In recent weeks, some commentators have tried to make the misguided argument that valuations of private companies are pointless. To support this viewpoint, they note that the IPO market has been valuing some new issuances at less than their assumed private value, and that private valuations sometimes use non-GAAP inputs and may require significant informed judgment. Further, they point to situations where corporate investors appear to have reached different valuation conclusions than private investors.
The idea that private valuations are pointless is far from reality—and dangerous to the investment process. Private investors need to understand the value of their non-publicly traded investments for a multitude of reasons. These include but are not limited to: exercising their fiduciary duty, making asset allocation decisions, selecting investment managers, and complying with financial reporting standards. To estimate and report relevant and reliable values, significant informed judgment is required.
Transparency is the Key to Understanding Valuation
Why then is there such a perception that private values are unreliable? In some cases, this may be because insufficient rigor is applied to determining value. Yet most large buyout funds and an increasing number of venture capital funds demonstrate valuation transparency to their investors by engaging qualified experienced third-party valuation experts to validate their periodic estimates of value. The American Institute of Certified Public Accountants (AICPA) just spent six years writing a new 670-page guide on how to value investments made by private equity and venture capital funds. This treatise will help regulators, auditors, investors, managers, and valuation providers improve the thoroughness of the judgments applied to valuing private investments.
The primary reason that private valuations are questioned is because they are indeed private, and the public at large does not have access to all the facts. However, the actual investors in the private company do have, or should have, significant transparency into the basis of and conclusion of value. Without access to a full set of facts it can appear that perceptions of value are speculative and subjective. Those who know and evaluate the facts, however, understand that the actual value of the private investment usually differs from the public perception for the following reasons:
- The rights and preferences for various share classes differ. Unless converted into common shares, series A may have a different value than series B or series C.
- Headline value is often misleading or incorrect. Private investors speak about a post-money value for a round of financing, but that post-money value is rarely determinative on a common stock equivalent basis of the value of underlying share classes.
- Significant judgment is required when assessing changes of value between financing dates for early stage companies. Performance against milestones is a key factor in determining value. Value should and does change up or down for individual share classes at quarterly reporting dates.
Ultimately, boards of directors have a duty to shareholders to transact at a “fair price,” which is the result of the interplay of buyers and sellers. New investors want to pay the lowest price possible—existing shareholders want to obtain the highest price possible; this willing-buyer willing-seller tension generally results in a fair price at the time of a transaction.
The premise that estimating the value of private investments is pointless has several harmful consequences, including:
- Generation of financial reports that are inaccurate and inconsistent with those that regulators and investors rely upon
- Flawed risk assessment by investors
- Faulty asset allocations resulting in non-optimal investment performance
- Inability to monitor performance based on investment expectations
Improving Private Investment Valuations
Transparency is essential to the continued viability of our markets in general, and to private markets in particular. Investors, especially private investors, need timely and accurate valuation information to effectively manage their portfolios and monitor individual company progress. Rather than rejecting the entire notion of valuing private investments, improvements should be made as the AICPA indicates, for example:
- Making sure valuation assessments are regularly and consistently prepared without ad hoc changes to methodologies
- Meticulously corroborating or calibrating inputs using multiple sources or reliable information
- Keeping the right “tone at the top” by ensuring that asset managers provide as much transparency to their investors as may be practical.
Serious investors and responsible managers have an obligation to provide reasonable and relevant estimates of value to be used as a basis for investor decision-making and reporting. Denying the validity of the valuation process creates an environment where it is difficult to decipher what information is factual and what is misperception. Investors must make decisions with their eyes wide open. Valuations without rigor are simply not sufficient; investors require a process that is transparent and rigorous, but also one that fully accounts for the worth of the “facts” that support it.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
David Larsen is a managing director in the San Francisco office of Duff & Phelps and part of the Alternative Asset Advisory service line, and a fellow at the Duff & Phelps Institute.