5.1 PREFACE
In its effort to provide guidance for organizing and unifying the performance measurement for its members, AVCA has combined and adapted the valuation guidelines and disclosure of Venture Capital and Private Equity Portfolios, from both the Southern Africa Venture Capital Association (SAVCA), which are based on the British Venture Capital Association (BVCA) guidelines, and the European Venture Capital Association EVCA) guidelines.

Principals of valuation, guidelines for valuing quoted companies, the examples of companies' valuations and the disclosure section, were based on the EVCA guidelines, while the valuation of unquoted companies section was based on those of SAVCA/BVCA.

These guidelines are subject to amendment if and when the need arises. Amendments to these guidelines will be disclosed and released on the AVCA website, in future editions of the Directory, and will be referred to in our quarterly newsletter. Members are advised to adhere to these guidelines, and in case different guidelines or methods are currently being applied by a member firm, it is recommended to highlight the variations to these guidelines in the firm's reporting.

Members are invited to comment on these guidelines and these comments will be considered in future releases.Please note that where the guidelines refer to 'venture capital' this should be read to include "private equity' as well.

5.2 AVCA Valuation Principles
Above all, two overriding principles should be employed when valuing investments:
. that the valuation should be prudent and applied consistently and professionally; and

. that the method, data and process used in coming to the valuation should be clearly disclosed (see below for more detail).

Furthermore, the following principles should be adopted in the valuation of all investments:

5.2.1 The basis of valuation should be consistent from year to year. Any changes in method used should be clearly stated, as should the effect of those changes.

5.2.2 A party, independent of the fund managers should review valuations (note - there is no suggestion that an independent body should set, formulate or approve the valuations, only, that the completed valuations should be explained to an independent body which should be able to give its comments).

It is recommended that the appropriate body to review the valuations is the fund's Advisory Committee, possibly to include the fund's auditor and/or recognised representatives of business having no direct relationship with the fund's managers, investors or investments.

Managers should ensure that no responsibility or liability is conferred on the body in performing this task.

5.2.3 All valuations should be calculated to account for the dilution resulting from the exercise of ratchets, options or other incentive schemes.

5.2.4 All quasi-equity investments should be valued as equity unless their realisable value can be demonstrated to be other than the equity value.

5.2.5 Valuations should be produced at least twice a year and audited once.

5.2.6 Valuations should take account of the effect of the difference between the currency of the investment and the currency of the fund, using the exchange rate applicable on the last day of trading of the relevant period.

5.3 VALUATION GUIDELINES
AVCA recommends that all members comply with these guidelines when reporting to their sources of finance, and state that compliance. Any areas where members depart from these guidelines should be highlighted.

5.3.1 Overriding Principle
The fundamental principle, which should underlie all valuations of venture capital investments, is to show a fair valuation of the investment to the investor. Prudence is a central concept in valuation; however, the valuer should beware not only of unwarranted optimism in valuations, but also of excessive caution.

For the sake of these guidelines investments have been divided into two categories:
•  Quoted investments, being investments where the principal security is traded on a recognized exchange or where regular third party dealings in those securities take place; and
•  Unquoted investments, which are all other investments.

A) Quoted Investments
Quoted investments should be valued on the basis of their quoted mid-market price on the last day of trading in the valuation period, to which each of the following discounts should be applied (if applicable):

1. for quoted investments which are not subject to a restriction on their sale, the level of discount is recommended to be between 10 and 20% and should be fixed by the manager and applied to all such quoted investments on a consistent basis. However, if the number of shares held is small relative to the quarterly trading volumes (i.e. less than 10%), then the discount may be reduced or removed altogether;

2. for quoted investments which are subject to a restriction or lock-up, a minimum discount of 25% should be applied, increasing if the lock-up is significant;

3. whether or not the investment is subject to a sale restriction, where the number of shares held is high in relation to the quarterly trading volumes (i.e. greater than 30%), an additional discount of 5 to 10% should be applied.

B) Unquoted Investments

1. Early Stage Investments
All early stage investments should be valued at cost, less any provision considered necessary, until they cease to be viewed as early stage. The only exception to this principle is where a significant transaction involving an independent third party at arms-length values the investment at a materially different value. In these circumstances the guidelines set out in 2.2 "Development Stage Investments - Third Party Basis" section should be followed.

A provision should be considered if the performance of the investment is significantly below the expectations on which the investment was based, leading to a diminution in value. Prima facie indicators of under-performance include the failure to meet significant milestones, to service equity or debt instruments, and breaches of covenants.

Provisions should be made as a percentage of cost in bands of 25% as the valuer thinks fit. The same level of provision need not be made against each of the instruments in any one investment. For example it might be considered appropriate to provide a greater percentage against the equity element than against a secured loan.

2. Development Stage Investments
All development stage investments should be valued according to one of the bases set out below:

•  Cost (less any provision required)

•  Third party valuation

•  Earnings multiple

•  Net assets

It is a matter of judgment and circumstances as to which of the above bases is the most appropriate for any investment. As a general rule, material arms-length third party valuations (other than by corporate investors) are prima facie evidence of fair valuation and should take precedence over other methods until the circumstances change (eg. an increase/decrease in the level of profitability). Furthermore, once it has been concluded that the cost basis no longer provides reliable evidence of value, it should rarely be used again.

2.1 Development Stage Investments - Cost Basis
Development stage investments should generally be valued at cost for at least one year unless this basis of valuation is unsustainable.

A provision should be considered if the performance of the investment is significantly below the expectations on which the investment was based, leading to a diminution in value.

Prima facie indicators of under-performance include material divergence from those expectations, the failure to service equity or debt instruments, and breaches of covenants. Provisions should be made on the same basis as is detailed above.

2.2 Development Stage Investments - Third Party Basis
A change of valuation may be justified by reference to the price at which a subsequent issue of capital is made, or at which a transaction for cash in the relevant security takes place. This basis of valuation should only be used when the transaction involves a significant investment by a new investor.

Some investors may have strategic reasons for investing which might lead to a valuation which would be inappropriate for the venture capital investor. Therefore, particular care should be taken to consider the motives of the third party and whether this method should be used.

2.3 Development Stage Investments - Earnings Basis
An earnings basis is likely to be the most common basis for valuing investments above cost (or supporting their valuation at cost). It is not recommended that this basis be used until at least a year has elapsed since the investment was made. There are a number of different methods of applying this concept which can lead to significantly different results for a given investment.

Therefore when using this basis the valuer should have particular regard to the overriding principle set above.

The suggested method for this basis of valuation is to apply a discounted Price/Earnings multiple ("P/E") to the investment's Earnings from which corporation tax has been deducted, normally at the full rate. It is a matter for the valuer's judgment, based on the circumstances of the individual investment, whether the Earnings used should be taken before or after interest. Particular care should be taken in making this assessment where there is a high level of gearing which makes the valuation sensitive to changes in interest rates. The Earnings used to arrive at the valuation will normally be taken from the audited accounts most recently completed.

If, however, Earnings in the current period are likely to be lower than in the previous period, these Earnings should be used as the basis for valuation. Equally, if the current period can be predicted with reasonable certainty to produce significantly higher Earnings and these are maintainable, these may also be used as the basis for valuation, bearing in mind the overriding principal to avoid excessive caution. Having determined the appropriate Earnings to be used as the basis of valuation, in those circumstances where a company's trading results have been affected by acquisitions and exceptional items, appropriate adjustments may need to be made.

The most suitable starting point for an appropriate P/E is that of a quoted company or companies, comparable both in business activities and where possible in magnitude of sales and profits. If such companies are not available, the specific sub-sector of the stock exchange Actuaries Share Indices may be used; however, whichever multiple is used it should be applied with considerable care as there are occasions when the holding being valued might command a lower rating than the comparable quoted company or companies.

The reason for discounting quoted company P/Es is, inter alia, to recognise the illiquidity and risk of unquoted investments and the approximate nature of a valuation based on Earnings. The discount may be applied either to the P/E or to the value of the equity holding. Clearly, the level of discount is highly judgmental and will depend on the particular circumstances of each investment. However, the minimum discount should be 25% unless there is a strong possibility of an early realisation, in which case it might be appropriate to apply a smaller discount. Furthermore, the valuer should recognise, when selecting the appropriate level of discount, that the application of the discount to the value of the equity holding (as opposed to the P/E) will normally result in a higher valuation.

2.4 Development Stage Investments - Net Asset Basis
It is envisaged that this basis will rarely apply to venture capital portfolios. However, some investments are more appropriately valued on this basis, for instance when there is a significant property element to the business.

When using this basis particular care must be taken to consider when and how each of the assets has been valued, the independence of the valuer and his/her qualifications, and whether the valuations are suitable in the current circumstances. A level of discounting will normally be appropriate to take into account the illiquidity of the investment.

5.3.2 Valuation Worksheet

A) THE BASIC LEVEL - for all Investors:

•  a statement as to whether the AVCA Valuation Guidelines are being applied

•  a statement as to whether the investment is quoted or unquoted

•  a statement of which valuation methodology is being applied and reasons for such choice

•  cost and date of the initial investment and subsequent financings where applicable

•  date and amount of the latest round of financing and the resulting percentage and valuation of the fund's investment, and an indication as to whether the round was provided by an independent third party, strategic investor or otherwise

•  change in valuation over prior 2 valuation exercises

•  where applicable, a statement as to the effect of the difference between the currency of the investment and the currency of the fund, using the exchange rate applicable on the last day of trading of the relevant period.

•  key financials - sales, EBIT, Net Earnings, Cash Flow, outstanding third party debt, cash burn rate and autonomy, all over prior three years, and budget for the coming year - unless restricted by confidentiality constraints

•  other significant co-investors

•  an assessment of the company's status compared to the expectation at the time of investment

• significant post investment events, including exit plans, where applicable.

B) THE ADVANCED LEVEL to the Advisory Committee or Review Body:

•  a statement as to whether the AVCA Valuation Guidelines are being applied; a statement as to whether the investment is quoted or unquoted

•  a statement of which valuation methodology is being applied and reasons for such choice; . cost and date of the initial investment, and subsequent financings where applicable

•  percentage of equity held;

•  date and amount of the latest round of financing and the resulting percentage and valuation of the fund's investment, whether or not the round was provided by an independent third party, strategic investor or otherwise

•  key financials - sales, EBIT, Net Earnings, Cash Flow, outstanding third party debt, cash burn rate and autonomy, all over prior three years, and budget for the coming year - unless restricted by confidentiality constraints

•  where applicable, a statement as to the effect of the difference between the currency of the investment and the currency of the fund, using the exchange rate applicable on the last day of trading of the relevant period

•  change in valuation over prior 2 valuation exercises

•  imminent flotation or realisation plans

•  specific restrictions on sale of shares (lock-up provisions etc.)

•  state of investment versus plan, milestones reached, strategic status versus industry

•  other significant co-investors

•  significant adverse events affecting the value of the business: including breach of covenants, failure to service debt, creditor protection or bankruptcy filing, major lawsuit (particularly relating to intellectual property rights), loss or change of management, fraud within the company, substantial changes in market conditions, any event resulting in profitability falling significantly below the levels at the time of investment, the company is performing substantially and consistently behind plan, and any other issue permanently and significantly affecting the value of the business

•  a worksheet used to arrive at the valuation detailing the manager's recommended valuation, including the set of comparable companies, and justification.

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