Explained: Why SEBI wants VC funds to explain startup valuation methodology

Venture capital and even private equity funds looking to invest in startups could face greater scrutiny in coming times. 

India’s market regulator is reportedly taking a close look at how venture capital and private equity firms value the startups and unicorns they back. 

The Securities and Exchange Board of India (SEBI), in a communication on September 6, asked a large number of funds to disclose their valuation practices and share details like the qualification of the valuer, whether the valuer hired is an associate of the fund or its manager or sponsor, and if there was a significant change in the valuation methodology in the past three years among other things. 

SEBI's move was perhaps driven by complaints from investors and recent reports of opaque accounting of a few unicorns, The Economic Times reported.

But why is propped-up valuation an issue of concern for SEBI?

A propped-up valuation gives a rosy picture of the portfolio to a fund's investors and paves the way for the fund manager to attract more money from new as well as old investors when it goes for the next round of fund-raising.

So, what does SEBI want?

The market regulator wants to understand the credibility of the valuation exercise carried out by these venture capital and private equity funds. 

Could this SEBI enquiry lead to more?

Possibly yes. The ET report says that this may be a precursor to forthcoming valuation policies, enhanced disclosures norms etc. which SEBI may prescribe for the alternative investment fund (AIF) industry to achieve consistency in the way valuations are carried out and increase transparency in the investor interest.

Most AIFs--the regulatory parlance for PE and VCFs--are close-ended funds having large exposure to unlisted stocks. While open ended funds have to publish every month the net asset value (NAV), which is the market value of the securities held by the fund or the scheme, close-ended funds may announce the NAV twice a year, or even annually if investors agree.

Though closely-held companies and unlisted securities are outside its purview, SEBI regulates pooled vehicles like PE, VC, mutual funds and portfolio management schemes.

So, what details has SEBI sought?

According to the SEBI directive, the funds have to also share the following information--the date of latest valuation, cost of cumulative investments made, latest valuation of investment portfolio, whether the valuation exercise is based on audited or unaudited data of the investee companies, whether the valuation is done by an independent or internal valuer, if additional valuation exercise was carried out during a financial year, details of valuation methodology and if there were any deviations.

Under the waterfall mechanism, cash generated from sale of stocks and dividend paid out by investee companies first goes to investors in the fund with fund managers receiving their 'carry' only if the fund performance crosses the hurdle or the preferred rate of return. For instance, if the hurdle rate is 14% and a fund records a return of 18%, then the extra 4% (above the hurdle) is shared between fund investors and the fund manager in the ratio of 80:20.