Top Valuation Challenges for Venture Capital Managers
Valuation of the components of a venture capital fund’s portfolio presents many challenges for the fund’s manager.
The practice of marking to cost, the last round of financing, or zero is not specific enough to capture what a portfolio company’s fair value would under U.S. GAAP reporting, and the documentation needed to ensure a smooth financial statement audit requires much more than just consideration of the valuation of the last round of financing.
As experts in helping organizations overcome valuation challenges, we have outlined some of the main issues fund managers may face in valuing a fund’s portfolio alongside the best practices that address such items.
Top Valuation Challenges for Venture Capital Managers
1. Lack of data
As venture capital funds invest in early-stage companies, information that can be used to value such companies can be scarce due to many factors.
Unlike later-stage companies, there usually are not any significant financial metrics that can be used to determine valuation, such as revenue, profits, or EBITDA.
In addition, while both quantitative and qualitative information are used in determining valuation, fund managers often have very limited quantitative information available and would then need to utilize qualitative information, such as achievement of milestones and indicators of potential.
Qualitative milestones are not uniform in nature, and thus, present difficulties in gathering, analyzing, and documenting as opposed to quantitative data.
Lastly, whereas identifying comparable publicly traded companies or recent transactions is an acceptable valuation practice, finding such a set of comparable companies or relevant, observable transactions could prove difficult for early-stage companies.
In fact, the most relevant observable transaction may indeed be the round of financing into which the fund invested into the portfolio company.
2. Market considerations
Venture capital fund managers may also encounter challenges in valuing portfolio companies based on market conditions.
Market volatility
Markets have been more volatile recently compared to relatively calmer periods in preceding years. Reasons for such volatility include geopolitical events, changes in interest rates in response to efforts to combat inflation while balancing the need for sustained economic growth, and overall economic uncertainty, including the possibility of economic downtowns or recession.
Valuing investments in a volatile environment is much more challenging than doing so in an environment of sustained, steady growth.
Investor sentiment
Venture-backed company valuation is affected by investor sentiment and market trends. An example may be found in the valuation of portfolio companies associated with blockchain technology, digital assets, and Web3.
While the exuberance around those industries drove bullish valuations in 2021, the so-called “crypto winter” that started in 2022 has challenged whether valuation based on metrics and transactions in 2021 remain relevant.
Exit uncertainty
Uncertainty over exits and the challenges of closing subsequent rounds of financing present additional challenges to venture capital fund managers.
As a significant amount of the valuation of a venture-backed company is driven by the consideration received at exit, whether by going public through an IPO or an acquisition, the valuation is highly sensitive to assumptions made regarding the timing and terms of an exit.
In a volatile market, those assumptions are more difficult to determine.
Furthermore, while a recent last round of financing is a very useful data point to determining value, market volatility and/or industry challenges may make the occurrence of such rounds of financing more difficult to close and fewer in number and thus yield fewer useful data points that could have been used by fund managers in determining portfolio company valuation.
Tips and Steps to Develop an Accurate and Reliable Valuation Process
Given the challenges described above, it becomes more important for venture managers to put in place steps to address those challenges and provide for an effective valuation process.
The valuation process should be an ongoing process aimed at effective information-gathering from portfolio companies, such that venture fund managers can assess the valuation of venture-backed companies on a recurring basis, and not just for annual reporting and/or financial statement audits.
1. Understand your data and maintain reliable methods of communication
It is key for venture fund managers to maintain avenues of communication through which portfolio companies can provide information useful to find managers in valuing such companies. Managers should understand what type of qualitative, financial, and accounting information would be available, and the timing and frequency of such reports.
This way, fund managers can assess what information is available and can then work with portfolio companies to enhance such reporting.
In addition, the nature of qualitative reporting can also be received, assessed, and documented by fund managers in order to supplement any financial reporting received with an understanding of how a portfolio company is performing against plan, against benchmarks, and against industry peers along with an understanding of the overall performance of the portfolio company’s industry.
2. Develop a process to assess and document impacts
Fund managers should also have a process to assess and document the impact of significant qualitative events on portfolio company valuation, such as passage or failure of a trial, and changes in the composition or volume of customers/clients, cybersecurity events, changes in company leadership, among other items.
If a fund is subject to a financial statement audit, it is critical that the fund manager and auditors discuss what qualitative and quantitative information may be available to auditors to test the valuation of portfolio companies and how the fund manager can document and present such documentation to the auditors.
Such a discussion with the auditors should happen in advance of the commencement of the audit, and, if possible, before year-end and the determination of year-end valuation.
Fund managers and auditors should also discuss best practices among peers and in the industry in the gathering and documentation of inputs used in determining portfolio company valuation.
3. Understand how market volatility affects your organization
It is also important for fund managers to understand that market volatility and a decrease of transactions in the market may render valuation based on the latest round of financing less reliable.
In such instances, a round of financing may be considered “stale” or not a good indicator of fair value if it occurs more than 9 or 12 months before a valuation date.
In addition, if an observed transaction is deemed to be a “fire sale” under distressed circumstances, such a transaction should be regarded as not being indicative of fair value between a willing buyer and seller.
Also, managers may need to consider a round as stale – even one that occurs within 12 months — in an especially volatile market. In such cases, it is then important for fund managers to undertake and document a benchmarking exercise.
Such benchmarks to be considered include the following:
- Are the financial condition and performance of a portfolio company as of the valuation date similar to that as when the company was most recently invested into by the fund?
- How is the portfolio company performing – considering both quantitative and qualitative inputs – against budgets or plans?
- How is the portfolio company performing compared to other companies in its industry or space or against a comparable set of public companies? When comparing against a comparable set of public companies, how was the valuation of such public companies changed of the valuation period?
Final Thoughts on Valuation Challenges for Venture Capital Managers
As a service provider in the venture capital space, Kranz is aware that there are real challenges facing venture fund managers in determining the valuation of portfolio companies. The early-stage nature of portfolio company investments face situations where information used in valuation may be sparse.
Further, market conditions present another set of issues, ranging from volatility, industry/investor sentiment, and exit uncertainty.
Kranz’s professionals can assist fund manager to address these challenges by assisting in the building of a robust valuation process, featuring frequent and relevant flows of qualitative and quantitative information from portfolio companies and assisting in the assessment and documentation of benchmarking exercises seeking to compare current portfolio company valuation inputs against previous valuations, budgets/plans, and comparable companies.
As a trusted business adviser in the fund administration and outsourced CFO space, Kranz stands ready to help fund managers as part of a solution to address those valuation challenges and to create or improve the valuation process.
Contact us today or learn more about how we can partner for growth here.
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