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Developed for preparers of financial statements, independent auditors, and valuation specialists, this guide provides nonauthoritative guidance and illustrations regarding the accounting for and valuation of portfolio company investments held by investment companies within the scope of FASB ASC 946, Financial Services -Investment Companies, (including private equity funds, venture capital funds, hedge funds, and business development companies).It features16 case studies that can be used to reason through real situations faced by investment fund managers, valuation specialists and auditors, this guide addresses many accounting and valuation issues that have emerged over time to assist investment companies in addressing the challenges in estimating fair value of these investments, such as:Unit of accountTransaction costsCalibrationThe impact of control and marketabilityBacktesting
Contents
Introduction .01-.11Background .02-.05Scope .06-.09Information Included in This Guide .10Guide to the Guide .111 Overview of the Private Equity and Venture Capital Industry and Its Investment Strategies .01-.81Introduction .01-.13Investment Strategies and Portfolio Company Life Cycle .14-.21Typical Fund Structures and Role of Fund Manager .22-.27Fund Entity (Limited Partnership) - The Investment Company .22-.24Compensation, Fund Management Fees, and Carried Interest .25-.27Investor Base .28-.38Defined Benefit Pension Plans .30-.31Sovereign Wealth Funds .32Development Finance Institutions .33Endowment Funds .34High-Net-Worth Individuals and Family Offices .35-.37Funds of Funds .38Investment Horizon and Return Considerations .39-.45Long-Term Orientation .39-.41Risk Tolerance .42-.45Impact on Portfolio Company Valuations .46-.57Planning for "Exits" .46-.48Strategic Buyers .49-.51Public Equity Markets and IPO .52-.57Considerations for Early-Stage Portfolio Companies .58-.73The Portfolio Company's Strategy and Positioning .66Market Opportunity .67Product Adoption and Customer Behavior .68Competitive Landscape and Presence of a First-to-Market Advantage .69Regulatory Approval and Other Gating Factors to Market Access .70Use of Subject Matter Experts and Advisers .71Executive Management and Their Track Records .72Macro Investment Environment for the Particular Early-Stage Portfolio Company .73Regulatory Environment .74-.77U.S. Securities and Other Regulation .75-.77Business Development Companies and Small Business Investment Companies .78-.81Business Development Companies .78Small Business Investment Companies .79-.812 Fair Value and Related Concepts .01-.45Definitions of Value .01-.06Why Do Financial Reporting Standards Require Fair Value? .07Fair Value Concepts - FASB ASC 820 .08-.30Fair Value and Exit Price .08-.10Entry or Transaction Price .11Transaction Costs .12Unit of Account .13Measurement Date .14Principal (or Most Advantageous) Market .15-.20Active Market .21-.24The Fair Value Hierarchy .25-.27Market Participants .28-.30Fair Value Concepts - SEC Matters .31-.37Securities Valued "in Good Faith" .34-.37Other Relevant Nonauthoritative Guidance .38-.45AICPA Accounting and Valuation Guide Valuation of Privately-Held-Company Equity Securities Issued as Compensation .38AICPA Technical Questions and Answers .39-.41Other Industry Guidance .42-.453 Market Participant Assumptions .01-.24Introduction .01-.03Market Participant Considerations .04-.06Required Rate of Return .07-.12Relevance of Observable Transactions in Developing Market Participant Assumptions .13Consideration of Future Conditions .14-.16Considering Whether Investors' Interests are Aligned .17-.22Types of Information Typically Considered .23-.244 Determining the Unit of Account and the Assumed Transaction for Measuring the Fair Value of Investments .01-.155Introduction .01-.03Relevant Technical Guidance .04-.12Grouping Assets for Measuring Fair Value .13-.16Time Horizon for the Investment .17-.24Implications of the Initial Transaction for Determining the Grouping of Assets in the Assumed Exit Transaction .25-.30Examples .31-.154Example 1: 100% of equity held within a single fund (single reporting entity) .32-.56Example 2: 45% of equity held in each of two funds managed by the same GP .57-.63Example 3: Club deal, 30% of equity held in each of three funds managed by different GPs .64-.67Example 4: 100% of equity in a reporting entity with a significant deferred tax asset .68-.73Example 5: Debt and 100% of equity held within a single fund (single reporting entity) .74-.78Example 6: Debt and 100% of equity held within different funds .79-.100Example 7: Repurchased debt and 100% of equity in a single fund .101-.109Example 8: Debt investment with options or warrants .110-.135Example 9: Distressed equity investment with options or warrants .136-.146Example 10: Multiple investments in different classes of equity .147-.154Summary .1555 Overview of Valuation Approaches .01-.109Market Approach .06-.09Considerations in Applying the Guideline Public Company Method .10-.45Identification of Guideline Public Companies .11-.17Number of Guideline Public Companies Selected for Comparison .18How to Calculate Multiples and Which Multiples to Use .19-.31Adjustments to Guideline Public Company Multiples to Enhance Comparability .32-.33Adjustments to Subject Portfolio Company Financial Data .34-.35Elimination of Multiples That are Not Meaningful .36-.37How to Select Multiples to Apply to the Subject Portfolio Company in the Guideline Public Company Method .38-.42Weighting of Multiple Type .43-.44Enterprise Versus Equity-Level Multiples .45Considerations in Applying the Guideline Company Transactions Method .46-.55Limitations on Availability of Data .47Assessing Relevant Time Period for Guideline Company Transactions .48Number of Guideline Company Transactions Selected for Comparison .49How to Select Multiples to Apply to the Subject Portfolio Company in the Guideline Company Transactions Method .50-.51Transactions in the Portfolio Company's Instruments .52-.55Income Approach .56-.94Significant Assumptions of the Income Approach .70-.90Income and Market Approach Summary .91Milestone-Driven Valuations .92-.94Asset Approach .95-.109Significant Assumptions of the Asset Approach .104-.1096 Valuation of Debt Instruments .01-.32Fair Value of Debt Instruments (When Debt is the Unit of Account) .05-.19Value of Debt for the Purpose of Valuing Equity .20-.327 Valuation of Equity Interests in Simple Capital Structures .01-.118 Valuation of Equity Interests in Complex Capital Structures .01-.79Rights Associated with Preferred Stock .09-.13Methods of Estimating the Fair Value of Multiple Classes of Equity .14Overall Comments Applicable to All Four Methods for Valuing Equity Interests .15-.17Considerations Affecting the Selection of a Method for Valuing Equity Interests in Complex Capital Structures .18-.79Scenario-Based Methods .20-.36The Option Pricing Method .37-.53The Current Value Method .54-.59Hybrid Methods .60-.66Considerations in Selecting a Methodology for Valuing Equity Interests .67-.799 Control and Marketability .01-.34Controlling Versus Minority Interests .04-.23Marketable Versus Nonmarketable Interests .24-.32Assessing Discounts or Premiums Via Calibration .33-.3410 Calibration .01-.47Introduction .01-.04Valuation Implications of Observed Transactions .05-.09Applying Calibration in Valuing a Debt Investment in a Business .10-.12Applying Calibration in Valuing an Equity Investment in a Business .13-.25Market Approach .13-.18Income Approach .19-.25Relevance of Calibration as Time Passes .26-.27Implications of Calibration When Considering Theoretical Discounts or Premiums Associated with Control and Marketability .28-.30Inferring Value From Transactions in a Portfolio Company's Instruments .31-.43Consistency with Other Valuations Performed for the Portfolio Company .44-.4711 Backtesting .01-.101Introduction .01-.15Relationship Between Backtesting and Evaluating Subsequent Events Under FASB ASC 855 .16-.20Factors to Consider When Performing Backtesting .21Illustrative Examples .22-.101Example 1: Potential buyer's synergies unknown .25-.33Example 2: Unidentified operational issues .34-.43Example 3: Subsequent IPO and significant price increase .44-.51Example 4: Subsequent rescue of a company in financial distress .52-.58Example 5: Bridge loan followed by down-round financing .59-.74Example 6: Material nonpublic information with publicly traded shares .75-.79Example 7: Subsequent working capital adjustment and contract claims .80-.85Example 8: Unidentified investor or market participant .86-.92Example 9: Clinical trial results .93-.10112 Factors to Consider at or Near a Transaction Date .01-.23Introduction .01-.05Fair Value Considerations at Initial Recognition .06-.10Fair Value Considerations at Interim Measurement Dates .11-.13Fair Value Considerations at or Near Exit .14-.15Illustrative Examples .16-.21Impact of Transaction Costs on Calibration .22-.2313 Special Topics .01-.100Introduction .01When an Enterprise Has Traded Securities .02-.24P x Q Rule .03-.07Underwriter Lock-Ups and SEC Rule 144A .08-.14Similar Versus Identical Securities .15-.19Significant Decrease in Volume or Activity or Distressed Transactions .20-.24Pricing Services and Broker and Dealer Quotes .25-.33Background .25-.28Management Responsibilities .29-.33Indicative Offers .34-.36Insider Financing Rounds .37-.38Early-Stage Companies with No Recent Financing Rounds .39-.43Rights and Privileges Not Enforced .44-.49Commitments to Portfolio Companies .50-.60Loan Commitments .50-.54Equity Commitments .55-.60Guarantees .61-.64Dilution .65-.76Anticipated Future Dilution .66-.72Changes to Anticipated Future Dilution .73Impact of Share-Based Awards .74Current Dilution .75Summary .76Options and Warrants, Convertible Notes, and Related Instruments .77-.82Contractual Rights (Contingent Consideration) .83-.87Private Fund Interests .88-.100NAV Practical Expedient .88-.95Alternatives to the NAV Practical Expedient .96Secondary Transactions in an Interest in a Private Fund .97-.99Discounted Cash Flows .10014 Frequently Asked Questions .01Introduction .01Material Covered in the Guide Q&A 14.1: Material Covered in the GuideQ&A 14.2: Intended Use of the GuideQ&A 14.3: Managing Complexity of the Valuation ProcessQ&A 14.4: Getting StartedQ&A 14.5: Impact of the GuideQ&A 14.6: Consistency with Other GuidanceQ&A 14.7: Measurements at Net Asset Value Internal Controls Over ValuationsQ&A 14.8: Internal Control Policies and Procedures for ValuationsQ&A 14.9: Mandatory Performance FrameworkQ&A 14.10: Third-Party OpinionsQ&A 14.11: Inherent Uncertainty of the EstimateQ&A 14.12: Conservativism in Fair Value EstimatesQ&A 14.13: Bid/Ask Spread Considerations Value Changes Over TimeQ&A 14.14: Frequency of Preparation of Fair Value EstimatesQ&A 14.15: Carrying Value at CostQ&A 14.16: Value Changes Over TimeQ&A 14.17: Adjusting the Value of the Portfolio From Period to PeriodQ&A 14.18: Portfolio Company Financial Information Used in the Valuation AnalysisQ&A 14.19: Shelf Life of Value-Related Information Reconciliation with Other ValuationsQ&A 14.20: Reliance on IRC Section 409A or FASB ASC 718 ReportsQ&A 14.21: Differences in Fair Value EstimatesQ&A 14.22: Valuation Diligence on Club Deals Considering Risks and Outcomes Associated with Contractual RightsQ&A 14.23: Valuation of an Equity Interest with a Put RightQ&A 14.24: Valuation of Contingent Consideration Q&A 14.25: Valuation of an Interest in a Company That Has Filed for Bankruptcy Valuing Businesses for the Purpose of Valuing InvestmentsQ&A 14.26: Earnings NormalizationQ&A 14.27: Incorporating Stock-Based Compensation Into the ValuationQ&A 14.28: Treatment of SynergiesQ&A 14.29: Considering Multiple Lines of Business Within a Single Portfolio CompanyQ&A 14.30: Using Data From Guideline Public Companies When the Portfolio Company is Not Really ComparableQ&A 14.31: Alternatives to Using Guideline Public Companies When the Portfolio Company is Not Really ComparableQ&A 14.32: Addressing the Lag in Available Financial Information for the Guideline Public Companies as of the Measurement DateQ&A 14.33: Incorporating Discounts or Premiums Into the Enterprise ValueQ&A 14.34: Private Equity Cost of CapitalQ&A 14.35: Company-Specific Assumptions CalibrationQ&A 14.36: Holding Value at CostQ&A 14.37: Insider Financing RoundsQ&A 14.38: Tranched FinancingQ&A 14.39: Considering Transaction Costs in CalibrationQ&A 14.40: Calibrating to a Transaction with Assumed DebtQ&A 14.41: Calibrating to a Transaction with a Contingent Tax LiabilityQ&A 14.42: Offers to PurchaseQ&A 14.43: Repayment of Debt InvestmentsQ&A 14.44: Calibration to Broker Transactions in Public Company SecuritiesQ&A 14.45: Calibration for Real Estate Investments Value of Debt for the Purpose of Valuing EquityQ&A 14.46: Valuing Debt for the Purpose of Valuing Equity Using the Book Value or Face ValueQ&A 14.47: Valuing Debt for the Purpose of Valuing Equity Using the Traded PriceQ&A 14.48: Using the Zero-Coupon Bond Equivalent for Including Debt in the Option Pricing MethodQ&A 14.49: Impact of Estimating Equity Value Using a Value of Debt Lower Than Face Value When Both the Enterprise Value and the Value of Debt Have DeclinedQ&A 14.50: Impact of Estimating Equity Value Using the Value of Debt for the Purpose of Valuing Equity When the Enterprise Value Has Remained Unchanged Q&A 14.51: Methodologies for Valuing Equity in a Business with Nonperforming Distressed Debt Valuing Equity Interests in Complex Capital StructuresQ&A 14.52: Use of the PWERMQ&A 14.53: Use of the Current Value MethodQ&A 14.54: Use of the Option Pricing MethodQ&A 14.55: Different Values for Earlier and Later Round InvestmentsQ&A 14.56: Value of Liquidation PreferencesQ&A 14.57: Treatment of Equity Interests with Different Liquidation PreferencesQ&A 14.58: Allocation Methods When Using Postmoney ValueQ&A 14.59: Using the OPM as the Fund's Standard Approach for All Portfolio CompaniesQ&A 14.60: Two Funds Under the Same Investment Company Manager Hold Different Classes of EquityQ&A 14.61: Measuring Volatility for Early-Stage Companies Control and MarketabilityQ&A 14.62: Basis of Value - Control Considerations When Measuring Enterprise ValueQ&A 14.63: Valuation Approaches and Controlling and Noncontrolling InterestsQ&A 14.64: Applying Discounts for Lack of Marketability to the Total Equity ValueQ&A 14.65: Illiquidity and Marketability of InvestmentsQ&A 14.66: Basis of ValuationQ&A 14.67: Differences in the Basis of Valuation for Controlling Versus Minority PositionsQ&A 14.68: Valuations with Multiple Related Fund Investors Information to Be Considered in the ValuationQ&A 14.69: Incomplete InformationQ&A 14.70: Use of Nonpublic ("Inside") InformationQ&A 14.71: Incorporating Nonpublic Information Into the ValuationQ&A 14.72: Postvaluation Event (Customer Financial Condition) - Assessment as Known or KnowableQ&A 14.73: Postvaluation Event (Product Approval) - Assessment as Known or KnowableQ&A 14.74: Expected Financing - Effect on ValuationQ&A 14.75: Measuring Fair Value When the Volume or Level of Activity for an Asset or a Liability with Observable Prices or Quotes Has Significantly Decreased - Applicability of GuidanceQ&A 14.76: Measuring Fair Value When the Volume or Level of Activity for an Asset or a Liability with Observable Prices or Quotes Has Significantly Decreased - Objective of a Fair Value MeasurementQ&A 14.77: Measuring Fair Value When the Volume or Level of Activity for an Asset or a Liability with Observable Prices or Quotes Has Significantly Decreased - Rules of Thumb or Quantitative Thresholds Remeasurements Relating to Changes in Portfolio Company FinancialsQ&A 14.78: Remeasurements Relating to Restatements of the Portfolio Company's Financial StatementsQ&A 14.79: Remeasurements Relating to Accounting ChangesAppendixA Valuation Process and Documentation ConsiderationsB Valuation Reference GuideC Valuation Case StudiesGlossaryIndex of Pronouncements and Other Technical GuidanceSubject Index
