In May 2018, the AICPA’s Private Equity and Venture Capital Task Force released a working draft of an accounting and valuation guide: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (the “Guide”).

Purpose of the Guide

The purpose of the Guide is to provide guidance to investment companies and their advisers regarding the valuation and accounting related to their investments in portfolio company investments. The target audience of the guide includes management and directors of investment companies, valuation specialists, auditors and other interested parties such as limited partners.

Instead of providing a detailed “how to” valuation guide, the intent is to provide the target audience with (a) an overview and understanding of the valuation process and the roles and responsibilities of the parties to the process and (b) best practice recommendations for complying with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 946, Financial ServicesInvestment Companies, and applying FASB ASC 820, Fair Value Measurement.

Information included in the Guide

Several chapters of the Guide do not offer significantly new guidance but instead give an overview on topics such as the private equity and venture capital industry and its investment strategies, fair value and related concepts of FASB ASC 820, market participant assumptions, and valuation approaches.

The guide includes chapters on the following concepts and topics that provide new or more in-depth knowledge to assist in determining or evaluating the fair value of investments in portfolio companies.

Unit of Account
FASB ASC 946 does not make available specific unit of account guidance, making it difficult for investment companies holding investment securities in portfolio companies or multiple types and/or classes of investment securities to determine the appropriate unit of account. The Guide provides considerations and assumptions that market participants might use to estimate the value expected to be realized from an investment, which helps define the unit of account.

Valuation of Equity Interests in Complex Capital Structures
The Guide provides guidance regarding the valuation of equity interests for a portfolio company with a capital structure involving multiple classes of stock. Often, these portfolio companies issue both preferred and common shares and options or warrants, with the preferred stock comprising several series, resulting from successive rounds of financing, each of which has rights that likely differ from those of other series. When estimating the fair value of the fund’s investment, the fund should determine how each class of equity would participate in future distributions from a sale or other liquidity event, and the implications for the fair value of each class of equity.

Calibration is the process of using observed transactions in the portfolio company’s own instruments, especially the transaction in which the fund entered a position, to ensure that the valuation techniques that will be employed to value the portfolio company investment on subsequent measurement dates begin with assumptions that are consistent with the original observed transaction as well as any more recent observed transactions in the instruments issued by the portfolio company. When using a valuation technique that requires unobservable inputs, it is important to calibrate these inputs to any observed transactions in the investment itself, providing an initial set of assumptions that are consistent with the transaction price when the transaction price represents fair value.

Valuation Case Studies
Case studies are presented to provide readers with a broad context for the types of fact patterns that are experienced in practice, examples of judgment that can be applied and the diversity of situations referenced in the topics presented in the earlier chapters.

Other Topics of Interest

  • Control and marketability
  • Back-testing
  • Factors to consider at or near the transaction date
  • Valuation reference guide on various industry topics such as capitalization multiples, derivation of the weighted-average cost of capital, and models used in calculating discounts for lack of marketability

What’s next?

The final publication is expected to be released in May 2019. This is our first installment of a multi-part series exploring the key topics that may be of interest to fund financial leaders that trade in equity and debt instruments of privately-held enterprises.

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The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.