Valuation of Private Securities at or Near a Transaction Date

In August 2019, the American Institute of Certified Public Accountants issued new guidance for investment companies on valuing portfolio company investments. Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (the “Guide”) is intended to harmonize views of industry participants, auditors and valuation specialists. The Guide is considered the “gold standard” that will be applied by investment fund valuation committees and their auditors in evaluating the fair values of portfolio companies. This article is part of a multi-part series exploring the key topics of the Guide and related implementation matters.IntroductionChapter 12 – Factors to Consider At or Near a Transaction Date of the Guide addresses valuation of private securities at or near a transaction date (a recent purchase or a contemplated exit). In accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 946, investment funds initially measure investments at capitalized cost including transaction costs. At the first reporting date following the transaction, funds are required to measure the investment at fair value in accordance with FASB ASC 820. Questions have arisen about the appropriate accounting treatment for transaction costs in the context of estimating fair value. To some extent, this is due to the apparent divergence between the FASB ASC 946 requirement to capitalize all transaction costs and the FASB ASC 820 requirement to exclude transaction costs. This chapter addresses what constitutes a transaction cost and how these costs should be accounted for in the context of estimating fair value.Fair Value Considerations at Initial RecognitionFor investment companies, the cost of an investment includes transaction costs that are a part of the purchase transaction. Transaction costs include legal fees, due diligence fees, commissions and other charges that are part of the purchase transaction. Since transaction costs are capitalized at initial recognition and would be excluded from the determination of fair value at subsequent measurement dates, unrealized and realized gains and losses from investments will be impacted in the statement of operations of the investment company at each subsequent measurement date.As an example, assume Fund A purchases Company X for $95 and incurs $5 in transaction costs. The total cost capitalized by Fund A for Company X would be $100 on Day 1. The Day 1 fair value measurement may or may not be equivalent to total cost. Because fair value measurement excludes transaction costs, the Day 1 fair value could be deemed to be the total cost less the transaction costs.To illustrate why this may occur, assume in the example above that immediately following the transaction, Fund A decides to sell Company X to a market participant with the same views and information on Company X as Fund A. The market participant would purchase Company X for $95 resulting in a $5 realized loss for Fund A. This example draws a clear distinction between the costs that are incurred to purchase an investment and how fair value is assessed after the transaction is complete. Fair value at any point in time is the amount a market participant would be willing to pay in an orderly transaction at the measurement date. Therefore, fair value immediately after the transaction would be $95. Fair value does not change solely due to the incurrence of entity specific costs.Fair Value Considerations At or Near ExitMany valuation professionals and financial statement users have questioned as to whether fair value measurements near an exit or sale date should be adjusted for costs expected to be incurred at exit. Expanding on the previous example, after the passage of time, Fund A is now the seller of Company X and, as part of the sales process, will incur certain sales transaction costs (such as investment bank fees, legal fees, third party valuation fees, and other costs). Assume that Fund A enters into a transaction to sell Company X for $200 and, in addition, Fund A’s seller transaction costs are expected to be $10.If the preceding deal terms are known as of Fund A’s measurement date but the deal has not yet closed, the fair value of Company X as of the measurement date would be the $200 sales price, excluding transaction costs to be incurred, and not the $190 of expected net proceeds. As the $10 of transaction costs have not yet been incurred, these costs would not yet represent a period expense pertaining to the holding of Fund A. Reporting entities may decide that disclosure of the expected net proceeds, when significantly different from the transaction price, would be meaningful to users of the reporting entity’s financial statements.Impact of Transaction Costs on CalibrationAs discussed in chapter 10 of the Guide, “Calibration,” when the initial transaction price is representative of fair value, the inputs used to determine fair value should be calibrated to the transaction price. As the calibration process focuses on fair value, it is important to ensure that transaction costs are reflected consistently when considering the expected return assumptions and valuation assumptions and related inputs. Calibration is the process of using observed transactions in the portfolio company’s own instruments, especially the transaction in which the fund entered a position, to ensure that the valuation techniques that will be employed to value the portfolio company investment on subsequent measurement dates begin with assumptions that are consistent with the observed transaction.For example, consider a scenario in which, on Day 1, the negotiated transaction price, excluding transactions costs, paid by Fund A for Company X, was $95. Total costs were $100, including $5 of transaction costs paid by Fund A. EBITDA of Company X on Day 1 was $10, implying an EBITDA multiple of 10.0X, based on total costs and 9.5X based on the total cost excluding transaction costs. In year 2, assume market multiples have not changed and all other inputs remain consistent with the original investment thesis on Day 1; however, Fund A now incorporates expected seller transaction costs upon exit of $15 into its fair value model and Company X now has EBITDA of $20. When calibrating using the original transaction multiple (assuming no market changes), Fund A would utilize an EBITDA multiple of 10X to value Company X at $200, and then exclude $15 of transaction costs to estimate fair value as $185, or would apply a multiple of 9.5x to estimate fair value as $190. These two approaches would result in a similar fair value estimate. As such, calibration demands methodological consistency but does not require a specific approach.ConclusionAs individual facts and circumstances vary widely, there is no requirement that the fair value shortly after the closing equal the transaction price excluding transaction costs, including transaction costs, or any amount between. The key point is that FASB ASC 946 requires transaction costs to be included in the transaction price as part of the initial measurement of the investment. At subsequent measurement dates (whether one day, one month, one quarter, one year, or beyond) a fair value measurement excludes transaction costs. As a result, the fair value at the first measurement date may be equal to, less than, or more than the transaction price under FASB ASC 946, depending on specific facts and circumstances.

We Can Help

Elliott Davis has the expertise needed to support and guide you through the valuation process for private securities at or near a transaction date. We can work with you to:

• Establish a consistent methodology for determining fair value or near a transaction date
• Establish appropriate guidelines for including or excluding transaction costs in the determination of fair value of private securities
• Establish an appropriate methodology for using calibration as a tool to determine fair value of private securities.

Contact our Alternative Investment Fund Services group for assistance.

The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.