In August 2019, the American Institute of Certified Public Accountants issued new guidance for investment companies on valuing portfolio company investments. Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (the “Guide”) is intended to harmonize views of industry participants, auditors, and valuation specialists. The Guide is considered the “gold standard” that will be applied by investment fund valuation committees and their auditors in evaluating the fair values of portfolio companies. This article is part of a multi-part series exploring the key topics of the Guide and related implementation matters.
What is Calibration?
Selecting reasonable assumptions for valuing investments in private companies is challenging and requires evaluation of both public and private company information and selection of different valuation techniques. Calibration is a process that uses observed transactions in a company’s own instruments to ensure that the valuation techniques used to value the investment on subsequent measurement dates begin with assumptions that are consistent with the original observed transaction and more recent observed transactions in a company’s instruments. Using selected valuation techniques such as the market or income approach with calibrated inputs will result in a fair value of the investment that equals the original transaction price. At subsequent measurement dates, these input assumptions; multiples of revenues or EBITDA, discounted cash flows or nonfinancial metrics, are updated to reflect changes in the investment based on the company’s performance and market considerations. For example, If an investment was made at a price that would equate to 7x last twelve months EBITDA when guideline public companies are trading at multiples of 9.5x last twelve months EBITDA, calibration involves the monitoring of the difference between the multiples in valuing the company in the initial investment and the changing market multiple for which the initial transaction was benchmarked.
Considerations when using calibration as a tool in the valuation process for private company investments.
- Is the transaction price considered fair value at transaction date? In most cases, this is the case, but evaluate whether these conditions exist:
- The transaction is between related parties
- The transaction takes place under duress (forced sale)
- The unit of account for the investment measured at fair value is different from the unit of account represented by the transaction price
- The market in which the transaction takes place is different from the principal or most advantageous market
- Calibration to an initial transaction price
- Consider if implied multiples of revenue/EBITDA are relevant/available at the transaction date
- Compare implied multiple to observable, comparable data (public company multiples) and reconcile by capturing specific characteristics of the investment that are different from securities of public companies.
- Consider more recent transactions in portfolio company instruments and differences in rights and preferences. Calibrate to the initial transaction price.
- Venture Capital/startup company investments – if there is no observable financial data, consider company milestones such as product development targets and other qualitative pre-operations targets and calibrate to the initial transaction price.
- Calibration to a subsequent measurement date
- Determine and consider transactions in portfolio stock/debt since the initial transaction date.
- Consider factors above pertaining to transaction prices that don’t reflect fair value, in particular, related party transactions or transactions that don’t include new independent investors
- Update calibrated inputs in subsequent periods to reflect changes in company and market conditions since the initial transaction date
- If recent transactions in portfolio company stock/debt do not exist, calibrate to previous measurement date inputs – implied multiples, growth rates, discount rates, terminal values, etc. Consider market and company operating conditions since last measurement date.
- Consider the appropriateness of premiums/discounts to the guideline public companies
Calibration is most relevant when the measurement date is close to the transaction date. However, even if a substantial period has passed between the measurement date and the transaction date, calibration can be used to ensure consistency in assumptions when additional orderly transactions in the portfolio company’s instruments are occurring. In these cases, calibrating the inputs to the more recent transactions would be more relevant than calibrating to the original transaction.
We Can Help
Elliott Davis has the expertise needed to support and guide you through the valuation process for private securities at or near a transaction date. We can work with you to:
- Establish a consistent methodology for determining fair value at initial or subsequent transaction dates
Establish an appropriate methodology for using calibration as a tool to determine fair value of private securities.