VENTURE CAPITAL REVIEW

Issue 27 2011

produced by the NatioNal VeNture capital associatioN aNd erNst & youNg llp

National Venture Capital Association (NVCA)

As the voice of the U.S. venture capital community, the National Venture Capital Association (NVCA) empowers its members and the entrepreneurs they fund by advocating for policies that encourage innovation and reward long-term investment. As the venture communitys preeminent trade association, NVCA serves as the definitive resource for venture capital data and unites its 400 plus members through a full range of professional services. Learn more at www.nvca.org.

National Venture Capital Association

1655 Fort Myer Drive Suite 850 Arlington, VA 22209 Phone: 703.524.2549 Fax: 703.524.3940 Web site: www.nvca.org

Fair Value, Who Cares? and Why They Should!

By steven Nebb, CFA, Director, and David L. Larsen, CPA, Managing Director, of Duff & Phelps LLC Primarily because of historical bias, during the past decade and especially during the past several years, venture capitalists have repeatedly been heard to say: Fair value reporting for the Venture Capital (VC) industry is meaningless; LPs dont need it; GPs dont want it; regulators dont understand it. However, a more critical examination of a wide range of reporting and governance issues demonstrates that fair value is not only required by most LPs, but provides key benefits to both LPs and GPs. Part of the stigma associated with fair value is a lack of understanding of what fair value means for the VC industry. some incorrectly believe that FAsB instituted fair value rules for the VC industry in 2006 with the issuance of the much-maligned sFAs 157. Yet sFAs 157 (now AsC Topic 820) does not require any asset or any liability to be measured at fair value. Fair value, for the investment industry, has its origins with the 1940 Investment Company Act. Further, investment 1 company accounting, which originated with the AICPA Audit and Accounting Guide for Investment Companies in the 1960/70s requires investments to be reported at fair value.

What is Fair Value?

Most discussions about fair value still begin with a description of what fair value represents. With liquid securities, fair value is a concept that is much easier to understand since the definition becomes somewhat formulaic: market price times number of
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US investment company accounting requirements are now promulgated by FASB Accounting Standards Codification (ASC) Topic 946.

shares owned, or a value that has direct benchmark indications from other market transactions. However, when considering illiquid investments, fair value represents a more qualitative and ambiguous concept. Even in such instances, fair value is still strictly defined. Accounting guidance establishes the definition of 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 2 at the measurement date. The guidance adds that to the greatest extent possible, valuations should be based upon observable market data from reliable sources. For VC investments, there is often limited or no reliable market data. each investment is unique (no comparable companies or transactions) and involves sensitive details that many times would be harmful to the investor if disclosed. As a result, VC investors must use supportable unobservable inputs, often using a managers own assumptions, about how a market participant would transact. Historically, VC fund managers have reluctantly embraced fair value concepts, using cost or the value of the last round of financing as their best estimate of fair value in between financing events. The use of cost to estimate fair value was driven by three key factors: 1. A historical convention that identified conservatism as a positive attribute; 2. Draft 1989 NVCA guidelines (which were never ratified or adopted), which encouraged the use of cost; and 3. An investor (LP) base made up of individuals rather than entities that had less strict fair value reporting requirements. Furthermore, because the development of an emerging business or technology requires financings more frequently, investors attempt to manage their exposures to certain risks by funding development at discrete points in time. Multiple financing events potentially generate an opportunity to assess implied values in Last Round of Financing (LRF) transactions. However, caution should be applied when considering LRF as indications of fair value since implying value for existing investments using LRF requires material assumptions that may or may not be appropriate. Because of this, the ability to use LRF as an indicator
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of value does not mitigate the need for alternative methods and procedures for estimating a robust fair value.

Why Fair Value?

Because many VC fund managers have partially convinced themselves that fair value is not estimable, is not cost-effective to estimate or is not needed by their investors, it is important to dispel such myths and once and for all acknowledge that while imperfect, estimating fair value is not only possible, but necessary for most investors and helpful to most managers. Our experience with our VC clientele is that while a current period valuation of a VC investment requires significant judgment, the focus on a valuation framework that considers the analysis of all meaningful factors and inputs beyond LRF, and the effort to document these considerations, does indeed help the fund in its strategic planning and in communication with its investors. It also provides a meaningful method for monitoring its investments and satisfying the funds governance requirements. Additionally, we find that most of our clients are already doing what is necessary in some form to satisfy these goals, but the lack of a formalized process or documented methodology has not allowed them to take full credit for the work performed. One other important consideration that should not be ignored is the fact that investment companies are not required to consolidate underlying investments because they report fair values. However, if a fund did not report its investments at fair value, arguably, from an accounting point of view, underlying control investments would be required to be consolidated, making internal and external reporting significantly more complex and less meaningful.

evidence of Fair Value

If there are real difficulties in estimating the value of an emerging company, how then do venture capitalists determine the valuation at which they will invest at various points in time? Many valuation practitioners and auditors like to refer to market studies that have been conducted over the past couple of decades as support for indications of value. These studies demonstrate the step-up in value between major rounds of financing typically consisting of 25% to

FASB ASC Topic 820-10-35-1

One other important consideration that should not be ignored is the fact that investment companies are not required to consolidate underlying investments because they report fair values. However, if a fund did not report its investments at fair value, arguably, from an accounting point of view, underlying control investments would be required to be consolidated, making internal and external reporting significantly more complex and less meaningful.
100%+ increases in value as companies progress through the stages of development. However, this is only true for investments at specific points of time that successfully secure financing and is only meaningful on an aggregate level, not necessarily applicable to a single investment. In working with our VC clients, we have observed numerous examples of a portfolio company being able to meet significant milestones only to have forced recapitalizations or down-round financing available to it. The question then becomes, why does this happen? The illiquid nature of the VC market sustains pricing inefficiencies. Ultimately, the supply and demand of VC capital and the bargaining power of entrepreneurs and ownership syndicates does change, and at times will not be correlated with the performance of the underlying company. This environment clearly muddies the waters for determining values. However, what this truly means is that when estimating the fair value of an investment, considerations beyond LRF or company performance are meaningful. The assessment of what could be termed nonperformance risk is the risk that a portfolio company with negative cash flow will be unable to raise additional capital when needed. This factor is material for VC investments that are capital intensive in one form or another, and are expected to generate negative cash flow over the development period of two to five years. In situations where capital becomes unavailable, the company is typically sold, possibly at a loss, recapitalized at a valuation significantly lower than the post-money valuation implied by the progress of the firm or is shut down. Ultimately valuations should consider the inputs used to derive value, the intangible assets of the business. These intangibles include intellectual property and know-how, long-term growth potential, management team talent, financial strength of existing investors, perception of VC market interest, progress toward milestones and competitive landscape. For earlystage, venture capital-backed companies that require additional capital, these intangibles may impact positively or negatively their ability to raise capital in the current venture capital environment. The resulting non-performance risk for companies that need to raise money to reach cash flow breakeven or a successful exit continues to be substantial, and may outweigh many or all other valuation considerations. While changes in value are certainly not linear, it should be clear that value does not magically increase or decrease on the day a new financing event takes place. Since VC investors are instrumentally involved with their portfolio companies, they likely are aware of how a company is progressing toward its milestones, and they typically have timely knowledge of trends in the VC capital market that lead to an understanding of the willingness and ability of the market to fund the next stage of development for a company. Therefore, while significant judgment is required, it should be evident that an estimate of value can be derived at times other than on the day of a financing event.

Why investors (lps) need Fair Value

One of the most troubling features of the GP/LP interactions is the seeming inability of both sides to fully understand the needs of the other. This failure to

communicate has given rise to more specific Limited Partner Agreements, requests for side letters, ad hoc data requests and LP initiatives such as the ILPA Private equity Principles. Any institutional LP (LPs that produce GAAP-based financial statements and invest on behalf of others fund of funds, pension funds, endowments, etc.) has need for timely, periodic, robustly estimated net asset values (NAV) supported by a rigorous measurement of the fair value of underlying investments. LPs dont always articulate the reasons they need fair value reporting. LP needs include, but are not limited to, the following: Fair value is the basis investors (LPs) use to report periodic (quarterly/yearly) performance to their investors, beneficiaries, boards, etc. Fair value is the best basis for LPs to make apples to apples asset allocation decisions. Fair value is an important data point in making interim investment (manager selection) decisions on a comparable basis. Fair value is often necessary as a basis to make incentive compensation decisions at the investor level.

Limited partners need consistent, transparent information to exercise their fiduciary duty. fair value provides such information on a comparable basis for monitoring interim performance. An arbitrary reporting basis such as cost does not allow comparability. Most investors are required by relevant GAAP to report their investments on a fair value basis. Not all LPs articulate their needs as described above. some may even tell GPs that they prefer cost. In many cases, this failure to communicate occurs because deal team members of LPs speak with deal team members at the GP and may not fully articulate all of the needs of the investor. Additionally, reporting fair value for financial instruments is required to be consistent with other financial reporting requirements. In particular, the recognition of the fair value of contractual rights for future cash flows typically resulting from earn-outs or 3 contingent considerations at fair value is required.
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Established by FASB Statement 141 (revised 2007), Business Combinations (FASB Accounting Standards Codification (ASC or Codification) 805, Business Combinations.

Based on the uncertainty embedded in many earlystage companies, it is not suppressing that many M&A transactions increasingly include earn-outs or some form of future consideration. Since other reporting entities (buyers) must report the contractual payments at fair value, it is logical that the seller should also recognize this contractual asset at fair value as well. LPs must have fair value-based NAV and, therefore, managers need to include the fair value of all investments, including contractual payments, in their calculation of NAV. Determining the acquisitiondate fair value of contractual rights (contingent consideration) may entail the estimation of the likelihood and timing of achieving relevant milestones and/or the development of expected or scenariobased projections relevant to sales- or profitabilitybased payments. The good news is that these types of assumptions and inputs are the same details that are considered by the manager in making the decision to sell its investment in the first place (and only need to be adjusted for buyer/negotiation considerations). Essentially, the reporting of fair value for contractual rights becomes an extension of the processes already performed by fund managers.

such as the use of independent third-party valuation experts to augment and validate the investee funds procedures for estimating fair value. Ultimately, the investor is required to assess, understand and conclude that the GP has delivered a NAV derived from a rigorous estimate of the fair value of underlying investments.

Why is Fair Value Meaningful?

Whether it is from the GPs perspective, or an LPs requirement, fair value is ultimately the contemporaneous measurement basis that allows the VC industry to deliver on its obligation to be fair, ethical and to effectively communicate critical information needed by multiple interested parties. Arbitrary valuations, such as cost, or inaccurate valuations can undermine effective asset allocation for investors, resulting in the inability of an investor to properly manage its investment strategy or possibly increasing the risk of fulfilling its fiduciary duty to its beneficiaries. Industry best practices centered around robust fair value determinations provide GPs with effective strategic tools for making appropriate comparisons and for monitoring interim performance of their investments, in addition to satisfying fiduciary obligations. Because fair value requires a systematic approach for estimating value and supporting assumptions, appropriate procedures that generate fair value will provide additional focused information to monitor portfolios regularly. An incomplete development of policies, procedures and processes that measure fair value may expose fund managers to significant reputational and legal risks and, ultimately may adversely affect their marketing and fund-raising efforts. In the current market environment, fund managers must now be aware that investors should, both in their initial due diligence process and in periodic reviews, discount managers that have not adopted appropriate valuation practices that generate robust indications of fair value. Additionally, auditors and regulators will scrutinize funds that dont have well-defined and documented valuation process and governance policies.

limited partner Valuation Needs

As noted above, limited partner investors have a number of reasons for needing and using fair value derived NAV. LPs must value their interest in an underlying fund at regular intervals to support their financial reporting process. The recent accounting guidance (Asu 2009-12) outlines when and how an LP may estimate the fair value of an interest in a fund using the reported funds NAV. Based on the guidance, reliance on a reported NAV is only appropriate to the extent that the investor has evidence that the reported NAV is appropriately derived using proper fair value principles as part of a robust process. In order to do this, the most frequent ways to assess the robustness of reported NAV are: 1. To conduct thorough pre-investment due diligence and to leverage this diligence in ongoing monitoring procedures; 2. To assess the funds fair value estimation processes and control environment, and to monitor any periodic changes; and 3. To review the funds policies and procedures for estimating fair value, including considering factors

Whats a Vc to do?
The determination of fair value, for VC investments, requires a significant level of informed judgment, rather than a rigid application of a mechanical process. Therefore, fair value requires thoughtful involvement from all stakeholders, including fund managers, institutional investors, auditors, valuation experts and regulators. The valuation process should not be a make work exercise. Best practice dictates that the information needed to make, monitor and improve investments is the same information used to value investments on an interim basis. Generally, there is no need for a fund manager to develop extensive policies, but leveraging or enhancing existing processes to develop and use a comprehensive and integrated valuation framework that is clear, consistent and pragmatic will provide effective documentation and communicate the funds efforts in monitoring its investments and reporting fair value robustly. This typically means that the valuation process is an extension of the funds, already developed, diligence, monitoring and strategic decision-making processes. A well-developed and documented valuation process can provide the basis for demonstrating to investors that the fund manager is compliant with fair value measurement principles. The specific components of a thorough process should include a governance structure, well-documented valuation policy and clearly defined roles and responsibilities, including independent personnel who are extremely knowledgeable about valuation methodologies. The elements of the valuation policy should cover specific approaches and valuation methodologies appropriate for various types of investments at various stages of development, and should include details regarding typical assumptions and sources of data that would be part of each valuation methodology. Additionally the policy should address the internal documentation procedures to support valuations (models and templates) and a delineation of circumstances that permit a manager to rely upon specific or different models. The valuation policy and supporting documentation should be periodically reviewed and updated. Having established valuation policies and procedures will allow a manager to communicate and discuss its approach to fair value and satisfy an

investors need to understand the processes and controls related to deriving value. It should be emphasized that fair value does not represent what a fund manager ultimately expects to receive for exiting an investment, but the amount that would be received in an orderly transaction as of the valuation date. This concept troubles some VC managers because they would not, and likely could not, sell the investment at an interim date. The orderly transaction price determination is hypothetical and requires the exercise of informed judgment. This means that fair value does not have to assume that the underlying business or investment is saleable, the investor or shareholders intend to sell in the near future or the likely transaction would have to be a forced sale or liquidation. In assessing fair value, fund managers should be able to answer the following questions in a consistent manner to explain how the investment is being valued. 1. How correlated is the investment to public market data? What objective data may indicate whether value is moving in a logical direction? This should be from a perspective that adjusts for outliers that may significantly impact reported trends. 2. What other recent transactions has the fund been involved with (or know the details of) that support the current fair value of an investment? Are there similar deals that provide an indication of the fair value of the subject investment? This may include transactions of the subject company securities, comparable company transactions, or sector and industry transactions involving companies in similar stages of development. 3. Are there any potential issues with obtaining the next round of financing for an investment (compared to original expectations)? Whats the likely impact of less/more demand to fund the portfolio company? 4. Does the fair value indication represent a price [as of the valuation date] that you would be willing to invest in the same portfolio company (with the same existing terms)? Would more investment for a higher or lower percentage interest be appropriate? Does it make sense to invest less money for the same percentage interest because the company has satisfied some development hurdles (milestones) and has less need for capital at the current stage? Will the company need more capital than originally

expected because the burn rate is higher, more uncertainty developed in the market or negative results require more development effort? 5. Is it possible to sell an interest in an existing portfolio company at the same price as you could have sold it previously? This question may help limit the hypothetical nature of a fair value transaction since it contemplates the comparison of a hypothetical transaction in the past to a current hypothetical transaction. 6. What has changed with the portfolio company in relation to the companys position at entry, during the LRF and with the expectations of the business over the holding period? Its more important to understand why things have changed than to simply recognize that things are different. An understanding of why changes have occurred should be helpful in

assessing the potential impact the changes will have on the success of the business, which is the key to assessing the progress of value during the holding period of an investment. 7. Have the current market and economic conditions affected the underlying opportunities, risks or probability of success of the portfolio company? Considering these questions and documenting the answers will be a good start at a well-thought-out and documented process for estimating the fair value of VC investments. Again, since these considerations are the same considerations that are used in making, monitoring and exiting an investment, they flow directly into the periodic (usually quarterly) valuation assessment. For example, a simplified way to consider valuing VC investments is using the following decision tree (for illustrative purposes only):

Policy Statement: All investments are recorded at fair value. All relevant information is taken into account to make the fair value determination.

Valuation Decision Tree

1. Barring contradictory information, the cost (excluding transaction costs) of an investment is deemed the exit price on the date of investment and is therefore used as its initial fair value. a. Fair Value is measured as the market price times the number of shares held less a possible discount. support for the discount generally model-based.

Thereafter Yes
2. Are shares publicly traded in an active market? 2a. Is there a legal restriction?

Yes

No
b. if there is no legal restriction (attributable to the shares, not to the holder), fair value is determined as the market price times the number of shares owned. No discount is allowed even if the number of shares owned is large relative to the average daily trading volume.

No

3. Is there a comparable company from which fair value can be derived?

Yes

utilize comparable company valuation techniques to determine fair value.

No
4. Does the investee company have positive sustainable performance (for example, positive recurring EBITDA)?

Yes

Fair value may be determined as ebitda times a reasonable marketplace multiple for the company.

No
5. Has there been any significant change in the results of the investee company compared to budget, plan, etc? Has there been any significant change in the market for the investee company or its products or potential products? Has there been any significant change in the global economy or the economic environment in which the investee company operates?

Yes

a. if the change is positive, there is an indication that value has increased. determine fair value using objective data from the company, investment professionals and other investors b. if the change is negative, there is an indication that value has decreased. determine the value decrease to be recorded based on objective measures and manager experience. c. if no, the value of most recent round of financing may be the best estimate of fair value.

No

By utilizing the simplified illustrative decision tree, many early-stage venture investments would fall into step 5. Therefore, for some period of time after investment, assuming none of the changes outlined in step 5 have occurred, fair value is often measured by using the value of the last round of financing. However, as knowledge is gained about the progress on a meaningful milestone, or it is clear that more or less funding will be needed (burn rate) to get to the next stage (probability of success), or that funding is or is not likely to occur at typical terms (performance risk), fair value has diverged from the last round of financing, and fund managers have a duty to acknowledge and report that fact in the normal reporting process to the funds investors.

conclusion
since the issuance of the PeIGG guidelines in 2003, the release of the IPeV Guidelines in 2005, FAsBs issuance of statement 157 in 2006, the financial crisis of 2008 and subsequent revisions and application of the preceding, fair value measurement has been a topic of concern in the VC industry for almost a decade. Rather than being vilified, fair value should be embraced as the best (albeit imperfect) basis for measuring investments at interim periods, resulting in the fulfillment of a multitude of needs for both investors and managers.

About the Authors

David L. Larsen is a Member of FASBs Valuation Resource Group, a Board Member of the International Private Equity and Venture Capital Valuations Board (IPEV), led the team that drafted the US PEIGG Valuation Guidelines, and is a Member of the AICPA Net Asset Value (NAV) Task Force. Mr. Larsen serves a wide variety of alternative asset investors and managers in resolving valuation and governance-related issues. Steven Nebb serves as the project lead for numerous Alternative Asset managers and investors, including large global private equity, venture capital, and Business Development Companies. He provides advisory support to many limited partnerships and corporate pension plans regarding fund management, financial reporting requirements and general valuation of investments, and has significant experience in performing valuations of intellectual property, private equity, illiquid debt, and complex derivatives for a variety of purposes, including fairness opinions and transaction advisory, financial reporting, tax, litigation, and strategic planning.

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