While private equity and venture firms have long been required to provide periodic fair value measurements to their investors, the investments made by corporate venture arms largely have been excluded from such requirements. However, an accounting standards update that took effect at the end of 2017 could cause big changes for corporate investors. The following is an excerpt from our recently published whitepaper that addresses the rise of corporate venture capital and the implications of this accounting update on corporate investment reporting.
Corporate venture capital has increased as an investment activity for large corporations in recent years. By one count, the top ten corporate venture capital groups made 1,640 investments between 2010 and 2016.
Intel Capital, the most active corporate venture capital investor over the past six years, made investments in 34 new companies totaling $455 million in 2016 alone.
With corporate venture capital activity on the rise, a keen eye is being turned to public company reporting of equity holdings, as well. Valuations of VC-backed startups have grown rapidly in recent years, making many early venture investments worth well in excess of original cost. For example, Google Ventures (GV) invested in AirBnB in late 2010 at a valuation of $71.8 million. In March 2017, less than seven years later, AirBnB completed a $448 million financing round at a reported valuation of $29.3 billion, an increase in postmoney value of more than 400x since the 2010 investment. [Source: VC Experts]
Yet, many corporate balance sheets carry minority investments at cost – the value originally paid for the interest. Current U.S. GAAP does not require disclosure of the gains (and occasional losses) attributable to minority investments held at cost. While the incumbent accounting methodologies provide some information about deterioration in investment value, large valuation increases remain largely hidden from view. Unlike an asset for which replacement cost similar to the original outlay may be a reasonable estimate of worth, the value of investments in fledgling investee startups can change dramatically as these companies develop into successful businesses. With startups remaining private longer in the absence of exit events like IPOs, rising valuations of the underlying companies can diverge significantly from the cost basis of early investments.
ASU 2016-01 seeks to provide more transparency and relevance to financial statement users, as well as decrease the complexity of equity investment impairment testing for financial statement preparers. The guidance applies to all equity investments that are not consolidated with the investor or accounted for under the equity method.1 That is, investments that represent less than 20% ownership or for which the owner lacks influence over investee operations. While the update has applications to both financial assets and financial liabilities, in this whitepaper we focus on the former, specifically minority equity interests. The update divides these investments into securities with readily determinable fair values and those without readily determinable fair values. Under current GAAP, unconsolidated equity investments are accounted for using either the cost or equity method. Investments with a readily determinable fair value (such as a share of public company stock) will be carried at fair value.
For equity investments without a readily determinable fair value, entities can choose to apply a new Measurement Alternative. “An entity may elect to measure an equity security without a readily determinable fair value [and that does not qualify for the ASC 820 practical expedient2 ] at its cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer.”3 Elections to measure a security using this guidance may be made on an investment-by-investment basis. However, once an entity elects to measure an equity security using the Measurement Alternatively, it should be applied consistently unless the alternative is no longer permitted.
Observable price changes mean those resulting from orderly transactions, including those that are known or can reasonably be known at the date of measurement. However, it is important to note that the transactions must involve identical or similar investments from the same issuer. Determining the similarity of a new security issuance to one held by the reporting company should take into consideration the specific rights and obligations of the issuance, such as voting rights, distribution rights and preferences, and conversion features.
While simplifying the process of determining changes (both upward and downward) to the reported value of equity investments, the Measurement Alternative does not eliminate the need to test for impairment. However, it does allow for the use of a single-step qualitative assessment at each reporting period. Qualitative indications of impairment include, but are not limited to, the following.
A significant deterioration in the earnings performance, credit rating, asset quality, or business prospects of the investee.
A significant adverse change in the regulatory, economic, or technological environment of the investee.
A significant adverse change in the general market condition of either the geographical area or the industry in which the investee operates.
A bona fide offer to purchase, an offer by the investee to sell, or a completed auction process for the same or similar investment for an amount less than the carrying amount of that investment.
Factors that raise significant concerns about the investee’s ability to continue as a going concern, such as negative cash flows from operations, working capital deficiencies, or noncompliance with statutory capital requirements or debt covenants.
If a qualitative impairment is identified, the reporting entity should estimate the fair value of the investment and recognize an impairment loss equal to the difference between the carrying amount of the investment and its fair value.
Although the intended result of ASU 2016-01 is to increase the scope of decision-useful information reported on corporate balance sheets, it also has the potential to complicate reporting for entities with investments in venture-backed startups. Re-measuring fair value of ownership interests in companies that have become significantly more valuable since the reporting entity’s initial investment could result in higher volatility of reported income (from non-core business sources). Beginning in their quarterly 2017 filings, a few major corporate investors – including Google, Salesforce, and Cisco – acknowledged an increase in income and expense volatility is expected as a result of this transition.
The portion of the investment landscape inhabited by corporate venture players continues to increase. Industry participants have begun adapting to the resulting changes of corporate participation. Both founders and investors will likely keep close watch as industry changes continue to unfurl and as corporate VCs begin to adopt these new requirements.