The Hardest Stage in Venture Capital Fair Value

In venture capital, there comes a point where a company has not raised a new funding round for a considerable period of time. It hasn't reached an IPO or an acquisition, there is no recent market transaction to rely on, and yet the fund still has to determine a robust fair value for its investment.

This is arguably the most challenging stage in venture capital valuation.

The challenge isn't performing the calculations. Modern valuation platforms can do that. The real challenge is understanding why there hasn't been a new funding round, because the answer to that question can fundamentally change fair value.

Sometimes the explanation is positive. The company has sufficient cash, is meeting its milestones and simply doesn't need to raise more capital. If it did raise today, the valuation might even be higher than the previous round.

Sometimes very little has changed. The business is progressing broadly as expected, and a financing today might look much like the previous one. A flat valuation could be entirely appropriate.

And there is a third possibility.

The company may be missing its targets. The venture market may have softened. Investors may have become more selective. Management knows that raising capital today would almost certainly result in a down round, so the financing is postponed.

The absence of a funding round is therefore not neutral.

It is information.

And understanding that information is often the starting point for determining fair value.

Applying the IPEV Principle

IPEV doesn't prescribe a single methodology for situations where there has been no recent transaction.

Instead, it reminds us of a fundamental principle:

"A Fair Value measurement assumes that a hypothetical transaction to sell an asset takes place in the Principal Market or, in its absence, the Most Advantageous Market for the asset." (IPEV 1.2)

My interpretation of applying that principle in practice is to ask a simple question:

If the company were to raise capital today, what would that financing actually look like?

Not what management hopes.

Not what investors paid two years ago.

But what knowledgeable market participants would realistically agree to today.

In many cases, I believe this hypothetical financing provides a practical way of estimating today's fair value.

It Isn't Just About the Price

One of the easiest mistakes is to think this exercise is simply about estimating today's share price.

It isn't.

The structure of that hypothetical financing may be just as important as the valuation itself.

Would it be an up round?

A flat round?

A modest down round?

Or a significant down round?

Would new investors require stronger liquidation preferences?

Would anti-dilution provisions be triggered?

Would an option pool need to be increased?

Would investors demand additional protections before committing capital?

These questions can materially change how value is allocated through the waterfall and ultimately affect the fair value of every share class.

Sometimes a Hypothetical Financing Isn't the Best Answer

There are also situations where I believe a hypothetical financing may no longer best reflect market participant assumptions.

If the company is close to being sold...

Or if a significant down round has become the overwhelmingly likely outcome...

There may be very little remaining upside optionality.

In those circumstances, a PWERM analysis may provide a more representative measure of fair value than an option allocation model.

Again, the objective is not to force every investment into the same methodology.

It is to select the methodology that best reflects how knowledgeable market participants would assess the investment today.

Why This Matters

This stage is where many venture-backed companies spend years.

They are no longer newly funded.

They are not yet approaching an IPO.

And because the vast majority of venture-backed companies will either fail or ultimately be sold for values well below unicorn status, this period often has the greatest influence on a fund's reported NAV.

Fair value isn't about waiting for the next funding round.

It is about asking what knowledgeable market participants would pay today, given everything that is known about the company and the market.

Sometimes that answer is higher than the previous round.

Sometimes it is unchanged.

Sometimes it is materially lower.

The difficult part is not performing the calculations.

The difficult part is understanding the company's circumstances and applying sound judgement to determine what today's market transaction would realistically look like.

Final Thought

This article reflects my own interpretation of how the IPEV fair value principle can be applied when there has been no recent financing transaction. It is intended to encourage discussion rather than prescribe a single methodology.

I'd be interested to hear how others approach this stage of venture capital valuation. Do you also start by considering what a financing would look like today, or do you favour a different approach?