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Valuations for venture capital investments have always been challenging. For a long time, investments were held at cost until a new round of financing was raised. The secondary market has evolved, providing incremental observable inputs for valuations, but only if one can obtain adequate details about the transactions. Most recently, the financial accounting rules continue to evolve, giving investors in venture and growth equity more to think about.
Below, Chris Franzek, co-leader of Stout’s Portfolio Valuation practice, explores these topics with a number of the Stout Portfolio Valuation Managing Directors: Michael Burke, Brendan Smith, and West Chapman, each of whom have long-tenured and varied experience, including time spent as valuation professionals, a secondary buyer, an auditor, a CFO, and a chief risk officer. Below is a recent discussion of the state of venture capital valuations.
Chris Franzek: Mike, when you’re talking to institutional investors about valuations, where do you get the most questions?
Mike Burke: Over the past year, Stout surveyed a group of institutional investors, asking them which asset class has the most robust valuation processes: private credit, private equity, real estate, or venture capital. It might not be a big surprise that venture capital didn’t get the most votes, but we were surprised that venture capital didn’t receive a single vote, while the other three asset classes received roughly equal numbers of votes.
Some of the institutional investors’ concerns relate to the lack of movement in valuations during times of market volatility, while other questions arise as increasingly sophisticated institutional investors see disparate valuations for the same investments across different investors.
Chris Franzek: Mike, what drives differences in valuations across investors?
Mike Burke: One of the most significant factors driving differences in valuations is information rights. Historically, differences in information rights originated from negotiated information rights at the time of investment. Increasingly, information rights may also include knowledge of trading activity in the secondary market, which has been increasingly active and transparent.
There are a growing number of data providers aggregating and publishing secondary trading prices and volumes that are increasingly becoming an important consideration in determining the fair values of investments. The data is far from perfect, however, since various share classes in the company’s capital structure are usually not differentiated. That is, we know that a series of preferred stock with a liquidation preference can be worth more than the common shares, especially if a company is underperforming.
Chris Franzek: Brendan, when you talk to venture capital valuation teams about their processes, can you highlight some of the best practices that you’re seeing in the market?
Brendan Smith: What we’re seeing today, in particular from the audit side, is a nudge to “do more.” Cost survived for decades as the predominant valuation metric unless there was a new round of financing or a realization. Today, cost or the last round of financing have a finite life — as time passes, portfolio companies evolve and markets change, and all three factors impact the time horizon over which cost or the last round of financing remains indicative of fair value. Each should be revisited for their impact on value at each valuation date. So we’re seeing valuation teams build more robust processes around data gathering and monitoring and mapping how that translates into valuation updates from both qualitative and quantitative standpoints.
Chris Franzek: How does one balance varying information rights on portfolio company performance and changes in market conditions?
Brendan Smith: The historical dependence on cost or the last round minimized the need to separately consider portfolio company performance. ASC 820 reinforced the need to consider portfolio company performance as well as current market conditions. While an investor’s access to portfolio company operating metrics may be limited, one must still consider and document changes in a portfolio company’s financial performance, operations, and progress toward achieving developmental milestones.
Similarly, as market conditions change, valuation professionals must consider market conditions as of the valuation date in estimating valuations. Considerations such as IPO activity, multiples for public guideline companies (company or sector level), and overall economic conditions (e.g., interest rates, GDP, inflation, etc.) should be documented
Chris Franzek: Brendan, since most venture capital-backed companies have complicated capital structures with varying classes of stock and preferences, what’s the best way to assess, support, and document when one performs the valuation on an as converted basis (i.e., ignoring value from preferences and simply assuming all shares convert)?
Brendan Smith: Depending on the portfolio company’s waterfall, this assumption can have a meaningful impact on the final valuation. After the ’08-’09 financial crisis, interest rates remained near 0% for a prolonged period, which contributed to significant capital flows into venture capital and growth equity. As a result, new rounds of financing were common and occurred relatively frequently, making the “as-converted” assumption the most common assumption in determining the value of venture investments.
When rates started to rise and equity markets declined in 2022, new rounds of financing diminished significantly and more ”structure” was out in place for financings that were able to get done (i.e., convertible notes, or more bells and whistles around the size of preferences and repayment options). Many funds didn’t adjust their underlying assumption of valuing their investments on an as-converted basis and ran afoul of their auditors and had to adjust their valuation methodology and results accordingly.
Chris Franzek: Brendan, what are some of the most significant challenges faced by venture capital investors in performing their periodic valuations?
Brendan Smith: One of the most basic challenges that venture capital investors face in valuing their portfolios is volume. Venture capital investors tend to have more investments in their portfolios than one would typically see for a given assets under management (AUM) in a private equity or private credit fund. With the size difference, a venture capital firm managing a fund of 75 investments would have fewer resources than a private equity fund manager with the same number of deals. The reality is that regardless of the investment size, the time to prepare and document a proper valuation doesn’t necessarily decrease with scale.
The next challenge faced is the collection of data from a large number of portfolio companies, most of which will represent minority interest investments, limiting the availability of data from the portfolio company. Waterfalls represent an incremental challenge to manage, especially when new rounds of financing, which can be frequent, lead to changing cap tables.
Lastly, to solve these challenges, venture capital investors are increasingly leveraging technology to alleviate various pain points. Ironically, many venture capital investors are using three to five niche tech applications to make their jobs easier, but the lack of integration lends itself to being “two steps forward, one step back.” We’ve heard this repeatedly at the venture capital round tables that we periodically host.
Chris Franzek: What do you see changing for venture capital investors as a result of the AICPA’s pending rules intended to align ASC 820, Fair Value Measurement, with ASC 718, Stock-Based Compensation, requirements?
Brendan Smith: The newly released draft of the AICPA’s guide, “Valuation of Privately-Held-Company Equity Securities Issued as Compensation,” is being interpreted by many as a precursor to additional guidance for ASC 820 valuations of venture investments. The guide reinforces a number of themes we’ve discussed, where audited entities are being pushed to “do more” and will ultimately be required to finds ways to:
- Monitor and track fundamental financial (and other) data to incorporate into valuations
- Account for a company’s equity capital structure under much more prescriptive guidance around acceptable methodologies (beyond Option Pricing Models, the guide suggests additional techniques rooted in quantitative finance applications)
- Be increasingly thoughtful as to how secondary transaction indications are taken into consideration
Venture funds will have to consider this new guidance as they continue to scale their internal functions to meet these ever-evolving requirements. Our view is that this will mean new, better, and more capable technology solutions to manage the entire process end-to-end.
Chris Franzek: West, as a former fintech entrepreneur, what’s your take on venture capital investors’ piecing together a variety of applications to manage the valuation process?
West Chapman: The venture capital space is a bit unique compared to other investment strategies. The large portfolios would tend to benefit from technology to scale any given process, yet the limited information and very disparate KPIs tracked for each portfolio company argue for more custom solutions that are usually less scalable.
Venture capital investors are also natural risk takers and are more pre-disposed to being willing to “try out” a new technology. Unlike five years ago, vibe coded tools are everywhere — some are better than others, but as Brendan noted, they are all narrow in focus and are not integrated with other applications which can result in shifting pain points from performing a given function to moving from function to function or application to application.
Chris Franzek: Are you implying that the recent media reports about the SaaS model being dead is even more true in the venture capital space?
West Chapman: It’s an interesting question. If there ever was a space that’s predisposed to trying something new, it’s the venture capital space. That being said, I expect that venture capital firms will be at least a little wary of adopting tools that may lack a support mechanism if/when the builder/owner moves to a new organization and that the larger the organization, the more reluctant to forego live without a safety net.
Chris Franzek: How does a venture capital firm weigh the tradeoffs between efficient scaling and enabling the bespoke capabilities needed to monitor and value investments that require unique KPIs?
West Chapman: Prior to joining Stout, my fintech specialized in diligencing asset managers’ operations. As part of the diligence process, we enabled the ability for users to “configure” our platform to ask any question in just about any form at any scale. We’re now leveraging that same technology to address the needs of private asset managers to monitor their portfolio companies and track different KPIs by portfolio company at scale. Tracking cash burn or headcount may apply to all portfolio companies, but AI companies will have some very different KPIs from a biotech company.
Chris Franzek: While that solves one challenge faced by venture capital investors, it sounds a bit like one more bespoke application that doesn’t integrate with the other three or four applications used by venture capital investors throughout the valuation process. Is that correct, or am I missing something?
West Chapman: We’ve talked to close to one hundred managers about their challenges and have spent the past year addressing those needs, including providing a more end-to-end integrated, scalable solution. We call our fully integrated solution “Drivr.” Drivr starts with data collection and data structuring, leveraging AI as well as keeping a human in the loop to get the best of rapid, systematic data collection that has been 100% verified by a trained professional.
Drivr then moves the collected data, with full audit trails, into our valuation model that incorporates rounds of financing, guideline company analytics, systematic approaches to allocate value to various share classes, and real-time scenario and risk analytics.
Lastly, Drivr provides all results in an interactive dashboard, allowing the user to analyze and benchmark individual positions, sectors, and funds.
Chris Franzek: Drivr sounds like a meaningful step forward. What about transparency? A lot of tools in the market have been described as black boxes. Is Drivr another multi-tool that leaves users questioning how results were produced?
West Chapman: Our goal with Drivr has been to not only improve the process but to provide what we’re calling “radical transparency” into the process. No more “copy, paste, values” models being emailed back and forth. Drivr provides full transparency and audit trails to front- and back-office teams as well third parties, such as auditors, which we believe will greatly enhance the overall attractiveness of Drivr.
Chris Franzek: Is Drivr available now?
West Chapman: Yes, Drivr is available and is actively being used by clients today. Incremental functionality is continually being brought online. We look forward to speaking with more managers to understand their needs and to demonstrate how Drivr can drive improvements in their valuation and portfolio monitoring processes.
Chris Franzek: Mike, Brendan, and West, thank you for your time and market insights today.
