Price of Previous Transaction Method

The most convincing evidence of what an unlisted share is worth is what someone recently paid for it. The price of previous transaction method uses exactly that.

It is the first of the seven "most widely used" methods the IPEV Guidelines identify for valuing a portfolio company. The workbook states it in two sentences: when the AIF makes a follow-on investment in a company, the pricing of that investment "becomes the implied market value of the company which can be applied to the entire investment". For the first investment, however, the holding "needs to be carried at cost at that time and revised thereafter, based on pricing of follow-on investments".

The appeal is objectivity. The workbook notes that fair value estimates based entirely on observable market data are deemed less subjective than those based on assumptions made by the valuer.

Where it fits. The IPEV Guidelines' central theme is that fair value is the best measure for valuing private equity portfolio companies. Fair value is recognised internationally as the arm's length price between a willing buyer and seller who are not connected; Ind AS 113 defines it as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date". The seven IPEV methods are:

1. Price of previous transaction
2. Early-stage companies — milestone approach, scenario analysis, option pricing method
3. Multiples approach
4. Net asset valuation
5. Discounted cash flow
6. Valuation of debt investments
7. Industry metrics

The mechanics.

• At the first investment: carry at cost.
• On a follow-on: apply the follow-on price to all the shares held, not only to the new tranche.
• Between follow-ons: the valuer still has to consider whether the price remains appropriate, because the workbook lists five other contributors to change in value — the external environment and market variables, the company's business performance, the tax environment, changes in capital structure, and changes in valuation methodology.

The regulatory frame. Category I and II AIFs must value their investments at least once every six months by an independent valuer, extendable to one year with the approval of at least 75% of investors by value. A change of methodology within the prescribed guidelines is not a material change, but valuations on both the old and new methodologies must be disclosed to investors.

Illustrative figures. Ganga Ventures I, a Category I AIF, buys 6,00,000 shares of a Jaipur agri-tech start-up at Rs 250 each — Rs 15 crore.

At the next half-yearly valuation there has been no new round. The holding is carried at cost: Rs 15 crore.

Eighteen months later, the company raises a Series B and the fund takes a follow-on of 2,00,000 shares at Rs 400 — Rs 8 crore.

Shares held          = 6,00,000 + 2,00,000 = 8,00,000
Implied price        = Rs 400 (from the follow-on)
Value of holding     = 8,00,000 × 400      = Rs 32 crore
Total cost           = 15 + 8              = Rs 23 crore
Unrealised gain      =                       Rs 9 crore

The Rs 400 is applied to the entire investment, including the first 6,00,000 shares bought at Rs 250.

Now the unhappy version. The Series B instead comes in at Rs 180 — a down round, a financing round at a valuation below the previous one. The fund takes the same 2,00,000 shares for Rs 3.6 crore. Its 8,00,000 shares are now marked at 8,00,000 × 180 = Rs 14.4 crore against a cost of Rs 18.6 crore. The previous-transaction method brings bad news onto the books as promptly as good news.

Chapter 11 (Valuation) lists the seven IPEV methods at 11.8.1, with the price of previous transaction first, and places them within the valuation regulations at 11.10 and the role of valuers at 11.11. Expect a question on how a first investment is carried (at cost) and on what happens to the whole holding when a follow-on is priced, alongside questions on the six-monthly independent valuation requirement.

• The first investment is carried at cost, not at a marked-up value, until a follow-on prices it.
• The follow-on price is applied to the entire investment, not only to the new shares.
• It is an IPEV method, not a SEBI-prescribed method. SEBI prescribes the valuation frequency and the independent valuer; the IPEV Guidelines describe the techniques.
• Six months, independent valuer, extendable to one year with 75% of investors by value — not two-thirds.
• A change in valuation methodology is not a material change, but both valuations must be disclosed.
• A down round lowers the mark on the whole holding just as an up round raises it.