By Kemp Moyer, Michael Ruane and Jean Chen
2022 year-end reporting is poised to be especially challenging for many venture capital (VC) and private equity (PE) firms given current market volatility and the 2022 market pullback. Those who proactively face the associated financial reporting challenges are more likely to come out ahead.
This year has not been kind to many market participants, with VC/PE participants being no exception. Stubbornly high levels of inflation have resulted in historic interest rate hikes by the U.S. Federal Reserve. The Fed’s goal is to lower inflation by cooling the economy down—and the markets have been substantially impacted through 2022 as a result.
So far this year, public markets have posted sizable losses. For example, year to date through October 31, 2022, the NASDAQ 100 was down over 30%. This has created a ripple effect across the financial sector. In the private markets specifically, decreasing asset values have resulted in fewer exits for VC-backed companies. In fact, this activity has essentially fallen off a cliff in just one year’s time, with just $14.0 billion in exit value generated in Q3 2022 (compared to $266.8 billion in exit value in Q2 2022)*. This means that some investments with anticipated liquidity will instead remain on the VC/PE balance sheet longer than expected.
Compounding matters, it has recently been reported that many startups in need of capital are borrowing from banks, private-equity firms and other financial services providers rather than risk selling shares at a lower price than in prior fundraising rounds and taking a resulting hit to their implied valuations.
Preparing for year-end reporting in a down market
Given these market disruptions and the impacts they are having across the VC/PE ecosystem, financial statements are under more scrutiny than when valuations were marching upward. With the year-end reporting season around the corner, VC funds with GAAP reporting requirements need to report the fair value of their investments to their stakeholders, including navigating their annual audit process.
VCs have traditionally been consistent when it comes to valuing their portfolio companies—often relying heavily on values indicated per the most recent financing rounds. However, considering the rapid changes in market conditions, and the general deterioration of market valuations in most industries, especially those in the growth segments, that approach likely will not meet the more stringent financial reporting environment associated with potentially impaired market indications.
Additionally, audit teams are under pressure due to the challenges presented by the decline in values in both public and private markets. As such, there will be a heightened level of scrutiny to ensure that reported values are appropriate for the year-end 2022 audit cycle.
“Auditors need to be comfortable that the numbers in the financial statements are accurate. If they don’t feel comfortable, they are not going to sign off on the audit which is going to create a problem for the VC,” said Michael Ruane, a Managing Director in BPM’s Advisory Practice.
It is important for executives and managers of VC and PE firms to approach these challenges accurately and objectively. Such an approach can help build trust with both investors and audit committees—even if the news isn’t positive.
“VC and PE firms are reliant on the trust of the marketplace and their LPs [limited partners]. Now is not the time to lose that trust,” stressed BPM Advisory Partner Kemp Moyer. “The best management teams will objectively report accurate numbers to their investors, building on the trust that these investors have placed in them.”
Considerations for VCs in this unique year-end reporting cycle
- Current market volatility necessitates a comprehensive assessment of fair value for VC portfolio investments and PE portfolio companies
- The value of a portfolio investment depends heavily on the outlook for the company and how it is navigating this turbulent environment, as well as the objective market impact on its industry
- Market conditions are shifting quickly—speed is critical for audit processes this year to ensure audit timelines are met despite more challenging reporting circumstances
- Transparency is key for building trust with auditors and investors, especially in market declines
- 2023 is looking highly uncertain; it is important to accurately tie up 2022 reporting swiftly to ensure proper preparation and focus for the year ahead
How BPM can help
As this macroeconomic uncertainty continues, we are more likely to see increased pressure on the VC and PE financial reporting landscape, including a higher percentage of down rounds for VC-backed companies. In this environment, you can’t assume your prior procedures are going to hold up to increased scrutiny. In other words, there’s no standard or simplified method that clearly checks the box in today’s market conditions.
BPM provides independent third-party fair value analysis, as well as in-depth reviews of valuations from an audit standpoint. Our experienced professionals have weathered these storms before and can help minimize uncertainty around your reporting—helping to instill trust and confidence in your investors and auditors when it matters most.