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In principle valuations are very simple. You just take the last round of financing and figure out what your investment is worth based on the company valuation at that last round.
Pragmatically, just look at the price per share at the round and multiply it by the number of shares you own. 90 per cent of the valuations you do will follow this very simple concept:
Share price of last round x Number of shares = Valuation of the investment
To put this on a more robust conceptual framework, have a look at the IPEV valuation guidelines (more below). They aren’t necessarily easy to read, but in an almost scientific way break down the concepts and conditions that are needed for the above principle to work.
The industry body that is drafting valuation guidelines is called IPEV (International Private Equity and Venture Capital). They draft the IPEV Valuation Guidelines. The guidelines are endorsed by almost all local VC associations (Like Invest Europe or NVCA) and are directly or via the associations referenced in most LPAs. You might find this sentence in your LPA: “The fund will provide a reporting in a format as endorsed by Invest Europe from time to time”. This means you effectively have to comply with the IPEV Guidelines.
The guidelines are updated every couple of years, and before 2018 the current one was the 2015 version. You can still find that one here: IPEV Valuation Guidelines 2015
We think the 2015 version was pretty good. It was never an easy read; they seem to try to use a language that is super correct, with the result being that you really have to think about what they mean. Kind of like law that needs to be interpreted. But they thought through many cases and used a language that avoids loopholes. Probably a pretty comprehensive guideline.
In 2018 they released a new version and - no joke - said the last round of funding is no longer a valid valuation method. It wasn’t an editing oversight - they even highlighted the change in their Press Release:
In addition, a number of enhancements have been made including:
Clarifying that using the Price of a Recent Investment should not be the default Valuation Technique. [...]
They have again updated the guidelines in 2022 and confirmed their suggested approach.
In your authors humble opinion this is nonsense. They introduced a concept of “calibration”. This approach is pretty complex, and in our view far off from how VCs value companies. In a nutshell, it means that you value your companies based on KPIs. By doing that you can easily end up with unrealistic valuations that are far off the actual market value.
Why did they do it? Perhaps they just really overthought this topic. Other people less sympathetic to IPEV people have suggested the service providers on the IPEV board wanted to create some business for themselves. We like to think everyone had only the best intentions 😊. Anyhow, the good news is: No one seems to really follow this part of the guidelines. We haven’t heard of anyone doing "calibration" in the way described by IPEV. The technique should not be confused with writing an investment down because of a bad business outlook. The requirement to do that existed long before "calibration". Calibration would mean to tie the valuation to a set of KPIs and update it everytime you have new KPIs.
So in effect people still use the last round of funding. So we much encourage you to read the guidelines and take all other considerations in there into account, but just ignore that part around the last round not being a good technique. It is the best valuation yardstick you have, and your LPs will thank you if you don’t go off and get some lofty valuation through Calibration.
Hopefully a future revision of the guidelines will revert back to the concept people actually use.
As you can read (in far more elaborate language) in the IPEV guidelines, sometimes you need to adjust the price of the last round. Adjusting it down if things don’t go as planned is usually seen as very prudent.
Our suggestion is as follows: If you hear bad news, like departing CEOs, fundraising problems, business not going well, take a discount of 50 per cent, 75 per cent, 90 per cent on the last round, or even on your cost of the investment. It’s all about figuring out what will flow back to you. We suggest not to put an investment to zero unless it is being liquidated / insolvent. If things don’t look good, keep it at some low level.
LPs will be surprised to see a company going from 3x to zero in a quarter. That is what you want to avoid. By going to 50 per cent you signal that things don’t go well and people won’t be surprised if you write it off in a subsequent quarter.
Some companies may not report regularly [Sign up for access]. There is little you can do about this. Ask your investment managers for an update. Sometimes news articles might even help. In general, we would not be too skeptical if the last round of funding happened within the last 12 months. Over 12 months, a closer look is probably justified. However - and this can be a fun discussion with your auditors - we would not assume something negative happened just because you don’t hear much. Writing an investment off because they don’t report is something we don’t recommend. However, some people might disagree and take a more conservative approach.
One other thing to consider is the publicity of your “write-down.” It is visible to LPs and (in breach of confidentiality) might make its way back to the company, its employees, customers, co-investors, etc. There is no easy way to balance this, but an explanation, or on the other hand no commentary at all, might avoid negative effects on the company. You don’t want to signal a lack of confidence if the company is actively fighting for survival. Generally we think the company is more important than your quarterly report.
In our view the answer is simple: Never! The basic idea would be that if the last round happened a while ago and the company developed well, the valuation should also go up. You might be able to demonstrate this by pointing to KPIs. However, we think practically you might run into big surprises; The assumed valuation may just not materialise in the next round.
In terms of the reliability of the valuation, going above the last round certainly has an effect. By introducing a KPI based valuation technique you are affecting the trust of your LPs in the robustness of numbers. As we all know, if you would want to write up a company based on KPIs, you will likely find a set of metrics to make this look reasonable. But LPs know that too. So they will generally be sceptical and your entire set of reports, like the TVPI becomes less solid. So we suggest you don’t do those write-ups.
A counterargument is that you might have secondary sales of LP interest. So an LP sells its stake to a new investor and might use the NAV to arrive at a price. If you are too low on your valuations, that distorts the price. It is a valid argument, however we believe secondaries happen too rarely, and if they do, the buyer will likely do their own bottom up assessment of the portfolio.
That said, there are funds that go above the last round. Our gut feeling however is that the vast majority (say 80 per cent) don’t do it.
If you have a convertible loan, even with a discount at conversion, we suggest keeping it at the nominal value (plus interest). We would not write it up based on an assumed conversion but rather reflect that uplift when the actual conversion happens.
If the business is not performing well, we would apply the same discounts on the value of the loan as on the equity.
The author of this section has spent many hours scratching his head trying to reconcile company valuations with share price multiples and investment multiples. The problem comes with the effect of dilution, which is unfortunately not at all intuitive to people. It is a very powerful dynamic and can mean that while your company valuation goes up 10x your investment only goes up by e.g. 4x. This happens when the company valuation rises because new money comes in and not because the shares get worth more.
It’s totally logical, but rather hard to grasp intuitively. It can lead to discussions (or even fights) with the investment team that can’t believe the valuation you put in the report. They are mostly focused on the headline “post-money” valuation you can read in the press releases. And those numbers don’t directly reconcile with your LP reporting.
So just be aware of this when communicating internally. An Excel sheet with these figures will help get everyone on the same page.
Shares normally come in different classes (”Series A”, “B”, etc.). Different classes have different shareholder rights. This may matter in the context of valuation if the different classes also entitle holders to different payouts on exit.
We will not lay out all things you can structure in an investment agreement, but normally you have two ways to exit:
A) The company gets sold and everyone gets their pro-rata per cent of the exit proceeds
B) The company gets sold or liquidated and you go through the “liquidation waterfall”
The liquidation waterfall usually means that from all proceeds, investors receive back their investment on a last-in-first-out basis. Meaning you first return money to Series C, then B, then A investors and then for holders of common stock.
Now there is a shortcut in terms of valuation: As long as round valuations of the company have always gone up, you don’t need to think about the liquidation waterfall. This is because in this scenario investors receive more by taking their pro-rata (option A above).
To be exact, you may have fancy stuff like a 2x liquidation preference which could break that rule of thumb, but it is not very common.
On the other hand, things get more difficult when there is a down round or you apply a discount to end up at a lower valuation than the last round.
What you need to draft in that case is a model that shows how much each investor (and your fund) would receive in case the company exited or liquidated.
Practically, we recommend setting up a simple Excel sheet to reflect this. We would draft it based on your own understanding of the legal documents first. Then - very importantly - we suggest to run this by the investment manager for the investment to confirm that understanding. “Waterfalls” and “Liquidation Preferences” are implemented via different wording in the legal documents. Lawyers use different ways to write it out and it can get complex and confusing in the actual legal text. So better confirm the understanding internally or even with the company and it’ Lawyers.
The good news is that you normally see more up rounds than down rounds. So having to do a waterfall is rather the exception.
There is another argument that even in the case of up rounds, a Series E share with Liquidation Preference is worth more than a Series A share that ranks below in the Waterfall. This is true. If one could choose between Series A and Series E shares, they take the latter one. So can we still apply the price of Series E shares to Series A shares? Arguably yes. We are assuming that the company sells for a price at which both Series A and Series E get the same payout. So the “intrinsic” value difference due to the different rights does not show and can be ignored. It might feel a little strange, but we think it is the right approach. Alternatively you would need to come up with an option-like price assessment which would not be feasible.
How do the valuations you come up with relate to your accounting books and financial statements?
If you follow IFRS, your investments will likely be valued according to IFRS 13. The standard does not talk specifically about how to value VC investments, but generally about how to come up with a “Fair Value”. It recognises that for unquoted investments you have “Level 3 inputs” - meaning information such as a last funding round and business performance that allows you to come up with a fair value. So we are in line with IFRS if we follow the ideas described in this chapter. We don’t need to worry exactly on what IPEV says.
This might help if you discuss valuations with auditors. They are normally only confirming numbers are consistent with IFRS. IPEV is not endorsed by the IFRS board, it is a completely different standard that happens to be aligned. If you follow IPEV for valuations, you should be good for IFRS too. But you may be compliant with IFRS even without following all of IPEV’s recommendations.
Funds that have financial statements in local GAAP may need to report different figures in their financial statements. This is a burden for example for German funds as German GAAP caps investment valuations at cost. Fund investors still want to see fair values. In this case you need to set up a process to track both fair value and accounting value. More on that here [Sign up for access].
Especially during fundraising, some LPs ask for an internal “Valuation Policy”. Probably this is more common in the PE world where valuations are a trickier exercise. A quick fix is to just point to the IPEV guidelines and claim compliance. However if you want to show something, feel free to use and extend this template:
Template_Valuation_Guidelines.docx [Sign up for access]
As IPEV puts it - in far more elegant language - you have to evaluate things on a case- by-case basis. So while the above techniques probably work 99 per cent of time, there might be situations in which you have to divert and come up with a completely different approach. Here is a non-comprehensive list of examples:
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