your valuation policy as one of the first parts of the audit. A clear valuation policy decreases friction in the audit process by making your internal valuations consistent.
How valuation policies work
Valuation policies lay out the standard framework a fund will use to value its assets. The framework should include two corresponding parts: a paired valuation approachand an allocation method. The valuation approachdetermines the implied enterprise value of a portfolio company. The allocation methodallocates that value across all classes of equity in the company. Valuation approaches and allocation methods are typically paired. While the valuation policy sets the fund’s standard approach and method pairing, it can also include criteria for using a different pairing.
Step 1: The implied enterprise value
The first step in establishing the fair value of investment holdings in a portfolio company is to determine its implied enterprise value. To do so, funds apply one or more valuation approaches. The most common valuation methods for companies that have raised a round of financing within the last 12 months are the post-money methodand the backsolve method. Other common valuation methods include the guideline public company and the guideline transaction methods, which are typically used when a portfolio company has gained material revenue traction, or has not raised a round of financing in the last 12 months. A discounted cash flowmethod may be best for late-stage companies that are generating positive cash flow and have reliable financial projections available.
Post-money valuation method
Roughly half of Carta’s VC and private equity ASC 820 customers have a valuation policy that includes the post-money valuation method. This method assigns portfolio companies an enterprise value based on each company’s most recent round of financing, assuming that the various classes of equity (e.g., preferred and common shares) would have the same per-share value. For example, if a VC invested $1M in exchange for 100K preferred shares at the most recent round price ($10 per share) for a 1% ownership, the portfolio company would have an implied post-money of $100M. In this scenario, the preferred and common shares would have the same per-share value of $10. Using the post-money valuation method is common practice within a year of a company’s primary financing because it represents a consensus between the company and its most recent investors about the company’s pre- and post-money valuation for that round of funding.
The AICPA’s ASC 820 guidance states that a post-money valuation method may be appropriate when a company is expected to exit at a value where the preferred rights and preferences do not come into play. In this scenario, investors assume all classes of equity would convert to common and that liquidation rights and preferences won’t influence distributions at the time of exit. These assumptions allow the post-money valuation to be allocated according to a simplified scenario analysis method, described below.
Backsolve valuation method
Like the post-money method, the backsolve method relies on the company’s most recent round of financing. Using the most recent preferred share price, the backsolve method determines a total implied enterprise value by calculating what the implied equity value of the company would need to be in order to yield that preferred share price. The backsolve formula also incorporates other inputs, including the expected time to exit, risk-free interest rate, liquidation rights and preferences, and the volatility of the market for comparable publicly traded companies as of the valuation date.
Some auditors think that the backsolve method offers a more suitable valuation approach for companies with longer or uncertain timelines to exit, or in cases where the recently negotiated financing terms had liquidation rights and preferences that heavily favored some investors (as with participating preferred stock). The backsolve method is used in conjunction with the option pricing method (OPM) allocation method, described in the next section.
Guideline public company (GPC) and guideline transaction company (GTC) valuation methods
When a portfolio company has meaningful revenue relative to its post-money valuation, a GPC valuation method may be more accurate. The GPC valuation method looks at public companies that are comparable in terms of business model, products, target market, and financial characteristics to arrive at an enterprise value. The GTC method looks at recent mergers and acquisitions of comparable companies and examines the implied multiples of relevant financial metrics (such as the ratio of revenue to acquisition price) to arrive at an enterprise value for a similar portfolio company. The GPC and GTC methods are often used with a current value method (CVM) or the OPM method for allocation, both described below.
Discounted cash flow method (DCF)
A DCF method may be applicable for late-stage companies that can accurately predict financial projections and that are generating, or soon expect to generate, positive cash flows. A DCF is generally not appropriate for early-stage VC investments because of the difficulty in projecting financials. Even if they eventually transition to profitability, these companies generate significant up-front losses, with those losses offsetting future, positive cash flows in traditional financial models. The DCF method is often used with a simplified scenario analysis or the OPM allocation method, described below.
Step 2: Allocating implied enterprise value
After establishing the enterprise value of a portfolio company, the next step is to allocate the enterprise value across each share class. This will allow you to give your fund’s investors an accurate estimate of the current value of their holdings.
The most common allocation methods for valuing equity holdings among Carta’s VC and private equity ASC 820 customers are simplified scenario analysis(also known as the common stock equivalent method), the current value method (CVM), and the option pricing method (OPM). Funds may also rely on a hybrid method that incorporates more than one of the previously mentioned allocation methods.
Simplified scenario analysis allocation
Also known as the common stock equivalent (CSE) method, simplified scenario analysis is an allocation method typically used in conjunction with the post-money valuation method, or for any companies nearing an initial public offering (IPO) or special purpose acquisition company (SPAC) listing (in IPOs and SPAC listings, all shares are converted to common stock). The simplified scenario analysis method doesn’t consider liquidation preferences. Instead, it allocates value to equity holders assuming that all preferred shares have converted to common.
Current value method (CVM) allocation
Also known as the waterfall method, the CVM allocates the company’s current value among equity owners based on liquidation preferences and other economic rights. The CVM is typically used when a portfolio company is expected to be acquired in the near term, or if the dissolution of the portfolio company is imminent. Funds might also decide to use the CVM as the primary allocation method in their valuation policy because it is relatively easy to implement, doesn’t require assumptions about future exits, and doesn’t use complex formulas like those used in an OPM calculation. The CVM is often used with the guideline public company and guideline transaction company valuation methods.
Option pricing method (OPM) allocation
The OPM incorporates the economic rights and preferences of different share classes to determine how proceeds from a liquidity event would be distributed among the various ownership classes. The industry standard model uses various inputs—such as the company’s capital structure and rights and preferences, the expected time to exit, the market volatility, and the risk-free interest rate—to allocate the company value to each class of stock. The OPM assumes normally distributed returns and models future outcomes according to an estimated timeframe to liquidity. Some auditors prefer the OPM allocation because of its consistent, quantitative structure, which provides a means to allocate value considering the economic rights of the classes of stock, as well as potential for future changes in company value based on expected volatility.
Hybrid valuation policies outline how the fund will weigh different valuation approaches and allocation methods to arrive at the fair value of their investments. These weights account for the probability of a company reaching different outcomes, such as going public (post-money/CSE) and staying private (backsolve/OPM). For example, a hybrid method might calculate a valuation using a formula that derives 85% of the total enterprise value from the post-money/CSE methods and 15% from the backsolve/OPM methods
Funds using a hybrid method can adjust this weighting methodology as their portfolio companies mature; meet specific criteria, such as revenue milestones; approach liquidity events; or as time elapses from a company’s most recent round of financing. Through backtesting, your fund should ensure that the weightings in the hybrid method continue to align with actual results as your portfolio companies realize more exits.
Versatility in valuation policies
A valuation policy can use a combination of approaches for establishing company valuations, as long as there are consistent criteria for determining when to move away from the default method. For example, the policy might stipulate a switch from a default OPM allocation to CSE allocation for companies that have begun the process of an IPO or SPAC listing. Or, a fund policy might stipulate a switch from a default OPM to a CVM for portfolio companies that receive a letter of intent to be acquired.
When to reassess your valuation policy
Since auditors request many of your fund’s financial and accounting materials months in advance of the audit, you’ll want to be sure your valuation policy reflects your evolving perspective on your investments, with any adjustments made well before the audit begins. Since fund audits typically begin in January, you’ll want to update your valuations policy by the end of Q3.
You’ll also want an updated valuation policy if your VC firm is thinking about raising capital for a new fund. Even if your existing fund is exempt from a legally required audit, conducting one can make it easier to raise capital for a new fund, especially if you intend to pursue institutional investors. Updating your valuation policy and undergoing an audit will show institutional LPs that your accounting and valuation practices are in order.
Carta’s valuations services
Carta brings deep experience to valuations: Our team of experts has insight into valuation methodologies used by established and emerging funds operating across the spectrum of venture capital and private equity. (The 15 largest funds that rely on Carta’s ASC 820 services hold more than $53 billion in assets under management.) Carta’s valuation experts can educate your team on current trends and best practices for valuations used by top and mid-tier public accounting firms: Our experts regularly work with auditors from Deloitte, Ernst & Young, PricewaterhouseCoopers, KPMG, BDO, and RSM.
Whether you’re a new or returning customer, Carta’s ASC 820 team can help you develop or update an internal valuation policy framework that meets best practices in the AICPA ASC 820 guidance. Understanding current best practices will help you align your fund’s internal stakeholders and auditors with your preferred fair value framework. Our valuations experts can also provide ASC 820 valuations that adhere to the AICPA valuation guidance and conform to your valuation policy.
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