Venture equity valuations in 2023: from darlings to dogs – part two

As discussed in part one of this article, the downturn in public equity markets will undoubtedly put pressure and scrutiny on private market valuations. Gone are the days when GPs could simply mark every security to the recent round price and have a reasonable expectation that their auditors would bless the results. This year, GPs will have to think critically about two components of the valuations. The first is the equity valuation, ie how much is the company worth, and the second is equity allocations, ie how much are the company’s various classes of equity securities worth.

Equity valuation

For equity valuations, we expect to see investments in later stage companies following trends in the public market, though possibly not to the same extent. Most GPs will likely use the market approach to value their investee companies, and valuation multiples have declined significantly. However, companies exhibiting strong growth over the past year may be able to blunt the impact of lower valuation multiples with that performance. That said, if valuation multiples are down 50%, investee companies would need to double their revenue in order to keep valuations flat, a tall order for later-stage companies.

One potential counterpoint to valuation declines among later stage companies is that average and median stepups in new financing rounds, while declining in 2022, are still positive¹, suggesting that valuations for private companies seeking additional equity are still increasing. It’s worth noting that there may be selection bias in the data, with weaker companies able to eschew priced rounds are going a different route for interim capital raises, hoping to push the next priced round out until market conditions are more favourable. However, this data may still help support conclusions that valuations for later stage VC investments should not correlate directly with public markets.

When it comes to equity valuations for earlier stage venture-backed companies, the data appears to be more favourable, with all metrics suggesting that valuations have not followed the public markets. Accordingly, when valuing these companies, it may be necessary to consider private market data, such as that recently published by PitchBook², in conjunction with qualitative factors when selecting valuation assumptions, so that changes in value align with performance as well as market trends for earlier stage investments. This may mean that calibration analyses used to select valuation multiples need to be recalibrated to align with the dislocation between public markets and early stage VC markets, even if there is no specific change in performance that would normally be required. Alternatively, it may be necessary to eschew the use of valuation multiples for early stage VC investments entirely, in favour of less traditional approaches.

Equity Allocation

As noted previously, valuation of venture investments is generally a two step process, the second of which is equity allocation. As noted in the PE/VC Valuation Guide:

Many (if not most) venture capital (VC) backed and private equity (PE) backed portfolio companies are financed by a combination of different classes of equity, each of which provides its holders with unique rights, privileges, and preferences (hereinafter referred to collectively as rights)…Estimating the value of the different classes of equity in a portfolio company requires an understanding of the rights associated with each class.

As discussed in part one of this article, when company valuations were consistently increasing, the use of a simplified scenario analysis (a fully diluted allocation) was both standard and supportable.

Equity allocation is often the least intuitive and most contentious aspect of private company valuations. It can also have a significant impact on investment values.

However, if GPs are concluding that their investee companies have declined in value, one tenet of a fully diluted allocation may be violated, that being the assumption that everything will convert and liquidation preferences won’t matter. As values decline, certain investors would suffer losses upon conversion. Accordingly, they would not consent to a fully diluted exit. Instead, they would look to leverage the rights afforded to them to be paid out based on their liquidation preferences and (if applicable) accrued dividends to preserve their invested capital. The amounts due to them based on their rights can be determined through the Current Value Method (CVM), generally referred to as the “waterfall”.

According to the PE/VC Valuation Guide, the CVM is not always an appropriate form of equity allocation:

Because the CVM focuses on the present and is not forward looking, the task force believes it is most appropriate in two types of circumstances. The first occurs when a liquidity event in the form of an acquisition or a dissolution of the portfolio company is imminent, and expectations about the future of the portfolio company as a going concern are virtually irrelevant. In this circum-stance, the CVM value, adjusted if necessary for the timing and risk associated with the expected transaction, would reflect the fair value of the equity interests. The second occurs when the fund's position to be measured has seniority over the other classes of equity in the portfolio company and the investors who hold this class of equity have control over the timing of exit. In this case, the investors could sell the portfolio company on the measurement date, and their position would realize the allocated value from the CVM (the CVM value).

Assuming a liquidation is not imminent, the key consideration here is whether the investors who in aggregate have control of the company would be willing to liquidate at the concluded current value. For example, if a company has preferred securities with a total liquidation preference of $75 million and a concluded equity value of $70 million, running the equity value through the waterfall would yield a value of $0 for common stock. At the current value, common shareholders would have no incentive to sell, as it locks them into being completely wiped out. If the common shareholders have sufficient voting power to block a liquidation, it’s unlikely that a liquidation at $70 million would occur, and use of the CVM would yield unreasonable results. Such an analysis is likely to receive pushback from auditors. Alternatively, if the concluded value is below the post-money value, but sufficiently in excess of total liquidation preferences, it’s possible that investors would be willing to liquidate and lock in profits (even if the most recent investors just recoup their costs), and so using the waterfall is reasonable.

For companies in particular distress, where common shareholders and maybe some preferred shareholders are out of the money at the concluded value, those out of the money securities are effectively options on the company’s value. They have no current value, but if the company’s value increases enough, they become in the money and accrue value. For this reason, it may be necessary to utilise the Option Pricing Method (OPM) for equity allocation. According to the PE/VC Valuation Guide, the OPM is supportable whenever there is a complex capital structure, so while it may not be a standard methodology for VC investors (and may appear daunting to execute), they may find their auditors pushing for the OPM this year, as valuations have declined.

Summary

There is little doubt that this year, more than many in the recent past, valuations will be carefully scrutinised by auditors and investors alike, as it is the most subjective and impactful component of VC fund financials. Funds continuing to mark solely to the most recent round of financing, especially if that financing was done prior to 2022, will be pushed hard to support that conclusion given the public equity markets. LPs may also push back on GPs suggesting that their funds have not diminished in value. Therefore, it will be important to be thoughtful about valuations, especially the equity allocation approach, as declining values will introduce considerations that were not relevant previously.

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¹Q3 2022 US VC Valuations Report, PitchBook, 2022. 

² Q3 2022 US VC Valuations Report, PitchBook, 2022.

³Accounting and Valuation Guide Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies. Available from: VitalSource Bookshelf, Association of International Certified Professional Accountants (AICPA), 2019.

⁴ Accounting and Valuation Guide Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies. Available from: VitalSource Bookshelf, Association of International Certified Professional Accountants (AICPA), 2019.