Valuation of Equity Interests in Portfolio Companies with Complex Capital Structures
In 2019, the AICPA issued guidance for investment companies on how to fair value their portfolio company investments. The accounting and valuation guide titled Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (the “Guide”) provides non-authoritative guidance for preparers of financial statements, independent auditors, and valuation specialists regarding the accounting for and valuation of portfolio company investments.
The Guide includes a discussion of valuation of equity interests in portfolio companies with a capital structure involving multiple classes of stock (a “complex capital structure”). A portfolio company with a complex capital structure may issue both preferred and common shares, and options or warrants. Each class of equity provides its holders with unique rights, privileges and preferences. To estimate the fair value of the fund’s investment, the Guide states that 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.”
Chapter 8 of the Guide discusses four methods for valuing multiple classes of equity: Scenario-based methods, option pricing method (OPM), current value method (CVM) and hybrid method. Of the four methods that are discussed in the Guide, CVM is a method frequently encountered in practice by private equity and venture capital funds. This method allocates the equity value to the various equity interests in a business as though the business were to be sold on the measurement date.
The Guide notes that the criteria that should be considered in selecting a method for valuing equity interests include “the expectations that market participants investing in those instruments would make about future economic events and the amounts, timing and uncertainty of future cash flows to be received by the holders of each instrument.” The Guide notes that certain “noneconomic rights” provided to holders of certain classes of equity may influence market participant expectations regarding expected exit scenarios and the timing of exit. Noneconomic rights may include voting rights, protective provisions and veto rights, board composition rights, drag-along rights, first refusal rights and tag-along rights. The Guide notes that when a liquidity event is imminent or the fund has both seniority and control over the timing of exit, a CVM may be appropriate.
Chapter 8 of the Guide also discusses additional criteria that should be considered in selecting a valuation method.
Importantly, the Guide acknowledges that no single method for valuing equity interests is “superior in all respects and circumstances over the others.”
As you plan ahead for the fund’s year-end valuation process, it is our recommendation that the persons responsible for the fund’s investment valuations consider the discussion contained in the Guide with respect to valuation of equity interests in portfolio companies with a complex capital structure and document the rationale for the methodology employed by the fund.
Please reach out to your Marcum team to discuss any questions you may have or you can direct questions to the following members of Marcum’s Alternative Investment Group.