How finance teams value venture capital investments

Once a fund has made an investment, determining the holding value of those investments can often feel like a guessing game. Thankfully, there are authoritative guides in the industry that help clarify the ambiguity of valuing venture capital investments by providing structured approaches. These approaches are essential for enhancing decision-making and reporting accuracy—crucial elements in the market.

Below, we’ve summarized the key valuation methodologies and their sub-components, serving as primer material for new joiners, a refresher for seasoned professionals, or helpful context for team members in other functions of a venture capital fund. 

Let’s dive in.

Market approach

The Market Approach derives the value of an asset by examining the prices and relevant information from market transactions involving identical or comparable assets. This approach is used most frequently in venture capital because the value of a portfolio company can usually be inferred from the market activity of similar businesses, both public and private.

Key concepts of the market approach

1. Guideline public company method: This method involves selecting publicly traded companies that are comparable to the portfolio company being valued. Factors such as industry, size, profitability, and growth potential are considered to identify suitable guideline companies. The valuation is then based on the trading multiples of these companies, adjusted for differences in risk and growth expectations. Multiples like enterprise value (EV) to sales or EV to gross profit are used most frequently given the nature of venture-backed investments. In the case where growth of the portfolio company is hyperbolic, it can be beneficial to consider growth-adjusted multiples such as EV/Sales/Growth to gauge the relative “cost” of growth.
2. Guideline company transactions method: This method examines transactions involving comparable companies, such as mergers and acquisitions, to infer the value of the portfolio company. By analyzing the transaction multiples, venture capitalists can gain insights into the market’s valuation of similar businesses that have exited. This method is particularly useful when there is a lack of publicly traded comparables but the considerable drawback with this methodology is the availability and trustworthiness of information. Rarely do private companies disclose multiples on completed transactions, which can lead to unreliable data as an input for this method.
3. Calibration: Calibration involves adjusting the valuation assumptions based on recent transactions involving the portfolio company’s own instruments. This process helps ensure that the valuation reflects current market conditions and the specific characteristics of the company. Calibration can also be used to align the assumptions of the Market Approach with those of the Income Approach, providing a consistent valuation framework.

Considerations for applying the market approach

• Selection of guideline companies: The selection of appropriate guideline companies is critical to the accuracy of the Market Approach. Factors such as industry, size, growth potential, and risk profile should be considered to ensure comparability. It is important to regularly review and update the list of guideline companies to reflect changes in the market and the portfolio company’s strategy. 
• Limitations for early-stage companies: The Market Approach may have limitations when valuing early-stage companies, as truly comparable public companies may not exist. In such cases, adjustments may be necessary to account for differences in growth and risk expectations. 
• Adjustments for synergies and control: When using transaction multiples, valuation teams may consider adjusting for any synergies or control premiums that may have influenced the transaction price. These adjustments ensure that the valuation reflects the fair value that market participants would expect. 

Income approach

The Income Approach estimates the value of an asset based on the present value of its expected future economic benefits. This approach is grounded in the principle that the value of an investment is derived from the income it is expected to generate over time. The Income Approach can be particularly useful for valuing companies with predictable cash flows and long-term growth potential, which is admittedly relatively infrequent in the venture capital space. 

Key concepts of the income approach

1. Discounted cash flow (DCF) analysis: This method estimates the present value of a company’s future cash flows, discounting them back to their current value. DCF analysis provides a detailed financial model that considers projected revenues and expenses which are then discounted using an appropriate rate that reflects the risk associated with those cash flows, allowing valuation teams to assess the intrinsic value of their investments.
2. Unobservable inputs: Unlike the Market Approach, which relies on market data, the Income Approach uses unobservable inputs and a number of assumptions about future performance. These inputs are developed using the best information available, including the company’s own data, adjusted to reflect what market participants would expect, ensuring that the valuation reflects the fair value that would be realized in an arms length transaction between knowledgeable and willing parties.
3. Risk assessment and discount rates: A critical component of the Income Approach is the assessment of risk, which is incorporated into the discount rate. As a general concept, the greater the perceived risk associated with the cash flows, the higher the discount rate applied, resulting in a lower present value.
4. Terminal value: The terminal value represents the value of the company at the end of the forecast period, capturing the value of cash flows beyond the discrete projection period. This is often a significant component of the total valuation and is calculated using methods such as the Gordon growth model (in the case of a dividend-paying company) or exit market multiples. The terminal value is then discounted to present value and incorporated into the DCF calculation. 

Considerations for applying the income approach

• Quality of projections: The reliability of the Income Approach depends heavily on the quality and reasonableness of the projected financial information. Especially in the early-stage, financial projections are difficult to rely on. 
• Terminal period assumptions: Careful consideration must be given to the assumptions used in calculating the terminal value, including growth rates and discount rates. These assumptions should reflect the company’s expected performance and market conditions at the end of the forecast period. 

Asset approach

The Asset Approach is a valuation method that determines the value of a business by assessing the fair value of its assets and liabilities. This approach is grounded in the principle that the value of a company is equivalent to the value of its tangible and intangible assets, minus its liabilities. While often considered the least conceptually robust of the three primary valuation approaches, the Asset Approach can serve as a useful “reality check” or "default value” when other approaches are not feasible. 

Key concepts of the asset approach

1. Asset accumulation method: This method involves estimating the value of a company by calculating the net fair value of its individual assets and liabilities. The fair value of these assets and liabilities is determined using various valuation methods, and the net value provides an indication of the company’s overall worth. This approach is particularly relevant for companies in the early stages of development in capex-intensive industries, where tangible assets may be the primary source of value.
2. Replacement cost: The replacement cost method estimates the value of an asset based on what it would cost to acquire a substitute asset of equivalent utility today. This involves considering the current cost of materials, labor, and other inputs required to replace the asset, adjusted for factors such as depreciation, obsolescence, and changes in market conditions. Replacement cost is often used for tangible assets, such as real estate or equipment. 
3. Consideration of intangible assets: While the Asset Approach primarily focuses on tangible assets, it is important to consider intangible assets that may not be recognized on the company’s financial statements. Internally developed intangibles, such as intellectual property or brand value, can be significant components of a company’s overall value, especially for early-stage enterprises. 

Considerations for applying the asset approach

• Applicability to early-stage companies: The Asset Approach is most applicable to capex-intensive companies in the earliest stages of development, where tangible assets are the primary source of value. As companies mature and develop intangible assets and goodwill, the relevance of the Asset Approach may diminish. 
• Adjustments for depreciation and obsolescence: When valuing tangible assets, it is important to consider adjusting for depreciation and obsolescence. This ensures that the valuation reflects the current utility and remaining useful life of the assets. 
• Inclusion of soft costs: In certain projects, such as real estate development, soft costs related to planning and approvals may be included in the valuation. These costs should be considered to the extent that they remain relevant to the completion of the project.

While each of these valuation methodologies can be deemed appropriate depending on the facts and circumstances, the reality is that most venture capital funds rely on the Market Approach for the vast majority of their portfolio holdings. However, given the subjectivity of the assumptions that go into the Market Approach, firms often retain the services of an independent valuation provider. Leveraging the expertise of such providers helps ensure that valuations are accurate and impartial, providing an additional layer of assurance. 

Independent valuations can be greatly beneficial in valuing startups, as they aid finance teams in making informed decisions and reporting transparently. This is especially important as auditors and LPs increasingly focus on robust determinations of fair value.

Aumni, in partnership with PricingDirect, offers private fund managers trusted independent ASC 820 valuations, combining market-leading private investment structuring capabilities with decades of expertise. 

Learn how Aumni is helping funds perform valuations with confidence.