Comment: Bridging venture capital uncertainty and fair value
Expansion and later-stage venture capital companies present unique valuation challenges for investors. Mark McMahon, a Director in the Portfolio Valuation group at international financial advisory investment banking firm Duff & Phelps, discusses what a robust Fair Value analysis should consider.
A Fair Value analysis of any venture-backed company, regardless of its development stage, should be a comprehensive exercise – one that considers familiar value indications such as new rounds of financing and an examination of important milestones.
However, for expansion and later-stage companies with dynamic capital structures characterized by multiple rounds of financing and uncertain yet improving operational visibility, consideration of a probability weighted expected return (PWER) or option-based contingent claims analysis (CCA) should be a documented component of any venture fund’s valuation policies and procedures.
Both PWER and CCA are dynamic, forward-looking and inclusive of the full economic and control rights of all equity classes within the capital structure. Whereas PWER estimates value based on an analysis of possible future outcomes, including various exit scenarios with probability weightings, CCA treats all equity classes as call options on the estimated enterprise value, with exercise prices reflecting each series’ liquidation preference.
The choice of the most appropriate methodology will depend on a variety of valuation issues, and should reflect for the full impact of an investment’s rights. For example, an investment that provides operational control may in some instances be captured more effectively in a PWER analysis as compared to CCA.
A fundamental underpinning of both approaches is a thoughtful analysis of expected future performance, usually relying on discounted cash flows and market comparables with appropriate adjustments.
Management’s effort to construct reasonable projections should incorporate relatively straightforward assumptions on appropriate comparable companies and industry transactions, as well as revenue growth and profit margins.
Details that may require additional diligence include net operating losses, expected form and timing of exit, and discount rates. Depending on the nature of the business and projections, values can be sensitive to changes in subjective inputs, all of which should be thoroughly understood and supported.
It’s also important to understand when not to apply these approaches. CCA is often ineffective when the expected enterprise value relies on a binary outcome, where success indicates a value well in excess of all liquidation preferences but protective rights are worthless upon failure.
Additionally, as the expected exit date draws near, CCA’s effectiveness diminishes as the theoretical option driving the methodology moves toward expiry. PWER does not suffer from these specific limitations, but the significant analytical discretion necessary for its application can produce a complex and time-consuming exercise, testing the adage that the quality of results should justify the effort and expense.
Incorporating a PWER or CCA analysis within a complete Fair Value analysis will not solve all of the valuation issues inherent in expansion and later-stage venture capital companies, where complexity and uncertainty exist to a degree that is often absent in early-stage and mature portfolios.
Nevertheless, consideration of these two approaches and a reconciliation of results with recent arm’s-length financings and other value indications should support general partners eager to demonstrate industry best practices in providing robust, transparent net asset values to their investors.
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