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Navigating Investment Risks: An Analytical Approach to Impairment Considerations in Equity Investments

Navigating Investment Risk In Equity Investments
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In the intricate field of venture investing, managing portfolio performance with accurate financial reporting requires constant vigilance. However, amid the complexity, a pragmatic, trigger-based system can offer fund managers an efficient strategy to identify investments requiring immediate attention. 

The goal is to create a simple method that pinpoints the investments needing additional focus (such as valuation performed by third-party appraisers) within a pool of equity investments such as those held by Corporate Venture Groups, Private Equity Firms, and Venture Capital Funds.

Before diving into the specific indicators, it’s important to understand the context of a similar test, the goodwill impairment test. Qualitative pre-tests for reporting units, often referred to as step 0, are largely descriptive in nature yet incorporate quantitative considerations that offer a view of the potential risk of goodwill impairment. 

Assessments often include a review of the following: 

      • changes in the overall market, industry, legal, or macroeconomic environment (such as declines in multiples)

      • financial results (such as misses against budgets)

      • III)changes in discount rates or overall forecast risk (e.g. increases in cost of capital)

      • IV)operational performance reviews (including missed milestones or loss of key personnel), and’

      • strategic changes (e.g. changes to the business model or significant pricing alterations)

    However, these qualitative considerations, while valuable, often involve a degree of judgment and interpretation, making the decision to perform a full quantitative test somewhat difficult. 

    For example, we could still ask questions such as: 

    How big was the financial miss against budgets? 

    How much has the forecast changed in light of these strategic changes? 

    Can the business continue to operate at capacity given the loss of a CTO? 

    These are all questions that may still remain open even after the reviewed considerations are documented. 

    In parallel, and to decrease judgment in the investment impairment space, the following three impairment indicator suggestions aim to be more quantitative in nature, providing concrete data to assess the financial health of an investment. 

    By focusing on these specific, measurable elements, the level of subjectivity in identifying risky investments is reduced, enabling the right level of analysis to be performed on an investment.

    Indicator 1: Missing Revenue or Profit Targets 

    When small companies miss their financial performance targets, it signals a significant impact on their value. Let’s consider the example of a B2B SaaS startup that projected an ambitious revenue target for the next fiscal year based on the expected success of its flagship software. 

    If the startup falls short of this revenue target by a significant amount (e.g., 30%, given the often-ambitious nature of startup forecasts), it becomes crucial to delve into the reasons behind this. The shortfall could be due to lower-than-expected sales team efficacy, issues with bugs or other software delivery, or challenges in scaling production or brand awareness. 

    A substantial miss indicates a significant misalignment between the management’s expectations and actual performance, which necessitates immediate scrutiny of potential impairment considerations. If the qualitative elements support long-term issues, an impairment test is likely needed.

    Remember, an investor usually invests considering the forecast provided, which informs value. Failing to meet the projection can be a bad sign and trigger an impairment. Thus, choose a target that would make your team uncomfortable [e.g., -(40%)], and use it as a trigger for full valuation if the investment fails to meet it.

    Indicator 2: Disparity in Growth Trends 

    Growth rate analysis provides critical insights into the health of venture investments. If an investment’s growth is lagging the industry norm or its competitors, it may signal a problem. 

    For instance, suppose you have a fintech investment that has been growing at a rate of 10%, while the overall fintech market is expanding at a more robust 30%. This divergence prompts critical questions: Is the company not keeping pace with innovations in the industry? Is it facing stronger competitive headwinds? Or is it struggling to scale its operations? 

    Understanding the cause of the disparity can provide valuable context for potential re-evaluation of its value.

    In bull markets, an investment’s value may increase solely because multiples are going up in the market. However, in bear markets, the opposite may be true. Slow growth paired with negative industry trends may signal an increased risk of impairment. 

    By setting a target (e.g., 20%) and comparing the addition of revenue growth plus the industry’s market cap growth (I.e. LTM revenue growth + growth in guideline company equity value) you can identify value declines. Multiple compression happens when industry value declines for a given level of actual/expected growth. 

    However, value also declines when revenue takes a dive even when multiples remain flat. 

    With this assessment, you can create an additional trigger for further testing by capturing changes in multiples and changes in growth in a single factor, using the concept thatRevenue * Multiple = Value. 

    Indicator 3: Going-Concern Considerations 

    The going-concern evaluation is a critical determinant of a company’s future, especially when funding is critical (such as in Venture Investments or highly levered PE investments). If a company’s runway – the length of time during which a company will remain solvent without additional funding – is less than X months (e.g., 9), it can trigger significant concerns about its survival. 

    Suppose a company that heavily relies on investor funding for research & development suddenly finds itself with a funding gap. With less than nine months of cash runway and no clear funding strategy, the company may face difficulties maintaining operations. This increases the risk of impairment, making the investment a candidate for scrutiny. 

    We can turn this into a test by selecting a level of cash runway we feel comfortable with, and determining whether the investment meets the criteria. Companies can also decide if the ability to raise funding should hold weight, as optimism is often high in this space.

    Thus, the trigger should only be voided if, for example, there is a term sheet in place or advanced discussions with a lead investor are active. Given that cash concerns increase risk, value is likely to decline the closer to a possible solvency issue we are.

    Additional Indicators 

    Other tests to consider include assessing industry metrics that create red flags. 

    Some of these may include:

        • declines in monthly active users, site visits, or average revenue per user

        • changes in key management (such as in the C-suite, sales, or engineering personnel), and 

        • III)major changes in strategy, product, or monetization model. 

      Said simply, you are looking for simple ways to create triggers that could impact an investment’s value and would make an auditor uncomfortable without further analysis. 

      Final Thoughts 

      It is worth doubling down on the idea that quantitative indicators are instrumental in identifying potential risks, but understanding that qualitative factors heavily influence the valuation of investments. 

      Changes in the company’s leadership, legal or regulatory challenges, alterations in the competitive landscape, and alignment with the investing firm’s portfolio strategy can all have a substantial impact on value. For example, a health tech company facing regulatory barriers could experience delays in product approvals, negatively affecting its cash flows and growth prospects. 

      Losing a founder / chief sales officer could mean a difficult situation for an early-stage startup. Thus, it is always important to allow qualitative factors to be triggers themselves. Setting up simple tests for large portfolios is a way to simplify the testing selection process, even if it is through binary tests.

      Lastly, it is crucial to recognize that positive performance should also trigger adjustments in valuation. If an investment significantly outperforms its projected performance, leaving it marked at cost would misrepresent its value. 

      The guiding principle for equity investment reporting is fair value. Robust performance is an opportunity for a valuation increase, reflecting the positive change in value in your books.

      In conclusion, a comprehensive understanding of these impairment considerations paired with a trigger-based assessment approach enables fund managers to make informed decisions about their portfolio valuation needs. 

      While these indicators do not replace comprehensive analysis, they serve as initial red flags to identify investments that merit a more detailed examination. By concentrating on these tests, auditors and fund managers can collaboratively safeguard the fund’s value and ensure robust reporting standards. 

      This analytical strategy empowers fund managers and auditors to better navigate the complexities of venture investing and optimize valuation considerations.

       

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