Venture capital valuation methods vs. IDW S1 – What is appropriate in the current environment?

published on 17 July 2024 | reading time approx. 3 minutes

The valuation of start-ups is regularly based on the International Private Equity and Venture Capital Valuation Guidelines (IPEV) and usually relies on market-oriented valuation methods in the form of new financing rounds or multiplier methods. Due to current developments and the global turnaround in interest rates, the number of financing rounds and other transactions in the start-up environment has decreased significantly, meaning that fewer prices actually observed in the market can be used to value funds and their fund reporting.

The IPEV guidelines will continue to be applied for the purposes of fund reporting to investors. However, other stakeholders are increasingly questioning whether more traditional valuation methods, such as the IDW S1 regulations, are more appropriate at the present time.

Venture capital valuation methods

Many venture capital funds invest primarily in companies in the start-up and growth phase. Once an investment has been made, the value of the fund's individual investments must generally be reported to its investors on a quarterly or at least annual basis. For many start-ups, this form of equity financing is usually the only source of financing. Established start-ups, on the other hand, also regularly raise debt capital from financing banks to avoid further dilution of their ownership structure through financing rounds. In addition to investors, financing banks are therefore also interested in the (value) development of any start-ups as part of their internal risk management.

Valuing start-ups faces a number of challenges, especially in the early stages of a company’s life. Traditional valuation methods, such as the discounted cash flow method, are primarily suited for established companies. Due to the lack of or hardly any meaningful historical data and the limited accounting and planning systems of start-ups, it is often very difficult to derive future developments from the past.

For this reason, the IPEV have established themselves as a uniform industry standard for fund reporting, which is also regularly sent to financing banks for documentation purposes. These guidelines provide a best practice approach for the valuation of early stage and later stage start-ups as part of an investment accounted for at fair value. As a result, the valuation guidelines are closely aligned with market values actually observable in the marketplace and are similar to the hierarchy of IFRS 13. Accordingly, new financing rounds represent a high degree of validity for an external market value. The entry of new investors as part of financing rounds results in an implicit valuation of the respective investment. The fund can then reassess the value of its investment and include a corresponding increase/decrease in value in its fund reporting to investors. The use of multiples, which can be derived from the market values of other comparable companies and can be used to approximate the value of the investment. This is less valid but is another market-oriented method. Discounted cash flow methods, as earnings value-oriented methods, are used less frequently and are considered to be more of a plausibility check for a fair value determined using market-oriented methods.

Concerns about market-oriented valuation methods

The global turnaround in interest rates has significantly reduced the number of financing rounds and other transactions in the start-up environment, meaning that fewer prices actually observed in the market can be used to value funds and their fund reporting. Due to the lack of financing rounds or potential exits, there is a lack of implicit valuations of specific investments and many funds resort to multiples, the methodology of which is naturally subject to corresponding uncertainties.

For the purposes of fund reporting to investors, this is still appropriate under the IPEVs. However, in cases where banks are involved in the financing of a start-up (usually only in the later stages), doubts have recently arisen as to whether this approach is still sufficient for the bank's internal risk management or whether alternative paths should be taken.

Auditing firms are increasingly being asked to prepare a company valuation of the more established start-ups in accordance with the IDW S1 standard of the Institute of Public Auditors in Germany (IDW) for the purposes of banks' internal risk management, as they no longer fully trust the market-oriented valuation methods due to the limited availability of current transaction data.

Valuation according to IDW S1 depending on purpose and addressee

The discounted earnings method and the discounted cash flow method are the preferred methods for a valuation in accordance with IDW S1. Both methods are based on the conceptual foundation of the net present value calculation and lead to the same results with the same assumptions. The capitalized earnings value method and the discounted cash flow method are based on the determination of future financial surpluses, which are to be discounted using a risk-adjusted capitalization interest rate.

According to IDW S1, a further method should be used to check plausibility. This may include simplified pricing methods such as the multiplier method, which are then used to check the plausibility of the results of the discounted cash flow method. However, they cannot replace a business valuation.

The validation of the calculated values using other valuation methods is also recommended in the IPEVs.

Finally, depending on the purpose of the valuation, a decision must be made as to which valuation method should be used for the purpose of the valuation (fund reporting, risk management documentation, exit, compensation, etc.).