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October 31, 2018

AICPA Offers Valuation Clarifications for Venture Capital, Private Equity, and Investment Companies (article)

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Last May, the American Institute of Public Accountants (AICPA) issued a working draft of a guide to help venture capital, private equity and other investment companies better value their assets. The Valuation Guide (“the Guide”), titled Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies addresses some of the concerns that have emerged over the years relating to divergent practices in estimating the fair value of portfolio company investments. It emphasizes specific techniques and provides industry-specific examples. Even though it is non-authoritative, the Guide reflects the best practices of applying U.S. Generally Accepted Accounting Principles (GAAP). In addition to considering the key provisions highlighted in this article, we encourage you to review the 15 real-life case studies included in the Guide as you begin your year-end valuation assessment.

The following is a summary of key considerations that the Guide suggests should be considered in valuing investments:

1 - View Your Investments from the Perspective of Market Participants

Consider the factors that the market will consider when valuing your investments. What market conditions are presumed? How do they view the stability of the investment, and how might their view change if majority control of the underlying asset shifts? Do they group certain assets together and assign value as one? Using the market’s perspective may feel like an imprecise method at first, but with the help of other techniques in the Guide, it can help you pinpoint the most accurate valuation.

2 - Consider the Time Horizon of the Investment

Value your investment by considering its entire lifespan. Simply focusing on the next quarter’s or the next year’s earnings may skew the appraisal. The business practices of venture capital and private equity firms rely on long-term investing, so viewing the asset’s entire time horizon will yield a more accurate assessment.

3 - Unit of Account

Defining the unit of account has long been a gray area for investment companies. Under FASB ASC 946, Financial Services – Investment Companies, an investment company is required to measure investments in debt and equity securities at fair value. However, the FASB guidance does not include any guidance on the level of aggregation or disaggregation required when determining fair value. The AICPA guide provides best practices on determining the unit of account with the main factor of that determination being how the market participant would transact.

4 - Complex Capital Structures

One of the main inputs or factors in determining the fair value of a portfolio company is to identify how each class of equity would participate in a distribution resulting from a sale or other liquidity event. This determination increases in difficulty as the capital structure becomes more complex, as entities may have multiple classes of equity each with different rights and preferences. The Guide outlines the scenario-based method, the option price method, the current value method and the hybrid method as the four main approaches to valuation in a complex capital structure situation. More information on the specifics of each of these methods are provided in the Guide. The Guide clearly indicates that no single method is superior as each has its merits and challenges and the Guide provides useful guidance on how they each can be applied.

5 - Calibration

Estimating the fair value of a portfolio company investment often includes the use of a wide range of potential inputs and assumptions, and therefore requires judgement in evaluating relevant information and techniques. Calibration is the process of aligning those estimates and judgements at the measurement date with the initial estimates and judgements made at the transaction date as well as other observed transactions in the portfolio company securities. For example, if an investment company were to use the market approach to value an investment, the relevant transaction multiples at the transaction date would be compared to the relevant guideline public company multiples to determine the differences in how the portfolio company is viewed versus comparable entities. Then, at subsequent measurement dates, rather than record the investment valuation based strictly on the public company guidelines, those guidelines would be adjusted to account for the initial differences from the transaction date. The overall goal of calibration assesses the differences between portfolio companies and guideline companies and how those differences change over time.

6 - Use Backtesting to See How Accurate Your Estimates Were

Backtesting, also known as a retrospective review, is the process of comparing your estimated fair value at a previous valuation date to the implied fair value at the exit date. By going back in time and testing to see how close your estimates were to the actual sale price, you can use the benefit of hindsight to improve your valuation process. Over time, as you fine-tune your methods, your estimates become more and more accurate. It is important to note that the intent of backtesting is not to highlight mistakes or adjust prior valuations, but rather to help improve the ongoing valuation process by identifying factors that may have led to the difference in valuations between the measurement and event date.

7 - Allocate Value to Debt and Debt Warrants Separately

Debt should be stated separately from its associated warrants on the financial statements because its values are not always aligned. Consider a debt security that is sold with a 20 percent warrant. Assigning 20 percent of the original debt’s price to the warrant may not be accurate. By viewing your investments through the lens of the market participants, you may discover that your debt warrants are worth more or less than their stated coverage. The warrants may only be exercisable in certain circumstances, or they may have a de-facto expiration date. These realities should be considered.

Valuation Guide: A Map to Interpreting ASC 820

The Guide should be used as a supplemental tool. Accounting Standards Codification ASC Topic 820, Fair Value Measurements, is the authoritative guidance on valuing investments. The Guide simply helps you interpret the standard. Consider what is in the guidance, and adopt the methods that make sense for your business. Often, adopting the leading practices can help you improve your own valuation policies so that your financial statements are more useful to its users, many of whom will likely expect that the Guide has been considered in your investment valuation policies.

The Guide is still in draft form. The AICPA has collected comments from the public and will process them over the next few months and adjust the draft as needed. A final version should be released in May 2019.

For More Information

If you have specific comments, questions, or concerns about the Guide, please contact us.

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Copyright © 2018, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.

CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).

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