VENTURE CAPITAL REVIEW
Issue 27 • 2011
produced by the National Venture Capital Association and Ernst & Young llp
National Venture Capital Association (NVCA)
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(NVCA) empowers its members and the entrepreneurs they fund by advocating for policies
that encourage innovation and reward long-term investment. As the venture community’s
preeminent trade association, NVCA serves as the definitive resource for venture capital data
and unites its 400 plus members through a full range of professional services. Learn more at
www.nvca.org.
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Fair Value, Who Cares?
and Why They Should!
By Steven Nebb, CFA, Director, and David L. Larsen, CPA, Managing Director, of Duff & Phelps LLC
Primarily because of historical bias, during the past
decade and especially during the past several years,
venture capitalists have repeatedly been heard to
say: “Fair value reporting for the Venture Capital (VC)
industry is meaningless; LPs don’t need it; GPs don’t
want it; regulators don’t understand it.” However, a
more critical examination of a wide range of reporting
and governance issues demonstrates that fair value
is not only required by most LPs, but provides key
benefits to both LPs and GPs.
Part of the stigma associated with fair value is a lack
of understanding of what fair value means for the VC
industry. Some incorrectly believe that FASB instituted
fair value rules for the VC industry in 2006 with the
issuance of the much-maligned SFAS 157. Yet SFAS
157 (now ASC Topic 820) does not require any asset
or any liability to be measured at fair value. Fair value,
for the investment industry, has its origins with the
1940 Investment Company Act. Further, investment
1
company accounting, which originated with the AICPA
Audit and Accounting Guide for Investment Companies
in the 1960/’70s requires investments to be reported
at fair value.
What Is Fair Value?
Most discussions about fair value still begin with
a description of what fair value represents. With
liquid securities, fair value is a concept that is much
easier to understand since the definition becomes
somewhat formulaic: market price times number of
1 US investment company accounting requirements are now promulgated by
FASB Accounting Standards Codification (ASC) Topic 946.
1
shares owned, or a value that has direct benchmark
indications from other market transactions. However,
when considering illiquid investments, fair value
represents a more qualitative and ambiguous
concept. Even in such instances, fair value is still
strictly defined. Accounting guidance establishes the
definition of fair value as “the price that would be
received to sell an asset or paid to transfer a liability
in an orderly transaction between market participants
2
at the measurement date.” The guidance adds that
to the greatest extent possible, valuations should be
based upon observable market data from reliable
sources. For VC investments, there is often limited or
no reliable market data. Each investment is unique (no
comparable companies or transactions) and involves
sensitive details that many times would be harmful to
the investor if disclosed. As a result, VC investors must
use supportable unobservable inputs, often using a
manager’s own assumptions, about how a market
participant would transact.
of value does not mitigate the need for alternative
methods and procedures for estimating a robust
fair value.
Why Fair Value?
Because many VC fund managers have partially
convinced themselves that fair value is not
estimable, is not cost-effective to estimate or is not
needed by their investors, it is important to dispel
such myths and once and for all acknowledge that
while imperfect, estimating fair value is not only
possible, but necessary for most investors and
helpful to most managers.
Our experience with our VC clientele is that while a
current period valuation of a VC investment requires
significant judgment, the focus on a valuation
framework that considers the analysis of all meaningful
factors and inputs beyond LRF, and the effort to
document these considerations, does indeed help the
fund in its strategic planning and in communication
with its investors. It also provides a meaningful method
for monitoring its investments and satisfying the funds
governance requirements. Additionally, we find that
most of our clients are already doing what is
necessary in some form to satisfy these goals, but
the lack of a formalized process or documented
methodology has not allowed them to take full credit
for the work performed.
Historically, VC fund managers have reluctantly
embraced fair value concepts, using cost or the value
of the last round of financing as their best estimate of
fair value in between financing events. The use of cost
to estimate fair value was driven by three key factors:
1. A
historical convention that identified “conservatism”
as a positive attribute;
2. D
raft 1989 NVCA guidelines (which were never
ratified or adopted), which encouraged the use of
cost; and
One other important consideration that should not
be ignored is the fact that investment companies are
not required to consolidate underlying investments
because they report fair values. However, if a fund
did not report its investments at fair value, arguably,
from an accounting point of view, underlying control
investments would be required to be consolidated,
making internal and external reporting significantly
more complex and less meaningful.
3. A
n investor (LP) base made up of individuals rather
than entities that had less strict fair value reporting
requirements.
Furthermore, because the development of an
emerging business or technology requires financings
more frequently, investors attempt to manage their
exposures to certain risks by funding development
at discrete points in time. Multiple financing events
potentially generate an opportunity to assess implied
values in Last Round of Financing (LRF) transactions.
However, caution should be applied when considering
LRF as indications of fair value since implying value
for existing investments using LRF requires material
assumptions that may or may not be appropriate.
Because of this, the ability to use LRF as an indicator
Evidence of Fair Value
If there are real difficulties in estimating the value of an
emerging company, how then do venture capitalists
determine the valuation at which they will invest at
various points in time? Many valuation practitioners
and auditors like to refer to market studies that have
been conducted over the past couple of decades
as support for indications of value. These studies
demonstrate the step-up in value between major
rounds of financing typically consisting of 25% to
2 FASB ASC Topic 820-10-35-1
2
One other important consideration that should not be
ignored is the fact that investment companies are not
required to consolidate underlying investments because
they report fair values. However, if a fund did not report its
investments at fair value, arguably, from an accounting point
of view, underlying control investments would be required to
be consolidated, making internal and external reporting
significantly more complex and less meaningful.
100%+ increases in value as companies progress
through the stages of development. However, this is
only true for investments at specific points of time that
successfully secure financing and is only meaningful
on an aggregate level, not necessarily applicable to
a single investment.
Ultimately valuations should consider the inputs used
to derive value, the intangible assets of the business.
These intangibles include intellectual property and
know-how, long-term growth potential, management
team talent, financial strength of existing investors,
perception of VC market interest, progress toward
milestones and competitive landscape. For earlystage, venture capital-backed companies that require
additional capital, these intangibles may impact
positively or negatively their ability to raise capital in
the current venture capital environment. The resulting
non-performance risk for companies that need to raise
money to reach cash flow breakeven or a successful
exit continues to be substantial, and may outweigh
many or all other valuation considerations.
In working with our VC clients, we have observed
numerous examples of a portfolio company being
able to meet significant milestones only to have forced
recapitalizations or down-round financing available to
it. The question then becomes, why does this happen?
The illiquid nature of the VC market sustains pricing
inefficiencies. Ultimately, the supply and demand of
VC capital and the bargaining power of entrepreneurs
and ownership syndicates does change, and at times
will not be correlated with the performance of the
underlying company. This environment clearly muddies
the waters for determining values. However, what this
truly means is that when estimating the fair value of an
investment, considerations beyond LRF or company
performance are meaningful.
While changes in value are certainly not linear, it
should be clear that value does not magically increase
or decrease on the day a new financing event takes
place. Since VC investors are instrumentally involved
with their portfolio companies, they likely are aware of
how a company is progressing toward its milestones,
and they typically have timely knowledge of trends in
the VC capital market that lead to an understanding
of the willingness and ability of the market to fund the
next stage of development for a company. Therefore,
while significant judgment is required, it should be
evident that an estimate of value can be derived at
times other than on the day of a financing event.
The assessment of what could be termed “nonperformance risk” is the risk that a portfolio company
with negative cash flow will be unable to raise
additional capital when needed. This factor is material
for VC investments that are capital intensive in one
form or another, and are expected to generate
negative cash flow over the development period of
two to five years. In situations where capital becomes
unavailable, the company is typically sold, possibly at a
loss, recapitalized at a valuation significantly lower than
the post-money valuation implied by the progress of
the firm or is shut down.
Why Investors (LPs) need Fair Value
One of the most troubling features of the GP/LP
interactions is the seeming inability of both sides to
fully understand the needs of the other. This failure to
3
• L
imited partners need consistent, transparent
information to exercise their fiduciary duty.
fair value provides such information on a
comparable basis for monitoring interim
performance. An arbitrary reporting basis such
as cost does not allow comparability.
communicate has given rise to more specific Limited
Partner Agreements, requests for side letters, ad hoc
data requests and LP initiatives such as the ILPA
Private Equity Principles. Any institutional LP (LPs
that produce GAAP-based financial statements and
invest on behalf of others — fund of funds, pension
funds, endowments, etc.) has need for timely, periodic,
robustly estimated net asset values (NAV) supported
by a rigorous measurement of the fair value of
underlying investments. LPs don’t always articulate
the reasons they need fair value reporting. LP needs
include, but are not limited to, the following:
• M
ost investors are required by relevant GAAP to
report their investments on a fair value basis.
Not all LPs articulate their needs as described above.
Some may even tell GPs that they prefer “cost.
In many cases, this failure to communicate occurs
because “deal” team members of LPs speak with
“deal” team members at the GP and may not fully
articulate all of the needs of the investor.
• F
air value is the basis investors (LPs) use to report
periodic (quarterly/yearly) performance to their
investors, beneficiaries, boards, etc.
Additionally, reporting fair value for financial
instruments is required to be consistent with other
financial reporting requirements. In particular, the
recognition of the fair value of contractual rights for
future cash flows typically resulting from earn-outs or
3
contingent considerations at fair value is required.
• F
air value is the best basis for LPs to make
“apples to apples” asset allocation decisions.
• F
air value is an important data point in making
interim investment (manager selection) decisions
on a comparable basis.
• F
air value is often necessary as a basis to
make incentive compensation decisions at the
investor level.
3 Established by FASB Statement 141 (revised 2007), Business Combinations
(FASB Accounting Standards Codification™ (ASC or Codification) 805,
Business Combinations.
4
such as the use of independent third-party valuation
experts to augment and validate the investee fund’s
procedures for estimating fair value.
Based on the uncertainty embedded in many earlystage companies, it is not suppressing that many
M&A transactions increasingly include earn-outs
or some form of future consideration. Since other
reporting entities (buyers) must report the contractual
payments at fair value, it is logical that the seller should
also recognize this contractual asset at fair value
as well. LPs must have fair value-based NAV and,
therefore, managers need to include the fair value of
all investments, including contractual payments, in
their calculation of NAV. Determining the acquisitiondate fair value of contractual rights (contingent
consideration) may entail the estimation of the
likelihood and timing of achieving relevant milestones
and/or the development of expected or scenariobased projections relevant to sales- or profitabilitybased payments. The good news is that these types
of assumptions and inputs are the same details that
are considered by the manager in making the decision
to sell its investment in the first place (and only need
to be adjusted for buyer/negotiation considerations).
Essentially, the reporting of fair value for contractual
rights becomes an extension of the processes already
performed by fund managers.
Ultimately, the investor is required to assess,
understand and conclude that the GP has delivered
a NAV derived from a rigorous estimate of the fair value
of underlying investments.
Why is Fair Value Meaningful?
Whether it is from the GP’s perspective, or an
LP’s requirement, fair value is ultimately the
contemporaneous measurement basis that allows
the VC industry to deliver on its obligation to be
fair, ethical and to effectively communicate critical
information needed by multiple interested parties.
Arbitrary valuations, such as cost, or inaccurate
valuations can undermine effective asset allocation
for investors, resulting in the inability of an investor
to properly manage its investment strategy or
possibly increasing the risk of fulfilling its fiduciary duty
to its beneficiaries.
Industry best practices centered around robust fair
value determinations provide GPs with effective
strategic tools for making appropriate comparisons
and for monitoring interim performance of their
investments, in addition to satisfying fiduciary
obligations. Because fair value requires a systematic
approach for estimating value and supporting
assumptions, appropriate procedures that generate fair
value will provide additional focused information
to monitor portfolios regularly.
Limited Partner Valuation Needs
As noted above, limited partner investors have a
number of reasons for needing and using fair value
derived NAV. LPs must value their interest in an
underlying fund at regular intervals to support their
financial reporting process. The recent accounting
guidance (ASU 2009-12) outlines when and how an
LP may estimate the fair value of an interest in a fund
using the reported fund’s NAV. Based on the guidance,
reliance on a reported NAV is only appropriate to the
extent that the investor has evidence that the reported
NAV is appropriately derived using proper fair value
principles as part of a robust process. In order to do
this, the most frequent ways to assess the robustness
of reported NAV are:
An incomplete development of policies, procedures
and processes that measure fair value may expose
fund managers to significant reputational and legal
risks and, ultimately may adversely affect their
marketing and fund-raising efforts. In the current
market environment, fund managers must now be
aware that investors should, both in their initial due
diligence process and in periodic reviews, discount
managers that have not adopted appropriate valuation
practices that generate robust indications of fair value.
Additionally, auditors and regulators will scrutinize
funds that don’t have well-defined and documented
valuation process and governance policies.
1. T
o conduct thorough pre-investment due diligence
and to leverage this diligence in ongoing monitoring
procedures;
2. T
o assess the fund’s fair value estimation processes
and control environment, and to monitor any
periodic changes; and
3. T
o review the fund’s policies and procedures for
estimating fair value, including considering factors
5
What’s a VC to Do?
investor’s need to understand the processes and
controls related to deriving value.
The determination of fair value, for VC investments,
requires a significant level of informed judgment,
rather than a rigid application of a mechanical process.
Therefore, fair value requires thoughtful involvement
from all stakeholders, including fund managers,
institutional investors, auditors, valuation experts
and regulators.
It should be emphasized that fair value does not
represent what a fund manager ultimately expects
to receive for exiting an investment, but the amount
that would be received in an orderly transaction as
of the valuation date. This concept troubles some VC
managers because they would not, and likely could
not, sell the investment at an interim date. The “orderly
transaction price” determination is hypothetical and
requires the exercise of informed judgment. This
means that fair value does not have to assume that
the underlying business or investment is saleable, the
investor or shareholders intend to sell in the near future
or the likely transaction would have to be a forced sale
or liquidation. In assessing fair value, fund managers
should be able to answer the following questions in
a consistent manner to explain how the investment is
being valued.
The valuation process should not be a “make work”
exercise. Best practice dictates that the information
needed to make, monitor and improve investments
is the same information used to value investments
on an interim basis. Generally, there is no need for
a fund manager to develop extensive policies, but
leveraging or enhancing existing processes to develop
and use a comprehensive and integrated valuation
framework that is clear, consistent and pragmatic will
provide effective documentation and communicate
the fund’s efforts in monitoring its investments and
reporting fair value robustly. This typically means that
the valuation process is an extension of the fund’s,
already developed, diligence, monitoring and strategic
decision-making processes.
1. H
ow correlated is the investment to public market
data? What objective data may indicate whether
value is moving in a logical direction? This should be
from a perspective that adjusts for outliers that may
significantly impact reported trends.
A well-developed and documented valuation
process can provide the basis for demonstrating to
investors that the fund manager is compliant with
fair value measurement principles. The specific
components of a thorough process should include
a governance structure, well-documented valuation
policy and clearly defined roles and responsibilities,
including independent personnel who are extremely
knowledgeable about valuation methodologies. The
elements of the valuation policy should cover specific
approaches and valuation methodologies appropriate
for various types of investments at various stages of
development, and should include details regarding
typical assumptions and sources of data that would
be part of each valuation methodology. Additionally
the policy should address the internal documentation
procedures to support valuations (models and
templates) and a delineation of circumstances that
permit a manager to rely upon specific or different
models. The valuation policy and supporting
documentation should be periodically reviewed and
updated. Having established valuation policies and
procedures will allow a manager to communicate
and discuss its approach to fair value and satisfy an
2. W
hat other recent transactions has the fund been
involved with (or know the details of) that support
the current fair value of an investment? Are there
similar deals that provide an indication of the fair
value of the subject investment? This may include
transactions of the subject company securities,
comparable company transactions, or sector and
industry transactions involving companies in similar
stages of development.
3. A
re there any potential issues with obtaining the
next round of financing for an investment (compared
to original expectations)? What’s the likely impact of
less/more demand to fund the portfolio company?
4. D
oes the fair value indication represent a price [as
of the valuation date] that you would be willing to
invest in the same portfolio company (with the same
existing terms)? Would more investment for a higher
or lower percentage interest be appropriate? Does
it make sense to invest less money for the same
percentage interest because the company has
satisfied some development hurdles (milestones)
and has less need for capital at the current stage?
Will the company need more capital than originally
6
expected because the burn rate is higher, more
uncertainty developed in the market or negative
results require more development effort?
assessing the potential impact the changes will have
on the success of the business, which is the key
to assessing the progress of value during the
holding period of an investment.
5. Is it possible to sell an interest in an existing portfolio
company at the same price as you could have
sold it previously? This question may help limit the
hypothetical nature of a fair value transaction since
it contemplates the comparison of a hypothetical
transaction in the past to a current hypothetical
transaction.
7. H
ave the current market and economic conditions
affected the underlying opportunities, risks or
probability of success of the portfolio company?
Considering these questions and documenting the
answers will be a good start at a well-thought-out and
documented process for estimating the fair value of
VC investments. Again, since these considerations
are the same considerations that are used in making,
monitoring and exiting an investment, they flow
directly into the periodic (usually quarterly) valuation
assessment. For example, a simplified way to consider
valuing VC investments is using the following decision
tree (for illustrative purposes only):
hat has changed with the portfolio company in
6. W
relation to the company’s position at entry, during
the LRF and with the expectations of the business
over the holding period? It’s more important to
understand why things have changed than to simply
recognize that things are different. An understanding
of why changes have occurred should be helpful in
Policy Statement:
All investments are recorded at fair value.
All relevant information is taken into account to make the fair value determination.
Valuation Decision Tree
1. Barring contradictory information, the cost (excluding transaction
costs) of an investment is deemed the “exit” price on the date of
investment and is therefore used as its initial fair value.
a. Fair Value is measured as the market price times the number of
shares held less a possible discount. Support for the discount
generally model-based.
Thereafter
Yes
Yes
2. Are shares publicly traded in an active market?
2a. Is there a legal restriction?
No
b.If there is no legal restriction (attributable to the shares, not to
the holder), fair value is determined as the market price times
the number of shares owned. No discount is allowed even if the
number of shares owned is large relative to the average daily
trading volume.
No
3. Is there a comparable company from which fair value can
be derived?
Yes
Utilize comparable company valuation techniques to determine
fair value.
No
4. D
oes the investee company have positive sustainable
performance (for example, positive recurring EBITDA)?
Yes
Fair value may be determined as EBITDA times a reasonable
marketplace multiple for the company.
No
5. H
as there been any significant change in the results of the
investee company compared to budget, plan, etc? Has there been
any significant change in the market for the investee company or
its products or potential products? Has there been any significant
change in the global economy or the economic environment in
which the investee company operates?
Yes
a. If the change is positive, there is an indication that value has
increased. Determine fair value using objective data from the
company, investment professionals and other investors
b. If the change is negative, there is an indication that value has
decreased. Determine the value decrease to be recorded based
on objective measures and manager experience.
No
c. If no, the value of most recent round of financing may be the
best estimate of fair value.
7
Conclusion
By utilizing the simplified illustrative decision tree, many
early-stage venture investments would fall into step 5.
Therefore, for some period of time after investment,
assuming none of the changes outlined in step 5
have occurred, fair value is often measured by using
the value of the last round of financing. However,
as knowledge is gained about the progress on a
meaningful milestone, or it is clear that more or less
funding will be needed (burn rate) to get to the next
stage (probability of success), or that funding is or is
not likely to occur at typical terms (performance risk),
fair value has diverged from the last round of financing,
and fund managers have a duty to acknowledge and
report that fact in the normal reporting process to the
fund’s investors.
Since the issuance of the PEIGG guidelines in 2003,
the release of the IPEV Guidelines in 2005, FASB’s
issuance of Statement 157 in 2006, the financial crisis
of 2008 and subsequent revisions and application
of the preceding, fair value measurement has been
a topic of concern in the VC industry for almost a
decade. Rather than being vilified, fair value should
be embraced as the best (albeit imperfect) basis for
measuring investments at interim periods, resulting
in the fulfillment of a multitude of needs for both
investors and managers. 
About the Authors
David L. Larsen is a Member of FASB’s Valuation Resource Group, a Board Member of the International Private Equity
and Venture Capital Valuations Board (IPEV), led the team that drafted the US PEIGG Valuation Guidelines, and is a Member
of the AICPA Net Asset Value (NAV) Task Force. Mr. Larsen serves a wide variety of alternative asset investors and managers
in resolving valuation and governance-related issues.
Steven Nebb serves as the project lead for numerous Alternative Asset managers and investors, including large global
private equity, venture capital, and Business Development Companies. He provides advisory support to many limited
partnerships and corporate pension plans regarding fund management, financial reporting requirements and general
valuation of investments, and has significant experience in performing valuations of intellectual property, private equity,
illiquid debt, and complex derivatives for a variety of purposes, including fairness opinions and transaction advisory,
financial reporting, tax, litigation, and strategic planning.
8
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i