What is ASC 820, and why does it matter for venture capital and private equity? When companies prepare for funding rounds, acquisitions, or IPOs, precise asset valuation is essential. ASC 820 is the accounting standard that guides how investments are valued and reported, ensuring financial transparency and consistency. 

The Financial Accounting Standards Board (FASB) established ASC 820 on June 30, 2022. Then, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2022-03Fair Value Measurement (Topic 820) (Source): . It brings structure to fair value measurement. This is crucial for investors, fund managers, and stakeholders. 

Understanding ASC 820 and Its Role in GAAP

ASC 820 is part of a broader accounting framework known as Generally Accepted Accounting Principles (GAAP). GAAP aims to create consistent and transparent reporting standards. 

The Financial Accounting Standards Board (FASB) developed GAAP to promote comparability in financial reporting across industries. ASC 820 plays a specific role in this system. It standardizes the fair value measurement process.

The fair value of an asset or liability is defined in ASC 820. It is the price at which the asset or liability would sell in an orderly deal. This exchange occurs between market participants on the measurement date. In essence, ASC 820 mandates that businesses report the value of their assets to align with observable market conditions. This obligation applies even if those assets aren’t easily traded on public exchanges. 

This standard is particularly important in venture capital and private equity, where many investments lack liquidity and direct price data.

What is Fair Value in ASC 820?

Fair value measurement under ASC 820 centers around the “exit price” concept. This is the price at which an asset can be sold or a liability transferred between willing market participants. This idea is crucial in venture capital and private equity. Valuing certain assets is often complex due to the lack of active trading. 

ASC 820 requires fund managers and investors to estimate fair value as accurately as possible using all available market data. This means that a startup's fair value can be assessed using standardized valuation techniques outlined by ASC 820. This is true whether the startup is just beginning its journey or nearing an exit.

The ASC 820 Fair Value Hierarchy: Levels 1, 2, and 3

ASC 820 introduces a fair value hierarchy. It classifies assets and liabilities based on the liquidity and observability of their pricing inputs. Each level in this hierarchy helps financial professionals decide how straightforward or complex a valuation will be:

The ASC 820 Fair Value Hierarchy: Levels 1, 2, and 3

Level 1 (Most Liquid): Assets and liabilities classified as Level 1 have quoted market prices in active markets. Publicly traded stocks on exchanges like NASDAQ fall into this category due to their high liquidity and easy valuation.

Level 2 (Moderately Liquid): Level 2 assets do not have direct price quotes. Their value is based on observable inputs like similar transactions or market indices. Interest rate swaps and corporate bonds are common examples, where prices are derived from indirect but observable data.

Level 3 (Least Liquid): These are the most complex assets to value. They often need unobservable inputs. This is because there is little or no market data available. Level 3 assets are highly relevant to venture capital and private equity. They include investments in private companies. These also cover early-stage startups and complex derivatives. 

Since market data for these assets is often unavailable, valuations rely on financial models and management’s best estimates.

ASC 820 Valuation Approaches for Level 3 Assets

Level 3 assets are central to venture funds and private equity, as these investments typically lack direct market prices. ASC 820 outlines three main approaches to decide fair value for these complex assets:

ASC 820 Valuation Methods for Level 3 Assets

1. Market Approach

The market approach determines fair value by examining comparable public companies. It also considers recent financing rounds or mergers and acquisitions (M&A) of similar businesses. This approach is ideal when comparable data is available. There are a few sub-techniques within the market approach:

  • Guideline Public Company Method: Here, valuations are based on comparable companies’ financial metrics, like price-to-earnings or EV-to-EBITDA ratios.
  • Guideline Deal Method: This method leverages recent M&A deals for comparable companies, providing a benchmark for enterprise value.
  • Post-Money Valuation Method: This approach is often used in venture capital. It employs the latest funding round to calculate a company's post-money valuation. If significant time has passed, adjustments are often necessary to keep accuracy.

2. Income Approach

The income approach is also known as the discounted cash flow (DCF) method. It estimates a company’s future cash flows and discounts them to their current value. It is most suitable for mature companies with a predictable cash flow. 

The DCF model incorporates assumptions about revenue growth, operating expenses, and future market conditions to project a valuation. While valuable, this method is more applicable to companies with steady cash flow, making it less common for early-stage startups.

3. Asset Approach

The asset approach focuses on a company’s net assets, making it ideal for early-stage startups with limited financial history. This approach examines total assets minus liabilities. It offers a straightforward way to estimate enterprise value based solely on balance sheet data. While simple, the asset approach overlooks intangible factors, like growth potential or brand value.

Each of these techniques requires comprehensive documentation and disclosure of assumptions used to arrive at fair value. This transparency is vital in ASC 820, allowing investors to understand the underlying valuation process and make informed decisions.

ASC 820 Disclosure Requirements

ASC 820 emphasizes transparency by requiring thorough disclosures for each fair value measurement. This includes detailing the assumptions, inputs, and valuation techniques used, particularly for Level 3 assets. 

For example, a venture fund that values a startup using the market approach must reveal comparable public companies. It must also show relevant financial ratios and adjustments. Such disclosures give investors a clear view of the reasoning behind valuations and instill confidence in the fund’s reporting.

ASC 820 requires disclosure of any significant unrealized gains or losses. This is especially true if there have been major changes in valuation from the earlier period. This is also alongside assumptions and inputs. 

These disclosures not only guarantee accountability but also enhance comparability between reporting periods.

Examples of ASC 820 Fair Value Disclosures

Financial reports must reveal the basis and techniques used for fair value measurement to adhere to ASC 820. This is especially important for complex Level 3 assets. Below are examples of how fair value disclosures for each level within the hierarchy, offering insight into different valuation approaches:

Level 1 (Quoted Prices): 

Publicly traded investments, like stocks or bonds, need minimal disclosure beyond the market price at the measurement date. A report will state: “The fair value of publicly traded shares in XYZ Corp depends on the closing price. This price is on NASDAQ.” This is true as of the valuation date.

Level 2 (Observable Inputs): 

For corporate bonds or interest rate swaps, disclosures should include information about observable inputs. These inputs can be interest rates or market indices. For example: “The fair value of ABC bond is derived using the Bloomberg Bond Pricing Service. This valuation is based on similar bonds within the same credit rating and maturity bracket.”

Level 3 (Unobservable Inputs): 

For private equity or venture investments, ASC 820 disclosures become more comprehensive. A typical Level 3 disclosure include data on comparable public companies, assumptions about growth rates, or other key inputs: 

“The fair value of equity in Startup ABC was calculated using the market approach. We referenced recent financing rounds. We also considered comparable company EV-to-EBITDA multiples, adjusting for size and market volatility.”

These disclosure examples guarantee investors are aware of the valuation methodologies used. They also offer transparency about the assumptions and inputs that support those valuations. This is particularly important for Level 3 assets, where reliance on unobservable inputs can make valuations subjective.

Why ASC 820 Matters in Venture Capital and Private Equity

ASC 820 isn’t just an accounting standard—it’s a strategic tool for private equity and venture capital (VC) firms. Precise valuation and disclosure practices under ASC 820 help a range of stakeholders:

  • For Investors: ASC 820-compliant valuations allow investors to make informed decisions. These valuations guarantee they understand the true value of each portfolio company. This is especially critical when portfolio companies span a range of growth stages. Fair value measurement varies based on maturity and exit potential. For related information on business combinations and their fair value implications, see ASC 805.
  • For Fund Managers: Consistent valuations are essential for maintaining trust with limited partners (LPs). By adhering to ASC 820 standards, fund managers show that their valuations align with industry practices. This fosters transparency and accountability in reporting. Furthermore, precise reporting ensures compliance across various standards like ASC 842, which covers lease accounting.
  • For Founders and Startups: Precise ASC 820 valuations aid startups seeking funding or preparing for exit events. Investors and potential buyers can rely on ASC 820-compliant reports. This helps gauge a startup's market value more accurately. It streamlines investment decisions and improves deal efficiency.

Case Study: Applying ASC 820 in Venture Fund Valuations

Consider a venture capital firm that recently invested in a Series B startup with a post-money valuation of $100 million. The startup has a simple cap table, a well-defined revenue model, and anticipates a potential IPO within five years. Here’s how ASC 820 guides this firm’s valuation process:

  1. Choosing the Valuation Method: Given the recent financing, the firm opts for the Market Approach. They reference the startup’s most recent post-money valuation. If needed, they adjust this figure based on market shifts or comparable companies’ financial data.
  2. Applying the Fair Value Hierarchy: The startup’s shares are not publicly traded. Thus, this investment is classified as a Level 3 asset. The valuation team reviews comparable public companies. They also analyze recent M&A transactions in the same industry. This process refines their estimate of the startup’s fair value.
  3. Disclosing Assumptions and Inputs: In their financial report, the VC firm details the assumptions made in the valuation process. They reveal, for example, that "fair value was derived using the backsolve method." This method references the startup’s Series B round. It also applies adjustments based on market volatility and liquidity discounts.

This case study highlights ASC 820’s role. It ensures that fair value measurements are grounded in quantitative data. They are also based on qualitative insights. The required disclosures offer transparency to LPs, making it clear how each assumption influences the final valuation.

How ASC 820 Handles Fair Value Impairments

Valuation isn’t just about measuring gains. ASC 820 also addresses fair value impairments. It ensures valuations are adjusted in response to negative financial developments. 

When market conditions deteriorate, ASC 820 allows fund managers to mark down the value of a portfolio company. This often happens when a company faces significant challenges. The value is often reduced to a conservative baseline, like zero.

This conservative approach is common when a startup’s financial future becomes uncertain. For example, a VC firm will reduce its fair value if a portfolio company is at risk of liquidation. They will also do this in case of significant loss. This adjustment reflects the asset’s reduced liquidity and marketability. 

By adjusting valuations through ASC 820-compliant disclosures, firms can offer a realistic view of their portfolio’s current state. This helps to protect investors' interests. It also maintains the accuracy of their reports.

Allocating ASC 820 Fair Value Across Share Classes

Once the fair value of an investment is established, ASC 820 provides guidance. It explains how to distribute that value across multiple share classes. These include common stock and preferred shares. In venture capital, share classes often differ in rights, privileges, and liquidation preferences, complicating the allocation process. ASC 820 offers four distinct allocation approaches:

Allocating ASC 820 Fair Value Across Share Classes
  1. Common Stock Equivalent: This method treats all shares as if they were common stock, ignoring liquidation preferences. It’s a straightforward allocation method commonly used when relying on post-money valuations.
  2. Waterfall Method: This method is designed for complex cap tables. It allocates value according to each share class’s rights and privileges. This makes it ideal for firms nearing an exit event or acquisition.
  3. Option Pricing Model (OPM): The OPM considers each share class as a call option on the company’s equity. It accounts for volatility and market conditions. It’s best suited for early-stage companies without a clear exit timeline.
  4. Probability-Weighted Expected Return Method (PWERM): This method weighs potential future outcomes. It allocates value based on the probability of each exit scenario. PWERM is useful for firms with distinct exit plans or anticipated liquidity events soon.

The choice of allocation way varies based on the fund’s portfolio, stage of investment, and expectations for exit. In early-stage venture capital, the Common Stock Equivalent approach is often preferred for its simplicity. As companies progress, their cap tables grow more complex. Other ways like Waterfall or OPM are more appropriate.

Summary

ASC 820 is more than just a standard. It is a vital benchmark for transparency in venture capital and private equity reporting. ASC 820 guides fund managers and investors through fair value measurement. It ensures that valuations are precise. Valuations are aligned with the market, even for illiquid Level 3 assets. This transparency strengthens relationships with LPs, fostering investor confidence and setting up venture funds for long-term success. To learn more about ASC standards and fair value measurement, visit NJCPA USA’s Accounting Standards Codification. Here, you can explore a full range of ASC topics.