Insights for Private Equity & Venture Capital Firms
Did you know that private fund advisers account for 20% of the US Securities and Exchange Commission (“SEC”) examinations annually, with valuation practices being a top area of focus?
In recent years, the SEC has increased its oversight of private equity and venture capital firms, often targeting issues in portfolio valuations, disclosures, and fee calculations. Portfolio valuations are more than just a compliance exercise, they’re a cornerstone of investor trust and strategic decision-making. Yet, in the fast-paced world of private equity and venture capital (“PE/VC”), even the most sophisticated firms can fall into common valuation pitfalls. These mistakes not only attract regulatory scrutiny but can also erode investor confidence and lead to costly missteps.
Indeed, most companies were affected by the pandemic, and we often hear that we are finally emerging from the hangover of Covid, the infamous “Covid dip”, and all the resulting Covid-adjustments. Thankfully, it seems we can once again evaluate companies based on their actual results and outlook.
With nearly 15 years in valuations—including 12 years at EY, where Hitesh Nathani performed hundreds of portfolio valuations, and now leading the valuation practice at CriticalPoint—he has seen these challenges firsthand. In this article, Hitesh breaks down the top mistakes PE/VC firms make in portfolio valuations and shares actionable insights to avoid them.
1. Misplaced Ownership of the Valuation Process
Pitfall: Letting deal teams handle valuations.
When deal teams juggle valuations alongside transactions, accuracy and timeliness often suffer. CFOs struggle to get updates, and auditors end up in an endless back-and-forth cycle.
Solution:
- Build a dedicated valuation team or partner with experienced third-party providers
- Standardize processes and implement robust financial controls
Pro Tip: Best-in-class firms strike a balance between in-house expertise and outsourcing for specialized valuations.
2. The Cost Trap
Pitfall: Leaving investments at cost for too long.
Holding investments at cost might feel “conservative,” but it violates fair value requirements. Ignoring market conditions (e.g., declining or improving multiples) can lead to both overvaluation and undervaluation, creating regulatory red flags and misaligned strategic decisions.
Solution:
- Regularly recalibrate valuations using income, market, and cost approaches
- Factor in secondary transactions and backtest against initial investments
- Monitor both upside and downside scenarios to ensure valuations reflect true fair value
Watch Out: Delayed write-downs for underperformers can attract auditor scrutiny—or worse, SEC attention. Similarly, failing to recognize appreciation in value can lead to missed opportunities, misinformed decision-making, and non-compliance with fair value standards.
3. The Post-Money Illusion and Hybrid Method Pitfalls
Pitfall: Over-relying on post-money valuations and misapplying the hybrid method.
Post-money valuations ignore preferential rights (e.g., liquidation preferences), overstating common equity value. This assumption only holds if an Initial Public Offering (“IPO”) is certain. Similarly, allocating post-money valuations using an Option Pricing Model (“OPM”) will misstate fair value.
Solution:
- Use hybrid method or Probability-Weighted Expected Return Method (PWERM) to account for multiple exit scenarios
- Allocate post-money equity value pro-rata for IPO scenarios
- For non-IPO scenarios, use weighted average enterprise valuations (from Discounted Cash Flow method (“DCF”), Guideline Public Company method (“GCM, Similar Transactions Method (“STM”)) to reflect realistic outcomes and then allocate the equity value using an OPM
Key Insight: Post-money valuations and OPM frameworks are powerful tools, but they must be applied with care. Ignoring preferential rights or failing to account for multiple exit scenarios can lead to significant misstatements in fair value.
4. Guideline Multiples Gone Wrong
Pitfall: Blindly using median multiples.
Median multiples are convenient but often irrelevant if they don’t reflect the subject company’s size, growth, or profitability. Similarly, using only one or two guideline companies limits representativeness and can skew valuations.
Solution:
- Compare the subject company’s attributes to 5-7 guideline companies
- Ensure the multiple reflects the subject company’s size, growth, and profitability. For example, if the subject company falls in the first quartile of guideline companies, use the first quartile multiple instead of the median
- Broaden the criteria to include a sufficient number of guideline companies to better reflect market conditions
5. Discounts and Premiums: Handle with Care
Pitfall: Arbitrary adjustments for control or minority interests.
Applying discounts or premiums without calibration leads to inconsistencies and auditor pushback.
Solution:
- Embed control or minority differences in the valuation model via calibration
- Avoid separate adjustments unless explicitly justified by market participant assumptions
Pro Tip: Calibration ensures valuations align with prior transactions and reflect realistic investor expectations.
The Bottom Line
Portfolio valuations are more than a compliance exercise, they’re a cornerstone of investor trust and strategic decision-making. By avoiding these pitfalls and adopting best practices, PE/VC firms can deliver defensible, accurate valuations that stand up to scrutiny.
At CriticalPoint, we combine deep technical expertise with a tailored approach to help PE/VC firms navigate the complexities of portfolio valuations. Our proprietary tools and methodologies ensure defensible, audit-ready valuations that align with both regulatory requirements and investor expectations.
We are passionate about helping private equity and venture capital firms navigate the complexities of portfolio valuations. If you’ve faced challenges with valuations or want to discuss how CriticalPoint can support your firm, please contact us.
About CriticalPoint
Headquartered in Los Angeles, CriticalPoint is a leading full-service financial M&A firm that uniquely combines the best of investment banking, private capital, and valuation service offerings. CriticalPoint executes, sources, and invests in deals across a wide variety of industries for the traditionally underserved middle market. Since our founding in 2012, our mission has been to serve the needs of owners, entrepreneurs, management teams, and stakeholders with our experience, knowledge, and expert judgment, to help them realize their companies’ greatest potential. From our deep-rooted foundation in private equity and investment banking, and our devotion to deal origination and business development, combined with being entrepreneurs at heart, we believe we are differentiated and well positioned to help companies wherever they are in their life cycle.
