1. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L VA L U AT I O N G U I D E L I N E SThese guidelines have been developed by the Association Franaise des Investisseurs en Capital (AFIC),the British Venture Capital Association (BVCA) and the European Private Equity and Venture Capital Association (EVCA) with the valuable input and endorsement of the following associations:AIFI - Italian Private Equity and Venture Capital Association APCRI - Portuguese Private Equity and Venture Capital Association APEA - Arab Private Equity AssociationASCRI - Spanish Private Equity and Venture Capital Association ATIC - Tunisian Venture Capital AssociationAVCA - African Venture Capital Association AVCAL - Australian Venture Capital Association AVCO - Austrian Private Equity and Venture Capital Organization BVA - Belgian Venturing AssociationBVK - German Private Equity and Venture Capital Association e.V.CVCA - Canadas Venture Capital and Private Equity AssociationCVCA - Czech Venture Capital and Private Equity Association DVCA - Danish Venture Capital Association FVCA - Finnish Venture Capital Association HKVCA - Hong Kong Venture Capital AssociationHVCA - Hungarian Venture Capital and Private Equity Association ILPA - Institutional Limited Partners Association IVCA - Irish Venture Capital AssociationLVCA - Latvian Venture Capital AssociationNVCA - Norwegian Venture Capital & Private Equity Association NVP - Nederlandse Vereniging van ParticipatiemaatschappijenPPEA - Polish Private Equity AssociationRseau Capital - Qubec Venture Capital and Private Equity Association RVCA - Russian Private Equity and Venture Capital AssociationSAVCA - Southern African Venture Capital and Private Equity Association SECA - Swiss Private Equity and Corporate Finance Association SLOVCA - Slovak Venture Capital Association (Endorsement as of 1st of November 2005)

2. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E S W W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M These guidelines have been developed by AFIC, BVCA and EVCA with the valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, CVCA, DVCA, FVCA, HKVCA, HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RSEAU CAPITAL, RVCA, SAVCA, SECA, SLOVCA(Endorsement as of 1st of November 2005) 3. P L EA S E N OT E The information contained within this paper has been produced with reference to the contributions of a number of sources. AFIC, BVCA and EVCA have taken suitable steps to ensure the reliability of the information presented. However, neither AFIC, BVCA, EVCA nor other named contributors, individuals or associations can accept responsibility for any decision made or action taken, based upon this paper or the information provided herein. For further information please visit: www.privateequityvaluation.com 4. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E S W W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M 4 These guidelines have been developed by AFIC, BVCA and EVCA with the valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, CVCA, DVCA, FVCA, HKVCA, HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RSEAU CAPITAL, RVCA, SAVCA, SECA, SLOVCA(Endorsement as of 1st of November 2005) 5. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E S These guidelines have been developed by AFIC, BVCA and EVCA withthe valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, DVCA, HKVCA,HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RVCA, SAVCA, SECA, SLOVCA P R E FAC E These Guidelines set out recommendations, intended to represent current best practice, on the valuation of private equity and venture capital investments. The term private equity is used in these Guidelines in a broad sense to include investments in early stage ventures, management buyouts, management buy-ins and similar transactions and growth or development capital. The recommendations are intended to be applicable across the whole range of investment types (seed and start-up venture capital, buy-outs, growth/development capital, etc) and financial instruments commonly held by private equity funds. The recommendations themselves are set out in bold type, whereas explanations,W W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M illustrations, background material, context and supporting commentary, which are provided to assist in the interpretation of the recommendations, are set out in normal type. Where there is conflict between a recommendation contained in these Guidelines and the requirements of any applicable laws or regulations or accounting standard or generally accepted accounting principle, the latter requirements should take precedence. Neither the AFIC, BVCA, EVCA nor the endorsing associations nor the members of any committee or working party thereof can accept any responsibility or liability whatsoever (whether in respect of negligence or otherwise) to any party as a result of anything contained in or omitted from the Valuation Guidelines nor for the consequences of reliance or otherwise on the provisions of these Valuation Guidelines. These Valuation Guidelines should be regarded as superseding previous guidelines issued by the AFIC, BVCA or EVCA with effect for reporting periods post 1 January 2005. 6. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E S W W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M These guidelines have been developed by AFIC, BVCA and EVCA with the valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, CVCA, DVCA, FVCA, HKVCA, HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RSEAU CAPITAL, RVCA, SAVCA, SECA, SLOVCA(Endorsement as of 1st of November 2005) CO N T E N TS INTRODUCTION7 Definitions 7SECTION I: DETERMINING FAIR VALUE9 1 The Concept of Fair Value9 2 Principles of Valuation9 3 Valuation Methodologies 12 3.1 General 12 3.2 Selecting the Appropriate Methodology 13 3.3 Price of Recent Investment14 3.4 Earnings Multiple 15 3.5 Net Assets20 3.6 Discounted Cash Flows or Earnings (of Underlying Business)21 3.7 Discounted Cash Flows (from the Investment) 22 3.8 Industry Valuation Benchmarks 23 3.9 Available Market Prices 23SECTION II: APPLICATION GUIDANCE27 Introduction27 1 Selecting the Appropriate Methodology 27 2 Specific Considerations 29 2.1 Internal Funding Rounds 29 2.2 Bridge Financing29 2.3 Mezzanine Loans 30 2.4 Rolled up Loan Interest 30 2.5 Indicative Offers 31 3 Events to Consider for their Impact on Value31 4 Impacts from Structuring33WORKGROUP 35 7. INTRODUCTION INTRODUCTIONHowever, the requirements andand a valuation methodology (such as implications of the Financial Reportingthe earnings multiple technique), which Private Equity Managers may beStandards and in particular Internationaldetails the method or technique for required to carry out periodic valuations Financial Reporting Standards and US deriving a valuation. of Investments as part of the reporting GAAP have been considered in the process to investors in the Funds theypreparation of these guidelines. This has manage. The objective of these Guidelines been done, in order to provide a frame- is to set out best practice where private work for arriving at a Fair Value for equity Investments are reported at Fairprivate equity and venture capitalDEFINITIONS Value, with a view to promoting best Investments which is consistent withThe following definitions shall apply in practice and hence helping investors in accounting principles.these Guidelines. Private Equity Funds make better These guidelines are intended to represent economic decisions. current best practice and therefore will Enterprise Value The increasing importance placed by be revisited and, if necessary, revised toThe Enterprise Value is the value of international accounting authorities on reflect changes in internationalthe financial instruments representing Fair Value reinforces the need for theregulation or accounting standards.ownership interests in an entity plus consistent use of valuation standards These Guidelines are concerned withthe net financial debt of the entity. worldwide and these guidelines provide a valuation from a conceptual standpoint framework for consistently determining and do not seek to address best practice Fair Value valuations for the type of Investments as it relates to investor reporting, held by private equity and venture The Fair Value is the amount for which internal processes, controls and capital entities.an asset could be exchanged between procedures, governance aspects,knowledgeable, willing parties in an The accounts of Private Equity FundsCommittee oversights, the experiencearms length transaction. are governed by legal or regulatory and capabilities required of the Valuer provisions or by contractual terms. It is or the audit or review of valuations. not the intention of these Guidelines to A distinction is made in these Guidelines prescribe or recommend the basis on between a basis of valuation (such as which Investments are included in the Fair Value), which defines what the accounts of Funds. carrying amount purports to represent, 7 8. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E S W W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M 8 These guidelines have been developed by AFIC, BVCA and EVCA with the valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, CVCA, DVCA, FVCA, HKVCA, HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RSEAU CAPITAL, RVCA, SAVCA, SECA, SLOVCA(Endorsement as of 1st of November 2005) FundMarketability Quoted Instrument The Fund, i.e. a private equity orMarketability is defined as the relative ease A Quoted Instrument is any financial venture capital fund, is the generic term and promptness with which an instrument instrument for which quoted prices used in these Guidelines to refer to anymay be sold when desired. Marketability reflecting normal market transactions are designated pool of investment capital implies the existence of current buying readily and regularly available from an targeted at private equity Investment,interest as well as selling interest. exchange, dealer, broker, industry group, including those held by corporate pricing service or regulatory agency. entities, limited partnerships and otherMarketability Discount investment vehicles.Realisation The Marketability Discount is the consequence of the return MarketRealisation is the sale, redemption or Gross Attributable Enterprise Value Participants demand to compensate repayment of an Investment, in whole or The Gross Attributable Enterprise Value for the risk arising from the lackin part; or the insolvency of an Investee is the Enterprise Value attributable to the of Marketability. Company, where no significant return to financial instruments held by the Fundthe Fund is envisaged. and other financial instruments in theMarket Participants entity that rank alongside or beneath the Unquoted Instrument Market Participants are potential or highest ranking instrument of the Fund. actual willing buyers or willing sellersAn Unquoted Instrument is any financial when neither is under any compulsioninstrument other than a Quoted Instrument. Investee Company to buy or sell, both parties having The term Investee Company refers to a reasonable knowledge of relevant factsUnderlying Business single business or group of businesses in and who have the ability to perform The Underlying Business is the which a Fund is directly invested.sufficient due diligence in order to be operating entities in which the Fund has able to make investment decisions invested, either directly or through a Investmentrelated to the enterprise. number of dedicated holding companies. A Funds Investment refers to all of the Net Attributable Enterprise Value financial instruments in an InvesteeValuer Company held by the Fund. The Net Attributable Enterprise Value The Valuer is the person with direct is the Gross Attributable Enterprise responsibility for valuing one or more Value less a Marketability Discount. of the Investments of the Fund. 9. S EC T I O N I: D E T E R M I N I N G F A I R V A LU E 1 THE CO N C E P T O F F A I R V A LU E 2 PRINCIPLESOF V A LU AT I O N Fair Value is the amount for which an asset could beInvestments should be reported at Fair Value at the exchanged between knowledgeable, willing parties in an armsreporting date. length transaction. In the absence of an active market for a financial instrument, The estimation of Fair Value does not assume either that thethe Valuer must estimate Fair Value utilising one of the Underlying Business is saleable at the reporting date or that valuation methodologies. its current shareholders have an intention to sell their holdings In estimating Fair Value for an Investment, the Valuer in the near future. should apply a methodology that is appropriate in light of The objective is to estimate the exchange price at whichthe nature, facts and circumstances of the Investment and hypothetical Market Participants would agree to transact. its materiality in the context of the total Investment portfolio and should use reasonable assumptions and Fair Value is not the amount that an entity would receive or estimates. pay in a forced transaction, involuntary liquidation or distressed sale.In private equity, value is generally crystallised through a sale or flotation of the entire business, rather than a sale of an Although transfers of shares in private businesses are often individual stake. Accordingly the Value of the business as a subject to restrictions, rights of pre-emption and other whole (Enterprise Value) will provide a base for estimating barriers, it should still be possible to estimate what amount a the Fair Value of an Investment in that business. willing buyer would pay to take ownership of the Investment. The Fair Value is estimated by the Valuer, whichever valuation methodologies are used, from the Enterprise Value, as follows: (i) Determine the Enterprise Value of the Investee Company using the valuation methodologies; (ii) Adjust the Enterprise Value for surplus assets, orexcess/unrecorded liabilities and other relevant factors; 9 10. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E S W W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M 10 These guidelines have been developed by AFIC, BVCA and EVCA with the valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, CVCA, DVCA, FVCA, HKVCA, HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RSEAU CAPITAL, RVCA, SAVCA, SECA, SLOVCA(Endorsement as of 1st of November 2005) (iii) Deduct from this amount any financial instrumentsAs such, it must be recognised that, whilst valuations do provide ranking ahead of the highest ranking instrument of useful interim indications of the progress of a particular the Fund in a liquidation scenario and taking into Investment or portfolio of Investments, ultimately it is not account the effect of any instrument that may dilute until Realisation that true performance is firmly apparent. the Funds Investment to derive the Gross AttributableFair Value should reflect reasonable estimates and Enterprise Value;assumptions for all significant factors that parties to an arms (iv) Apply an appropriate Marketability Discount to thelength transaction would be expected to consider, includingGross Attributable Enterprise Value to derive the Net those which impact upon the expected cash flows from theAttributable Enterprise Value;Investment and upon the degree of risk associated with thosecash flows. (v) Apportion the Net Attributable Enterprise Value between the companys relevant financial instruments In assessing the reasonableness of assumptions and estimates, according to their ranking;the Valuer should: (vi) Allocate the amounts derived according to the Funds note that the objective is to replicate those that the parties inholding in each financial instrument, representing theiran arms-length transaction would make;Fair Value. take account of events taking place subsequent to the It is important to recognise the subjective nature of privatereporting date where they provide additional evidence of equity Investment valuation. It is inherently based on conditions that existed at the reporting date; and forward-looking estimates and judgments about the take account of materiality considerations. Underlying Business itself, its market and the environment in which it operates, the state of the mergers and acquisitions Because of the uncertainties inherent in estimating Fair market, stock market conditions and other factors. Value for private equity Investments, a degree of cautionshould be applied in exercising judgment and making the Due to the complex interaction of these factors and often thenecessary estimates. However, the Valuer should be wary lack of directly comparable market transactions, care should beof applying excessive caution. applied when using publicly available information in deriving a valuation. In order to determine the Fair Value of an Investment,Private Equity Funds often undertake an Investment with the Valuer will have to exercise judgement and make necessarya view to effecting substantial changes in the Underlying estimates to adjust the market data to reflect the potential Business, whether it be to its strategy, operations, management, impact of other factors such as geography, credit risk, foreignor whatever. Sometimes these situations involve rescue currency and exchange price, equity prices and volatility. refinancing or a turnaround of the business in question. 11. S EC T I O N I: D E T E R M I N I N G F A I R V A LU E Whilst it might be difficult in these situations to determine In situations where Fair Value cannot be reliably measured Fair Value based on a transaction involving a trade purchaser,the Investment should be reported at the carrying value at it should in most cases be possible to estimate the amount athe previous reporting date as the best estimate of Fair Value, Private Equity Fund would pay for the Investment in question. unless there is evidence that the Investment has since then been impaired. In such a case the carrying value should be The Valuer will need to assess whether, in the particular reduced to reflect the estimated extent of impairment. circumstances of a specific Investment, he is able reliably to measure Fair Value by applying generally acceptedIn respect of Investments for which Fair Value cannot be methodologies in a consistent manner based on reasonablereliably measured, the Valuer is required to consider whether assumptions.events or changes in circumstances indicate that an impairment may have occurred. There may be situations where: Where an impairment has occurred, the Valuer should reduce the range of reasonable Fair Value estimates is significant the carrying value of the Investment to reflect the estimated the probabilities of the various estimates within the range extent of impairment. Since the Fair Value of such cannot be reasonably assessed Investments cannot be reliably measured, estimating the extent of impairment in such cases will generally be an the probability and financial impact of achieving a key intuitive (rather than analytical) process and may involve milestone cannot be reasonably predicted reference to broad indicators of value change (such as relevant there has been no recent Investment into the business.stock market indices). In these situations, the Valuer should conclude that Fair Value cannot be reliably measured. 11 12. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E S W W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M 12 These guidelines have been developed by AFIC, BVCA and EVCA with the valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, CVCA, DVCA, FVCA, HKVCA, HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RSEAU CAPITAL, RVCA, SAVCA, SECA, SLOVCA(Endorsement as of 1st of November 2005) 3 V A LU AT I O N M E T H O D O LO G I E S In determining the Fair Value of an Investment, theValuer should use judgement. This includes a detailed 3.1 Generalconsideration of those specific terms of the Investmentwhich may impact its Fair Value. In this regard, the A number of valuation methodologies that may be consideredValuer should consider the substance of the Investment, for use in estimating the Fair Value of Unquotedwhich takes preference over the strict legal form. Instruments are described in sections 3.3 to 3.9 below. These methodologies should be amended as necessary toIt is important conceptually to distinguish the value that incorporate case-specific factors affecting Fair Value.may be ascribed to an Investment from the value that may For example, if the Underlying Business is holding surplus be ascribed to the Underlying Business. For example, in cash or other assets, the value of the business should reflect valuing the Underlying Business one may seek to estimate that fact. the amount a buyer would pay for the business at thereporting date. In valuing an Investment stake in that Because, in the private equity arena, value is generallybusiness, one would not merely take the relevant share of crystallised through a sale or flotation of the entirethe businesss value, since that would fail to recognise the Underlying Business, rather than through a transfer ofuncertainty and risk involved in actually selling the business individual shareholder stakes, the value of the business as aand crystallising the Investment value, and particularly the whole at the reporting date will often provide a key insightrisk that value may be eroded before a sale can be achieved into the value of investment stakes in that business. For thisunder the current market conditions. reason, a number of the methodologies described below involve estimating the Enterprise Value as an initial step.The estimation of Fair Value should be undertaken on theassumption that options and warrants are exercised, where There will be some situations where the Fund has littlethe Fair Value is in excess of the exercise price. The exercise ability to influence the timing of a Realisation and aprice of these may result in surplus cash arising in the Realisation is not likely in the foreseeable future, perhapsUnderlying Business if the exercise price is significant. because the majority shareholders are strongly opposed to it. In these circumstances (which are expected to be rare in Other rights such as conversion options and ratchets, which private equity), Fair Value will derive mainly from themay impact the Fair Value of the Funds Investment, should expected cash flows and risk of the relevant financial be reviewed on a regular basis to assess whether these are instruments rather than from the Enterprise Value. likely to be exercised and the extent of any impact on value The valuation methodology used in these circumstancesof the Funds Investment. should therefore reflect this fact. 13. S EC T I O N I: D E T E R M I N I N G F A I R V A LU E Differential allocation of proceeds may have an impact on it is also important to consider the stage of development the value of an Investment. If liquidation preferences exist, of an enterprise and/or its ability to generate maintainable these need to be reviewed to assess whether they will giveprofits or positive cashflow. rise to a benefit to the Fund, or a benefit to a third party to The Valuer will select the valuation methodology that is the detriment of the Fund. the most appropriate and consequently make valuation Further examples of specific matters for consideration that adjustments on the basis of their informed and experienced may impact valuations are set out in section II, 3 .judgment. This will include consideration of factors such as: Movements in rates of exchange may impact the value of the relative applicability of the methodologies used given the Funds Investments and these should be taken in the nature of the industry and current market conditions; account. the quality, and reliability of the data used in each Where the reporting currency of the Fund is different methodology; from the currency in which the Investment is denominated, the comparability of enterprise or transaction data; translation into the reporting currency for reporting purposes should be done using the bid spot exchange rate the stage of development of the enterprise; and prevailing at the reporting date. any additional considerations unique to the subject enterprise. 3.2 Selecting the Appropriate Methodology Where the Valuer considers that several methodologies are The Valuer should exercise her or his judgement to select appropriate to value a specific Investment, the Valuer may the valuation methodology that is the most appropriateconsider the outcome of these different valuation for a particular Investment.methodologies so that the results of one particular method may be used as a cross-check of values or to corroborate or The key criterion in selecting a methodology is that it otherwise be used in conjunction with one or more other should be appropriate in light of the nature, facts and methodologies in order to determine the Fair Value of the circumstances of the Investment and its materiality in Investment. the context of the total Investment portfolio. Methodologies should be applied consistently from An appropriate methodology will incorporate available period to period, except where a change would result information about all factors that are likely materially to in better estimates of Fair Value. affect the Fair Value of the Investment. In this context,13 14. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E S W W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M 14 These guidelines have been developed by AFIC, BVCA and EVCA with the valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, CVCA, DVCA, FVCA, HKVCA, HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RSEAU CAPITAL, RVCA, SAVCA, SECA, SLOVCA(Endorsement as of 1st of November 2005) This may occur for example in the case of a company3.3 Price of Recent Investment becoming profitable and cash flow becoming positive on aWhere the Investment being valued was itself made maintainable basis a few years after the start-up phase.recently, its cost will generally provide a good indication of Any changes in valuation methodologies should be clearlyFair Value. Where there has been any recent Investment in stated. It is expected that there would not be frequentthe Investee Company, the price of that Investment will changes in valuation methodologies.provide a basis of the valuation. The table below identifies a number of the most widely usedThe validity of a valuation obtained in this way is inevitably methodologies. In assessing whether a methodology iseroded over time, since the price at which an Investment was appropriate, the Valuer should be predisposed towardsmade reflects the effects of conditions that existed when the those methodologies that are generally accepted and thosetransaction took place. In a dynamic environment, changes in that draw on market-based measures of risk and return,market conditions, the passage of time itself and other factors since both these qualities would serve to enhance thewill act to diminish the appropriateness of this methodology reliability of the Fair Value estimates.as a means of estimating value at subsequent dates. Methodologies utilising discounted cashflows and industryIn addition, where the price at which a third party has benchmarks should rarely be used in isolation of theinvested is being considered as the basis of valuation, the market-based measures and then only with extreme caution.background to the transaction must be taken in to account. These methodologies may be useful as a cross-check ofIn particular, the following factors may indicate that the price values estimated using the market-based methodologies.was not wholly representative of the Fair Value at the time: METHODOLOGY a further Investment by the existing stakeholders withlittle new Investment;Price of Recent InvestmentEarnings multiple different rights attach to the new and existingInvestments;Net assets a new investor motivated by strategic considerations;Discounted cash flows or earnings(of Underlying Business) the Investment may be considered to be a forced sale orDiscounted cash flows (from the Investment) rescue package; orIndustry valuation benchmarks the absolute amount of the new Investment is relativelyinsignificant. 15. S EC T I O N I: D E T E R M I N I N G F A I R V A LU E This methodology is likely to be appropriate for all private service financial instruments, breaches of covenants equity Investments, but only for a limited period after theand a deterioration in the level of budgeted or forecast date of the relevant transaction. Because of the frequency performance; with which funding rounds are often undertaken for seed there has been a significant adverse change either in and start-up situations, or in respect of businesses engagedthe companys business or in the technological, market, in technological or scientific innovation and discovery, theeconomic, legal or regulatory environment in which the methodology will often be appropriate for valuingbusiness operates; Investments in such circumstances. market conditions have deteriorated. This may be indicated The length of period for which it would remain appropriate toby a fall in the share prices of quoted businesses operating use this methodology for a particular Investment will dependin the same or related sectors; or on the specific circumstances of the case, but a period of one year is often applied in practice. the Underlying Business is raising money and there isevidence that the financing will be made under significantly In applying the Price of Recent Investment methodology,different terms and conditions from the original Investment. the Valuer should use the cost of the Investment itself or the price at which a significant amount of new Investment into the company was made to estimate the Fair Value of3.4 Earnings Multiple the Investment, but only for a limited period followingThis methodology involves the application of an earnings the date of the relevant transaction. During the limitedmultiple to the earnings of the business being valued in period following the date of the relevant transaction, theorder to derive a value for the business. Valuer should in any case assess whether changes or events subsequent to the relevant transaction wouldThis methodology is likely to be appropriate for an imply a change in the Investments Fair Value. Investment in an established business with an identifiablestream of continuing earnings that can be considered to be For example, a reduction in the Investments Fair Valuemaintainable. may have occurred for a number of reasons, including the following: This methodology may be applicable to companies withnegative earnings, if the losses are considered to be the performance and/or prospects of the Underlyingtemporary and one can identify a level of normalised Business are significantly below the expectations on whichmaintainable earnings. the Investment was based. Prima facie indicators of this include a failure to meet significant milestones or to 15 16. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E SW W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M 16 These guidelines have been developed by AFIC, BVCA and EVCA with the valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, CVCA, DVCA, FVCA, HKVCA, HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RSEAU CAPITAL, RVCA, SAVCA, SECA, SLOVCA(Endorsement as of 1st of November 2005) This may involve the use of averaging of earnings figuresGuidance on the interpretation of underlined terms is given for a number of periods, using a forecast level of earningsbelow. or applying a sustainable profit margin to current or forecast revenues. Appropriate Multiple In using the Earnings Multiple methodology to estimate A number of earnings multiples are commonly used, the Fair Value of an Investment, the Valuer should:including price/earnings (P/E), Enterprise Value/earningsbefore interest and tax (EV/EBIT) and depreciation and i. apply a multiple that is appropriate and reasonableamortisation (EV/EBITDA). The particular multiple used(given the risk profile and earnings growth prospectsshould be appropriate for the business being valued.of the underlying company) to the maintainable(N.B: The multiples of revenues and their use are presentedearnings of the company;in 3.8. Industry Valuation Benchmarks) ii. adjust the amount derived in (i) above for surplusIn general, because of the key role of financial structuring assets or excess liabilities and other relevant factorsin private equity, multiples should be used to derive an to derive an Enterprise Value for the company;Enterprise Value for the Underlying Business. Therefore, iii. deduct from the Enterprise Value all amounts relating where a P/E multiple is used, it should generally be appliedto financial instruments ranking ahead of the highest to a taxed EBIT figure (after deducting finance costsranking instrument of the Fund in a liquidation and relating to working capital or to assets acquired or leasedtaking into account the effect of any instrument that using asset finance) rather than to actual after-tax profits,may dilute the Funds Investment in order to derive since the latter figure will generally have been significantlythe Gross Attributable Enterprise Value;reduced by finance costs. iv. apply an appropriate Marketability Discount to the By definition, earnings multiples have as their numerator Gross Attributable Enterprise Value derived in (iii) a value and as their denominator an earnings figure. above in order to derive the Net AttributableThe denominator can be the earnings figure for any Enterprise Value; andspecified period of time and multiples are often defined ashistorical, current or forecast to indicate the earnings v. apportion the Net Attributable Enterprise Valueused. It is important that the multiple used correlates to theappropriately between the relevant financialperiod and concept of earnings of the company being valued.instruments. 17. S EC T I O N I: D E T E R M I N I N G F A I R V A LU E Reasonable Multiplecosts associated with them which should be reflected in thevalue attributed to the business in question. The Valuer would usually derive a multiple by reference to market-based multiples, reflected in the market valuations It is important that the earnings multiple of each comparator of quoted companies or the price at which companies have is adjusted for points of difference between the comparator changed ownership. This market-based approach presumes and the company being valued. These points of difference that the comparator companies are correctly valued byshould be considered and assessed by reference to the two the market. Whilst there is an argument that the marketkey variables of risk and earnings growth prospects which capitalisation of a quoted company reflects not the value of underpin the earnings multiple. In assessing the risk profile the company but merely the price at which small parcelsof the company being valued, the Valuer should recognise of shares are exchanged, the presumption in thesethat risk arises from a range of aspects, including the nature Guidelines is that market based multiples do correctly of the companys operations, the markets in which it operates reflect the value of the company as a whole. and its competitive position in those markets, the quality of itsmanagement and employees and, importantly in the case of Where market-based multiples are used, the aim is toprivate equity, its capital structure and the ability of the Fund identify companies that are similar, in terms of risk attributesholding the Investment to effect change in the company. and earnings growth prospects, to the company being valued.For example, the value of the company may be reduced if it: This is more likely to be the case where the companies are similar in terms of business activities, markets served, size, is smaller and less diverse than the comparator(s) and, geography and applicable tax rate. therefore, less able generally to withstand adverseeconomic conditions; In using P/E multiples, the Valuer should note that the P/E ratios of comparator companies will be affected by is reliant on a small number of key employees; the level of financial gearing and applicable tax rate of is dependent on one product or one customer; those companies. has high gearing; or In using EV/EBITDA multiples, the Valuer should note that such multiples, by definition, remove the impact on for any other reason has poor quality earnings. value of depreciation of fixed assets and amortisation of goodwill and other intangibles. If such multiples are used without sufficient care, the Valuer may fail to recognise that business decisions to spend heavily on fixed assets or to grow by acquisition rather than organically do have real17 18. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E SW W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M 18 These guidelines have been developed by AFIC, BVCA and EVCA with the valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, CVCA, DVCA, FVCA, HKVCA, HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RSEAU CAPITAL, RVCA, SAVCA, SECA, SLOVCA(Endorsement as of 1st of November 2005) Recent transactions involving the sale of similar companiesMaintainable Earnings are sometimes used as a frame of reference in seeking toIn applying a multiple to maintainable earnings, it is derive a reasonable multiple. It is sometimes argued, sinceimportant that the Valuer is satisfied that the earnings figure such transactions involve the transfer of whole companiescan be relied upon. Whilst this might tend to favour the use whereas quoted multiples relate to the price for smallof audited historical figures rather than unaudited or parcels of shares, that they provide a more relevant sourceforecast figures, it should be recognised that value is by of multiples. However, their appropriateness in this respectdefinition a forward-looking concept, and quoted markets is often undermined by the following:more often think of value in terms of current and forecast the lack of forward-looking financial data and other multiples, rather than historical ones. In addition, there is information to allow points of difference to be identified the argument that the valuation should, in a dynamic and adjusted for;environment, reflect the most recent available information.There is therefore a trade-off between the reliability and the generally lower reliability and transparency ofrelevance of the earnings figures available to the Valuer. reported earnings figures of private companies; andOn balance, whilst it remains a matter of judgment for the the lack of reliable pricing information for the transaction Valuer, he should be predisposed towards using historical itself.(though not necessarily audited) earnings figures or, if hebelieves them to be reliable, forecast earnings figures for It is a matter of judgment for the Valuer as to whether,the current year. in deriving a reasonable multiple, he refers to a single comparator company or a number of companies or Whichever periods earnings are used, the Valuer should the earnings multiple of a quoted stock market sector or satisfy himself that they represent a reasonable estimate of sub-sector. It may be acceptable, in particular circumstances, maintainable earnings, which implies the need to adjust for for the Valuer to conclude that the use of quoted sector orexceptional or non-recurring items, the impact of sub-sector multiples or an average of multiples from a discontinued activities and acquisitions and forecast basket of comparator companies may be used without downturns in profits. adjusting for points of difference between the comparator(s) and the company being valued. 19. S EC T I O N I: D E T E R M I N I N G F A I R V A LU E Appropriate Marketability Discount In assessing the influence of the Fund over the timing ofRealisation, nature of Realisation and Realisation process, The notion of a Marketability Discount relates to ansome of the factors the Valuer should consider are as follows: Investment rather than to the Underlying Business. Paragraph (iv) above therefore requires the discount to are there other like-minded shareholders with regard to be considered and applied at the level at which the Fund Realisation and what is the combined degree of influence? begins to participate in the Enterprise Value. is there an agreed exit strategy or exit plan? Marketability will vary from situation to situation and is a do legal rights exist which allow the Fund together with question of judgment. It should be noted that the Fair Valuelike-minded shareholders to require the other shareholders concept requires that the Marketability Discount is to beto agree to and enable a proposed Realisation to proceed? determined not from the perspective of the current holder of the Investment, but from the perspective of Market Participants. does the management team of the Underlying Businesshave the ability in practice to reduce the prospects of a Some of the factors the Valuer should consider in thissuccessful Realisation? This may be the case where the respect are as follows:team is perceived by possible buyers to be critical to the the closer and more certain is a Realisation event for ongoing success of the business. If this is the case, what is the Investment in question, the lower would be the the attitude of the management team to Realisation? Marketability Discount;The Valuer might consider that under specific circumstances the greater the influence of the Fund over the timing of the Marketability Discount is not appropriate and should Realisation, nature of Realisation and Realisation process,not be applied. When a discount is applied, the Valuer the lower would be the Marketability Discount; should consider all the relevant factors in determiningthe appropriate Marketability Discount in each particular if the underlying company were not considered saleablesituation. A discount in the range of 10% to 30% (in steps or floatable at the reporting date, the questions arise ofof 5%) is generally used in practice, depending upon the what has to be done to make it saleable or floatable, howparticular circumstances. difficult and risky that course of action is to implement and how long it is expected to take; and the impact of stock market conditions and mergers and acquisitions activity levels on the ability to achieve a flotation or sale of the Underlying Business. 19 20. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E S W W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M 20 These guidelines have been developed by AFIC, BVCA and EVCA with the valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, CVCA, DVCA, FVCA, HKVCA, HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RSEAU CAPITAL, RVCA, SAVCA, SECA, SLOVCA(Endorsement as of 1st of November 2005) By way of illustration:Apportion the Net Attributable Enterprise Valueappropriately Where the Fund (together with like-minded shareholders with regard to Realisation) has legal rights and the ability The apportionment should reflect the respective amounts in practice to initiate a Realisation process and requireaccruing to each financial instrument holder in the event other shareholders to co-operate, or there is in place anof a sale at that level at the reporting date. Where there agreed Realisation strategy, a discount rate of 10% mayare ratchets or share options or other mechanisms (such as be appropriate.liquidation preferences, in the case of Investments in early-stage businesses) in place which would be triggered in the Where the Fund (together with like-minded shareholdersevent of a sale of the company at the given Enterprise Value with regard to Realisation) does not have such a degree ofat that date, these should be reflected in the apportionment. influence over Realisation, possibly by virtue of holding a minority of the equity, but the other shareholders are not Where, in respect of financial instruments other than equity strongly opposed to a Realisation, a discount rate of 30%instruments, the apportionment results in a shortfall when may be appropriate (NB. where a Realisation event is not compared with the amounts accruing up to the reporting foreseeable at all, perhaps because the Fund holds a date under their contractual terms, the Valuer should minority equity stake and the majority shareholders areconsider whether, in estimating Fair Value, the shortfall should totally opposed to a Realisation, methodologies whichbe applied and, if so, to what extent. If the circumstances involve an assessment of the value of the business as aare such that it is reasonably certain, taking account of whole may not be appropriate). the risks attaching, that the Fund will be able to collect allamounts due according to the relevant contractual terms, Where the Fund (together with like-minded shareholdersthen the shortfall should not be applied. with regard to Realisation) does not have the ability to require other shareholders to co-operate regarding Realisation, but there is regular discussion about 3.5 Net Assets Realisation prospects and timing by the board and/orThis methodology involves deriving the value of a business shareholders, a discount rate of 20% may be appropriate.by reference to the value of its net assets.This methodology is likely to be appropriate for a businesswhose value derives mainly from the underlying value of itsassets rather than its earnings, such as property holdingcompanies and investment businesses. 21. S EC T I O N I: D E T E R M I N I N G F A I R V A LU E This methodology may also be appropriate for a business that3.6 Discounted Cash Flows or Earnings is not making an adequate return on assets and for which a(of Underlying Business) greater value can be realised by liquidating the business and This methodology involves deriving the value of a business selling its assets. In the context of private equity, it may by calculating the present value of expected future cash therefore be appropriate, in certain circumstances, for flows (or the present value of expected future earnings, as a valuing Investments in loss-making companies and surrogate for expected future cash flows). The cash flows companies making only marginal levels of profits. and terminal value are those of the Underlying Business, In using the Net Assets methodology to estimate the Fairnot those from the Investment itself. Value of an Investment, the Valuer should: The Discounted Cash Flows (DCF) technique is flexible in i. derive an Enterprise Value for the company using the sense that it can be applied to any stream of cash flowsappropriate measures to value its assets and liabilities (or earnings). In the context of private equity valuation, this(including, if appropriate, contingent assets andflexibility enables the methodology to be applied in situationsliabilities);that other methodologies may be incapable of addressing. While this methodology may be applied to businesses ii. deduct from the Enterprise Value all amounts relating going through a period of great change, such as a rescue to financial instruments ranking ahead of the highest refinancing, turnaround, strategic repositioning, loss making ranking instrument of the Fund in a liquidation in order or is in its start-up phase, there is a significant risk is to derive the Gross Attributable Enterprise Value; utilising this methodology. iii. apply an appropriate Marketability Discount to The disadvantages of the DCF methodology centre aroundthe Gross Attributable Enterprise Value to derive its requirement for detailed cash flow forecasts and the need tothe Net Attributable Enterprise Value; and estimate the terminal value and an appropriate risk-adjusted iv. apportion the Net Attributable Enterprise Value discount rate. All of these inputs require substantial subjective appropriately between the relevant financialjudgments to be made, and the derived present value instruments.amount is often sensitive to small changes in these inputs. Guidance on the interpretation of underlined terms is given Due to the high level of subjectivity in selecting inputs for this in the Earnings multiple section above. technique, DCF based valuations are useful as a cross-check of values estimated under market-based methodologies and should only be used in isolation of other methodologies under extreme caution. 21 22. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E S W W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M 22 These guidelines have been developed by AFIC, BVCA and EVCA with the valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, CVCA, DVCA, FVCA, HKVCA, HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RSEAU CAPITAL, RVCA, SAVCA, SECA, SLOVCA(Endorsement as of 1st of November 2005) In assessing the appropriateness of this methodology,3.7 Discounted Cash Flows (from the Investment) the Valuer should consider whether its disadvantagesThis methodology applies the DCF concept and technique and sensitivities are such, in the particular circumstances,to the expected cash flows from the Investment itself. as to render the resulting Fair Value insufficiently reliable.Where Realisation of an Investment or a flotation of the In using the Discounted Cash Flows or EarningsUnderlying Business is imminent and the pricing of the (of Underlying Business) methodology to estimaterelevant transaction has been substantially agreed, the the Fair Value of an Investment, the Valuer should:Discounted Cash Flows (from the Investment) methodology i. derive the Enterprise Value of the company, using (or, as a surrogate, the use of a simple discount to the expectedreasonable assumptions and estimations of expectedRealisation proceeds or flotation value) is likely to be thefuture cash flows (or expected future earnings) and most appropriate methodology.the terminal value, and discounting to the presentThis methodology, because of its flexibility, is capable ofby applying the appropriate risk-adjusted rate thatbeing applied to all private equity Investment situations.quantifies the risk inherent in the company;It is particularly suitable for valuing non-equity Investments ii. deduct from the Enterprise Value all amounts relatingin instruments such as debt or mezzanine debt, since the to financial instruments ranking ahead of the highestvalue of such instruments derives mainly from instrument- ranking instrument of the Fund in a liquidation in order specific cash flows and risks rather than from the value of to derive the Gross Attributable Enterprise Value; the Underlying Business as a whole. iii. apply an appropriate Marketability Discount toBecause of its inherent reliance on substantial subjectivethe Gross Attributable Enterprise Value derived judgments, the Valuer should be extremely cautious of usingin ii above in order to derive the Net Attributable this methodology as the main basis of estimating Fair ValueEnterprise Value; and for Investments which include an equity element.The methodology will often be useful as a sense-check iv. apportion the Net Attributable Enterprise Valueof values produced using other methodologies. appropriately between the relevant financial instruments. Private equity risk and the rates of return necessary tocompensate for different risk levels are central commercial Guidance on the interpretation of underlined terms is givenvariables in the making of all private equity Investments. in the Earnings multiple section above.Accordingly there exists a frame of reference against whichto make discount rate assumptions. 23. S EC T I O N I: D E T E R M I N I N G F A I R V A LU E However the need to make detailed cash flow forecasts over 3.8 Industry Valuation Benchmarks the Investment life may reduce the reliability and cruciallyA number of industries have industry-specific valuation for equity Investments, there remains a need to estimate thebenchmarks, such as price per bed (for nursing-home terminal value.operators) and price per subscriber (for cable television Where the Investment comprises equity or a combination companies). Other industries, including certain financial of equity and other financial instruments, the terminal valueservices and information technology sectors and some would usually be derived from the anticipated value of services sectors where long-term contracts are a key feature, the Underlying Business at Realisation. This will usuallyuse multiples of revenues as a valuation benchmark. necessitate making assumptions about future business These industry norms are often based on the assumption performance and developments and stock market and otherthat investors are willing to pay for turnover or market valuation ratios at the assumed Realisation date. In the caseshare, and that the normal profitability of businesses in of equity Investments, small changes in these assumptions canthe industry does not vary much. materially impact the valuation. In the case of non-equityThe use of such industry benchmarks is only likely to instruments, the terminal value will usually be a pre-definedbe reliable and therefore appropriate as the main basis amount, which greatly enhances the reliability of the valuation.of estimating Fair Value in limited situations, and is more In circumstances where a Realisation is not foreseeable, likely to be useful as a sense-check of values produced the terminal value may be based upon assumptions of theusing other methodologies. perpetuity cash flows accruing to the holder of the Investment. These circumstances (which are expected to be rare in3.9 Available Market Prices private equity) may arise where the Fund has little ability to influence the timing of a Realisation and/or those shareholdersPrivate Equity Funds may be holding Quoted Instruments, that can influence the timing do not seek a Realisation. for which there is an available market price. In using the Discounted Cash Flows (from the Investment) Instruments quoted on a stock market should be valued methodology to estimate the Fair Value of an Investment, at their bid prices on the Reporting Date. the Valuer should derive the present value of theFor certain Quoted Instruments there is only one market Investment, using reasonable assumptions and estimationsprice quoted, representing, for example, the value at which of expected future cash flows and the terminal valuethe most recent trade in the instrument was transacted. and date, and the appropriate risk-adjusted rate that quantifies the risk inherent to the Investment.23 24. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E SW W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M 24 These guidelines have been developed by AFIC, BVCA and EVCA with the valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, CVCA, DVCA, FVCA, HKVCA, HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RSEAU CAPITAL, RVCA, SAVCA, SECA, SLOVCA(Endorsement as of 1st of November 2005) For other Quoted Instruments there are two market prices If compliance with specific accounting principles that at any one time: the lower bid price quoted by a marketdiscourage the use of a discount under specific circumstances maker, which he will pay an investor for a holding (i.e. the is sought, the Valuer should not apply a discount to the investors disposal price), and the higher offer price, whichmarket price. an investor can expect to pay to acquire a holding. A thirdOutside of accounting principles compliance, the Valuer price basis for valuation purposes, as an alternative to eithershould consider whether factors exist which inhibit the bid or offer, is the mid-market price (i.e. the average of theRealisation of the asset and that it would be appropriate bid and offer prices). Where a bid and offer price exists, theto apply a discount to the market price. bid price should be used, although the use of the mid-market price will not usually result in a material overstatementFactors which indicate that the valuation based on of value.the available market price should be reduced by aMarketability Discount would include situations where: This methodology should apply when the bid prices are set on an active market. An instrument is regarded as quoted i. there is a formal restriction on trading in the relevant on an active market if quoted prices are readily andsecurities; or regularly available from an exchange, broker, dealer,ii. there is a risk that the holding may not be able to be industry group, pricing services or regulatory agency, andsold immediately. those prices represent actual and regularly occurring market transaction on arms length basis. In determining the level of Marketability Discount to apply,the method generally used in practice is for the Valuer to The Valuer should consider whether any legal or otherconsider the length of the period over which trading regulations apply to the context in which the valuation will berestrictions apply, or the size of the holding in relation to used. International Financial Reporting Standards (IFRS)normal trading volumes in that security. In this context, presume that the available price for a security may be appliedthe following levels of discount are generally used: to a holding of any size. Accordingly to remain compliant with IFRS, Marketability Discounts should generally not beNUMBER OF DAYS TRADING VOLUMEDISCOUNTS % applied to prices quoted on an active market. If compliance Up to 20 0 with accounting principles that discourage the use of a discount under specific circumstances is not sought, the20 to 4910 Valuer can elect to apply a discount to the market price. 50 to 100 20 100+25 25. S EC T I O N I: D E T E R M I N I N G F A I R V A LU E Occasionally, it may be inappropriate to consider Marketability Whilst it is a matter of judgment for the Valuer, where a by reference to trading volumes. For example, in the case ofholding is, at the reporting date, both subject to a formal a particular security, a number of parties may have littlerestriction on trading and also significant in relation to interest in buying on the market, because of the smallnormal trading volumes in that security, the discount quantities available, but may be interested in buying moreapplied to the holding should be the higher of the two that substantial stakes off-market. In this situation, the estimated would be considered appropriate in each of the price and size of such off-market transactions should becircumstances in isolation. taken account of in considering Marketability. By way of If a different level of discount is appropriate in light of the further example, where the quoted entity has a stated particular circumstances of an Investment, the Valuer should intention of seeking a buyer and there is a reasonable use that rate and should disclose the fact that he has done so expectation of a sale of the entity in the six months following together with the rationale for so doing. the reporting date at a price representing a bid premium, it may be appropriate in the particular circumstances for the Valuer to conclude that the positive bid premium effect offsets the negative trading volume effect, such that the undiscounted market price is on balance a reasonable estimate of Fair Value. In determining the level of Marketability Discount to apply under paragraph (iv) above, the Valuer should consider the extent of compensation a holder would require when comparing the Investment in question with an identical but unrestricted holding. In the case of a six-month lock-up period, in practice a discount of 20% to the market price is often used at the beginning of the period, reducing to zero at the end of the period. 25 26. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E S W W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M 26 These guidelines have been developed by AFIC, BVCA and EVCA with the valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, CVCA, DVCA, FVCA, HKVCA, HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RSEAU CAPITAL, RVCA, SAVCA, SECA, SLOVCA(Endorsement as of 1st of November 2005) 27. S EC T I O N II: A P P L I C AT I O N G U I DA N C E INTRODUCTION Set out below are the most commonly used valuationmethodologies based on the ability of the Underlying Business to Section I sets out the guidelines and principles which generate revenues and profits. The Valuer would be expected to represent best practice for the valuation of private equity anduse these methodologies unless there is compelling evidence that venture capital Investments. This section sets out further another methodology would provide a more reliable Fair Value. practical guidance to the application of those principles andMethodologies should be applied consistently from one methodologies to specific cases.reporting period to the next, unless there is a change incircumstances of the enterprise, for example the enterprisegenerating sustainable profits.1 S E L EC T I N G THE A P P R O P R I AT E M ET H O D O LO GY Early stage enterprises or enterprises without or withinsignificant revenues, and without either profits or In estimating Fair Value for an Investment, the Valuer shouldpositive cash flows apply a methodology that is appropriate in light of the nature,For these enterprises, typically in a seed, start-up or an facts and circumstances of the Investment and should useearly-stage situation, there are usually no current and no reasonable assumptions and estimates.short-term future earnings or positive cash flows. It is difficult When selecting the appropriate methodology each Investment to gauge the probability and financial impact of the success should be considered individually. Where an immaterial group or failure of development or research activities and to make of Investments in a portfolio are similar in terms of risk profile reliable cash flow forecasts. and industry, it is acceptable to apply the same methodologyConsequently, the most appropriate approach to determine across all Investments in that immaterial group. The methodologyFair Value is a methodology that is based on market data, applied should be the same as that used for materialthat being the Price of a Recent Investment. investments with a similar risk profile in that industry.This methodology is likely to be appropriate for a limited When selecting the appropriate methodology, it is importantperiod after the date of the relevant transaction. to consider the stage of development of an enterprise and/or its ability to produce maintainable profits or maintainableThe length of period for which it would remain appropriate to positive cash. use this methodology for a particular Investment will dependon the specific circumstances of the case, but a period of oneyear is often applied in practice. 27 28. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E S W W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M 28 These guidelines have been developed by AFIC, BVCA and EVCA with the valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, CVCA, DVCA, FVCA, HKVCA, HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RSEAU CAPITAL, RVCA, SAVCA, SECA, SLOVCA(Endorsement as of 1st of November 2005) After the appropriate limited period, the Valuer shouldIn the event that the enterprise is generating a return on its consider whether either the circumstances of the Investmentnet assets below expectations and that greater value may be have changed, such that one of the other methodologies realised by the sale of the assets, a valuation based on the net would be more appropriate, whether there is any evidence assets methodology may be appropriate. of deterioration or strong defensible evidence of an increase inOther methodologies such as the earnings multiple are value. In the absence of these indicators the Valuer will typicallygenerally inappropriate. The DCF methodologies may be revert to the value reported at the previous reporting date.utilised, however the disadvantages inherent in these, arising In the absence of significant revenues, profits or positive cash from the high levels of subjective judgement, may render the flows, other methodologies such as the earnings multiple are methodology inappropriate. generally inappropriate. The DCF methodologies may be utilised, however the disadvantages inherent in these, arising Enterprises with revenues, maintainable profits and/or from the high levels of subjective judgement, may render the maintainable positive cash flows methodology inappropriate.For some period of time after the initial Investment, the Priceof Recent Investment methodology, is likely to be the most Enterprises with revenues, but without either significantappropriate indication of Fair Value. profits or significant positive cash flowsThis period of time will depend on the specific circumstances of For these enterprises it is often difficult to gauge thethe case, but should not generally exceed a period of one year. probability and financial impact of the success of development activities or to make reliable future earnings or cash flowThereafter is it likely to be most appropriate to estimate forecasts. This is seen typically in early stage enterprises,Fair Value by reference to the quoted market and to use development, turnaround or recovery situations.the Earnings Multiple methodology. The most appropriate methodology is expected to be the price of a recent investment. The continuing validity of this basis as a reflection of Fair Value needs to be considered and as a part of this consideration, industry benchmarks may provide appropriate support. 29. S EC T I O N II: A P P L I C AT I O N G U I DA N C E 2 S P EC I F I C C O N S I D E R AT I O N Sfunds from investors at a higher valuation, the purposeof the down round may be, among others, the dilution of 2.1 Internal Funding Roundsthe founders or the dilution of investors not participatingin the round of financing. The price at which a funding round takes place is a clear indicator of Fair Value at that date. When using the Price Similarly when a financing is made at a higher valuation of Recent Investment methodology, the Valuer should(internal up round), in the absence of new investors or considered whether there are specific circumstancesother significant factors which indicate that value has been surrounding that round of Investment which may reduceenhanced, the transaction alone is unlikely to be a reliable the reliability of the price as an indicator of Fair Value.indicator of Fair Value. A round of financing that involves only existing investors of the Underlying Business in the same proportion to their 2.2 Bridge Financing existing Investments (internal round), is unlikely to be anFunds, or related vehicles, may grant loans to an Underlying appropriate basis for a change in valuation as theBusiness pending a new round of financing (Bridge loans). transaction may not have been undertaken at arms length.This may be provided in anticipation of an initial Investment Nevertheless, a financing with existing investors that isby the Fund, or ahead or a proposed follow on Investment. priced at a valuation that is lower than the valuationIn the case of an initial Investment, where the Fund holds reported at the previous Reporting Date (internal downno other investments in the Underlying Business, the Bridge round) may indicate a decrease in value and shouldloan should be valued in isolation. In these situations and if therefore be taken into consideration.it is expected that the financing will occur in due course and Internal down rounds may take various forms, including that the Bridge loan is merely ensuring that funds are made a corporate reorganisation, i.e. a significant change in the available early, the Valuer should value these loans at cost. equity base of a company such as converting all outstandingIf it is anticipated that the company may have difficulty shares into equity, combining outstanding shares into aarranging the financing, and that its viability is in doubt, smaller number of shares (share consolidation) or eventhe Valuer should consider making a provision against the cancelling all outstanding shares before a capital increase.cost of that loan. The objectives of the existing investors in making an internal down round may vary. Although a down round evidences the fact that the company was unable to raise29 30. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E S W W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M 30 These guidelines have been developed by AFIC, BVCA and EVCA with the valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, CVCA, DVCA, FVCA, HKVCA, HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RSEAU CAPITAL, RVCA, SAVCA, SECA, SLOVCA(Endorsement as of 1st of November 2005) If the bridge finance is provided to an existing Investmentand that the warrant holder will be unable to significantly in anticipation of a follow on Investment, the bridge financeinfluence the Realisation process. In these situations, a large should be included, together with the original Investment, Marketability Discount will be appropriate. as a part of the overall package of investment being valued.In the event that the Mezzanine loan is one of a number ofinstruments held by the Fund in the Underlying Business, 2.3 Mezzanine Loansthen the Mezzanine loan and any attached warrants shouldbe included as a part of the overall package of investment Mezzanine loans are one of the commonly used sourcesbeing valued. of debt finance for Investments. Typically these will rank below the senior debt, but above shareholder loans or equity, bear an interest rate appropriate to the level of risk 2.4 Rolled up Loan Interest being assumed by the loan provider and may have additionalMany financial instruments commonly used in private equity potentially value enhancing aspects such as warrants.Investments accumulate interest which is only realised in Often these are provided by a party other than the equitycash on redemption of the instrument (e.g. deep discount provider and as such may be the only instrument held bydebentures or Payment-in-Kind Notes). the Fund in the Underlying Business. In these situations, the Mezzanine loan should be valued on a stand alone basis.In valuing these instruments, the Valuer should assess the The price at which the Mezzanine loan was granted is a expected amount to be recovered from these instruments. reliable indicator of Fair Value at that date. The ValuerIf deterioration indicators exist, a provision against the cost should consider whether any indications of deterioration of the loan should be made to reflect the deterioration in in the value of the Underlying Business exist, which suggest value. The consideration of recoverable amount will also that the loan will not be fully recovered. In the event of include the existence of any reasonably anticipated deterioration, this should be reflected in the Fair Valueenhancements such as interest rate step increases. of the Mezzanine loan. The difference between the estimated recoverable amount(if in excess of the original cost) should be spread over Warrants attached to Mezzanine loans should bethe anticipated life of the note so as to give a constant rate considered separately from the loan. The Valuer shouldof return on the instrument. select a methodology appropriate to valuing the Underlying Business and apply the percentage ownership that the exercised warrants will confer to that valuation. It is expect that in most cases, the percentage ownership will be small 31. S EC T I O N II: A P P L I C AT I O N G U I DA N C E 2.5 Indicative Offers 3 EVENTSTOCO N S I D E RFOR THEIRI M PAC T Indicative offers received from a third party for the ON V A LU E Underlying Business may provide a good indication of When performing the valuation, at each Reporting Date, Fair Value. This will apply to offers for a part or the whole the Valuer should consider all factors that will contribute to a Underlying Business as well as other situations such as material creation or diminution in value of the Investment. price indications for debt or equity refinancing. In the absence of reliable value indicators, such as recent However, before using the offer as evidence of Fair Value, Investments or the generation of profits, there are many subtle the Valuer should consider the motivation of the party in factors which should be considered by the Valuer as these may making the offer. Indicative offers may be made deliberately indicate a material change in value. high for such reasons as; to open negotiations; gain access to the company or made subject to stringent conditions or Examples of events or changes in circumstances which may future events. Similarly they may be deliberately low if theindicate that a decrease or an increase in value has occurred offeror believes that the vendor may be in a forced saleinclude, but are not limited to: position, or to take an opportunity to increase their equity the performance or prospects of the Underlying Business stake at the expense of other less liquid stakeholders. being significantly below or above the expectations on In addition indicative offers may be made on the basis of which the Investment was based insufficient detailed information to be properly valid. the Underlying Business is performing substantially and These motivations should be considered by the Valuer, consistently behind or ahead of plan however it is unlikely that a firm conclusion can be drawn. the Underlying Business met or missed its milestones such Accordingly, typically indicative offers will provide useful as clinical trials, technical developments, divisions becoming additional support for a valuation estimated by one of the cash positive, restructurings being completed valuation methodologies, but are insufficiently robust to be used in isolation. there is a deterioration or improvement in the level of budgeted performance whether the Underlying Business has breached any banking covenants, defaulted on any obligations31 32. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E SW W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M 32 These guidelines have been developed by AFIC, BVCA and EVCA with the valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, CVCA, DVCA, FVCA, HKVCA, HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RSEAU CAPITAL, RVCA, SAVCA, SECA, SLOVCA(Endorsement as of 1st of November 2005) the existence of off-balance sheet items, contingent liabilities Where deterioration in value has occurred, the Valuer should and guarantees reduce the carrying value of the Investment reported at theprevious Reporting Date to reflect the estimated decrease. the existence of a major lawsuitIf there is insufficient information to accurately assess the disputes over commercial matters such as intellectualadjusted Fair Value, decreases in value are usually in practice property rightsassessed in tranches of 25%. If however the Valuer believes the existence of fraud within the companythat they have sufficient information to more accurately assessfair value (this may occur when 25% or less or the original a change of management or strategic direction of thevalue remains), then smaller tranches of 5% may be applied. Underlying BusinessIf there is evidence of value creation, such as those listed whether there has been a significant adverse or favourableabove, the Valuer may consider increasing the carrying value change either in the companys business or in theof the Investment. Caution must be applied so that positive technological, market, economic, legal or regulatorydevelopments are not being valued before they actually environment in which the business operates;contribute to an increase in value of the Underlying Business. significant changes in market conditions. This may beIn practice, in the absence of additional financing rounds or indicated by a movement in the share prices of quotedprofit generation, these more subtle indicators of value businesses operating in the same or related sectors; enhancement are generally only used to support the reversalof a previously recognised deterioration in value. the Underlying Business is raising money and there is evidence that the financing will be made under conditions different from those prevailing at the time of the previous round of financing. The Valuer will assess the impact of all positive and negative events and adjust the carrying value accordingly in order to reflect the Fair Value of the Investment at the Reporting Date. 33. S EC T I O N II: A P P L I C AT I O N G U I DA N C E 4 I M PAC T S FROMSTRUCTURINGIn assessing whether rights are likely to be taken up bystakeholders, the Valuer should limit their consideration to a Frequently the structuring of a private equity Investment is comparison of the value received by the exerciser against the complex with groups of stakeholders holding different rights cost of exercising. If the exerciser will receive an enhancement which either enhance or diminish the value of their interests, in value by exercising, the Valuer should assume that they depending on the success or otherwise of the Underlyingwill do so. Business.The estimation of Fair Value should be undertaken on the basis Valuations must take account the impact of future changes in that all rights that are currently exercisable and are likely to be the structure of the Investment which may materially impactexercised (such as options), or those that occur automatically the Fair Value. These potential impacts may take several on certain events taking place (such as liquidation preferences different legal forms and may be initiated at the Funds option, on Realisation, or ratchets based on value), have taken place. automatically on certain events taking place, or at the optionConsideration should be given to whether the exercise price of another investor. Common clauses include, but are notwill result in surplus cash arising in the Investee Company. limited to: Stock options and warrants Anti-dilution clauses Ratchet clauses Convertible debt instruments Liquidation preferences Commitments to take up follow-on capital Investments; These rights should be reviewed on a regular basis to assess whether these are likely to be exercised and the extent of any impact on value of the Funds Investment. At each Reporting Date, the Valuer should determine whether these rights are likely to be exercised. 33 34. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E S W W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M 34 These guidelines have been developed by AFIC, BVCA and EVCA with the valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, CVCA, DVCA, FVCA, HKVCA, HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RSEAU CAPITAL, RVCA, SAVCA, SECA, SLOVCA(Endorsement as of 1st of November 2005) 35. W O R KG R O U P W O R KG R O U P Marie-Fleur Bonte, Manager, PricewaterhouseCoopers Angela Crawford-Ingle, Partner, PricewaterhouseCoopers Herman Daems, Chairman, GIMV Jean-Yves Demeunynk, Managing Director, AFIC Javier Echarri, Secretary General, EVCA Pierre Esmein, Partner, Deloitte & Touche Ann Glover, CEO, Amadeus Capital Richard Green, Managing Director, Kleinwort Capital Limited Didier Guennoc, Chief Economist, EVCA John Mackie, Chief Executive, BVCA Sylvain Quagliaroli, Partner, Grant Thornton Monique Saulnier, Managing Partner, Sofinnova Partners Jean-Bernard Schmidt, Chairman, Sofinnova Partners Writer: Anthony Cecil, Partner, KPMG35 36. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E SW W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M 36 These guidelines have been developed by AFIC, BVCA and EVCA with the valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, CVCA, DVCA, FVCA, HKVCA, HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RSEAU CAPITAL, RVCA, SAVCA, SECA, SLOVCA(Endorsement as of 1st of November 2005) AFICAIFI APCRI (The Association Franaise(The Italian Private Equity and(The Portuguese Private Equity and des Investisseurs en Capital) Venture Capital Association) Venture Capital Association) AFIC is an independent organization.AIFI was founded in May 1986 in orderAPCRI was established in 1989 and is With 210 active members, AFIC bringsto promote, develop and institutionallybased in Lisbon. APCRI represents the together almost all of the private equity represent the private equity and venture Portuguese private equity and venture institutions in France. In addition,capital activity in Italy. The Association capital sector and promotes the asset class. AFIC has 110 associate members. is a non-profit organisation whose mainAPCRIs role includes representing activities are: to create a favourable legal In order to create a clear set of standardsthe interests of the industry to regulators environment for the private equity and for the private equity business, AFICand standard setters; developing venture capital investment activity, to drafted a "Code of Ethics", to which professional standards; providing analyse the Italian private equity market all members must adhere to.industry research; professional collecting statistical data, to organize AFIC regularly publishes reference development and forums, facilitating business seminars and specialized courses documents, which include the "Privateinteraction between its members and addressed to institutional investors and Equity Best Practices Guidelines". key industry participants including to people interested in operating within Lastly, AFIC issues recommendationsinstitutional investors, entrepreneurs, the industry, to publish research papers on corporate governance which arepolicymakers and academics. regarding specific topics about the private designed to promote transparency equity market, to build up stable andAPCRIs activities cover the whole and responsibility. solid relationships with other Nationalrange of private equity: venture capital Venture Capital Associations and key (from seed and start-up to development players in the international private capital), buyouts and buyins. equity market. In order to carry out theAPCRI represents the vast majority of above-mentioned activities, AIFI canprivate equity and venture capital in rely both on its permanent staff and onPortugal. APCRI has 16 full members different Technical Committeesand 5 associate members. Full members established with the task to carry outare active in making equity investments activities of study on specific mattersprimarily in unquoted companies. and projects. 37. APEA ASCRI The associate membership can include (The Arab Private Equity Association)(The Spanish Private Equity and those firms who invest directly inVenture Capital Association)APEA is the only pan-Arab industry private equity but for whom this is notassociation sponsored by the EconomicASCRI is a non-profit making association their principal activity, advisory firmsUnity Council of the Arab League, thethat was set up in 1986, to promote and experienced in dealing with privateAPEA was formed to address the develop the venture capital and private equity and educational or researchchallenges faced by private equity firms equity activity in Spain and represent, based institutions closely associatedas well as venture capitalists in the Arab manage and defend its members with the industry.world. APEA believes that privateprofessional interests.equity and venture capitalism can be The Association stimulates the promotionimportant catalysts for the provision and information analysis in the ventureof economic opportunities, increased capital/private equity sector in Spain,investment flows, and superior business and provides the contact between Officialperformance for Arab industries. Organisations, investors, professionalAPEA's core mission is to increase advisers, business schools and otherthe role of this young but rapidly relevant institutions. At the end ofgrowing industry in the Arab world, May 2005, ASCRI had 84 full membersand strengthen the performance and 28 associate members.of private equity investment in theemerging Arab market.The ASCRIs main activities are: Research activity, Organisation of different events such as: Annual General Assembly, ASCRI Congress, Training Seminars and Conferences/Workshops, Communication of investment opportunities between ASCRI members, and Institutional and lobbying activity. 37 38. I N T E R N AT I O N A L P R I VAT E E Q U I T Y A N D V E N T U R E C A P I TA L V A LUAT I O N G U I D E L I N E S W W W . P R I VAT E EQ U I T Y VA LU AT I O N . CO M 38 These guidelines have been developed by AFIC, BVCA and EVCA with the valuable input and endorsement of the following associations:AIFI, APCRI, APEA, ASCRI, ATIC, AVCA, AVCAL, AVCO, BVA, BVK, CVCA, CVCA, DVCA, FVCA, HKVCA, HVCA, ILPA, IVCA, LVCA, NVCA, NVP, PPEA, RSEAU CAPITAL, RVCA, SAVCA, SECA, SLOVCA(Endorsement as of 1st of November 2005) ATICAVCA (The Tunisian Venture Capital ATIC's third objective no less important(The African Venture Capital Association)is to inculcate the right private equityAssociation) and venture capital culture to local ATIC (Association Tunisienne desAVCA represents the private equity and professionals, to enhance the creation of Investisseurs en Capital) is a professional venture capital industry in Africa. a new generation of Funds managers association founded in April 2004, by AVCA was established in 2002 and its and to reach strategic alliances with more than 30 companies operating in head office is in Yaound, Cameroon. their European or US counterparts. the field of Private Equity and Venture AVCAs membership is drawn from ATIC aims to reach that by enforcing Capital in Tunisia. Its main gaol is to across Africa and internationally. the best practices of the profession play the vis-a-vis with the TunisianAVCAs objectives are to represent the according to international standards, authorities to introduce the appropriateindustry within Africa and internationally, through its planned training programs. legal and fiscal measures to ease the stimulate the growth and expansion development, and solve the problems ofof the industry throughout Africa, the private equity and venture capitalstimulate professional relationships and industry in Tunisia.co-operation, provide opportunities for professional development of industry ATIC second objective is to offer its practitioners, research, publish and members the appropriate space for circulate industry information and insights, networking, information exchange and provide policymakers with proposals to business development to upgrade the improve the corporate, fiscal and legal Tunisian industry by targeting higher environment for the industry, maintain value added technology projects, and high ethical and professional standards stronger alliances with its North African and contribute to the management and European Partners. development of investors, investees and other stakeholders. AVCAs activities include an annual industry conference, a quarterly newsletter, research, training and advocacy programs. For more information visit the AVCA website www.avcanet.com. 39. AVCAL AVCO In addition it takes the role of aninterface to international organisations (T