Evaluating and reporting venture capital portfolio rate of return performance to investors has always been a sensitive and complex issue for venture capital funds, even in good times. But recent, challenging market conditions along with the passage of the Sarbanes-Oxley Act has made it an even more contentious issue. Without a doubt, the Sarbanes-Oxley Act is the single most onerous legislation impacting governance, financial disclosure and the practice of public accounting since the US securities laws of the early 1930’s. The lack of a universally accepted standard for financial reporting, as well as a lack of consensus on what would constitute a set of best practices, creates a potentially dangerous financial scenario for the entire Venture Capital industry.<
In this article, I will explore the issues surrounding portfolio valuation metrics, the inequity in the current methods utilized to set valuations, their inherent conflicts and flaws, and, an approach to improving the fairness and accuracy within the valuation reporting process. Based on this analysis, my own venture capital fund, Geneva Venture Partners (GVP) a USA investment firm, has incorporated this approach as a means of improving the format along with the disclosure requirements in the spirit of Sarbanes-Oxley.
We will review the current valuation process of privately held companies by US venture capital firms, and contrast that to basic industry approaches (discounted cash flow, cost, market, earnings potential, patents, etc.) as well as discuss the impact of Sarbanes-Oxley on the Venture Capital industry, specifically as it affects portfolio valuation processes. I will also identify and discuss reasons for valuation variances, conflicts of interest issues, areas of noncompliance to Sarbanes-Oxley, the lack of industry enforcement and outline a set of recommendations to eliminate these variances and conflict of interest issues as they affect GVP.
Finally, I will suggest a re-design of the current system used by traditional VC firms with one incorporating the full spirit of Sarbanes-Oxley. The ambition of this refinement to the valuation process is to continue to provide credible and accurate information to all venture capital investors.
In concluding, I surmise that there is a clear necessity to implement certain Sarbanes-Oxley best practices to the process of setting values on portfolio holdings, as well as implementing sound business processes.
Maximizing the value of companies depends on their ability to combine the components of their business models in a perfectly orchestrated manner.
By refining our current valuation assessment process with the19 step guidelines and rules explored and discussed here, we are able to implement a valuation system which incorporates the spirit of Sarbanes-Oxley while enhancing reporting accuracy and providing the needed transparency of Geneva Venture Partners’ reports to its investors. I believe the set of guidelines described provides a solid foundation for applying consistent, valuation metrics for “hard to value” privately held companies. The implementation of these refinements will serve to provide credible and accurate information to our investors, holding true to our philosophy of “always do the right thing”.
Venture Capital History
It is said that the Venture Capital industry was created in the rnid-1950s when the US government wanted to speed the development of advanced technologies. This was partly in response to Cold War fears about the growing technical prowess of the Soviet Union. In 1957, the US Federal Reserve System conducted a study that concluded that a shortage of entrepreneurial financing was a chief obstacle to the development of what it called "enterprising businesses." In order to correct this, the US Congress passed the Small Business Act of 1958.
This legislative act created the Small Business Investment Company program within the U.S. Small Business Administration. The legislation allowed SBA-licensed SBICs to "leverage" their private capital up to three-to-one (and, starting in 1976, up to four-to-one) by borrowing from the federal government at below-market interest rates. To make certain the program got off to a fast start, Congress allowed commercial banks to form SBICs. Within four years of the legislation, nearly 600 SBICs were in operation. 1
At around the same time, a number of venture capital firms were forming private partnerships, outside the scope of SBIC’s format. For instance, private funds are not subject to limitations on the sizes of portfolio companies, as are SBICs. Within a decade, private venture capital partnerships passed SBICs in total capital under management.
The Venture Capital industry grew tremendously with investor commitments to venture funds hitting a record of approximately $21 billion. Private Venture Capital funds raised a record $4.5 billion in 2004. 2
There are several reasons why this is happening:
Some of the most successful and innovative companies were created with Venture Capital funding. They include: Adobe, Amazon, Amgen, Apple, BEA Systems, Business Objects, Digital Equipment Corp, eBay, Federal Express, Genentech, Google, Intel, Microsoft, Oracle, Red Hat Software, Siebel Systems, Storage Technology, Sybase, 3COM, Salesforce.com, Symantec, Weblogic (BEA) and Veritas, to name but a few.
1 Overview of the Venture Capital Industry & Emerging Changes, Steven P. Galante, The Private Equity Analyst, newsletter, February 2003
2 VC Institute, September 1995
Given the current US interest rate situation, large institutional investors are on an avid search for high-yielding investments. They have come to the conclusion that public market securities won't perform as well in the second half of this decade as they have in the past decade. Since 1991, the Standard and Poor’s 500 Index has appreciated at an annual rate of about 14%. That compares with a 60-year average of about 10.5%. Investors have concluded that the return on public market securities will return to the historical mean, which means that they would have to be less than 10.5% for the next few years. Venture Capital investments have averaged returns of 23% since 1984.3
Though I will cite numerous ideas and concepts of valuation approaches and guidelines from the European Venture Capital Association (EVCA) and the British Venture Capital Association (BVCA)4, this report will focus primarily on the issues associated with the US Venture Capital portfolio valuation practices and guidelines.
Current Venture Capital Valuation Guidelines:
Establishing fair market valuations for portfolios have always been a little bit of a black art. This is due to the fact that most venture capital investments, whether in the USA, Europe or Asia, lack any kind of objective valuation measure other than the price per share of the last round of financing. This situation can be further complicated by the fact that most companies only sell stock once every 2 to 3 years providing precious few opportunities to truly “compare to market” a particular investment.
In the US, venture capital fund managers typically follow valuation guidelines developed in 1990 by a committee of general partner and limited partner representatives under the auspices of the National Venture Capital Association (NVCA). This has become the closest thing to a standard valuation guide. Controversial at the time, these valuation guidelines were never formally adopted by the NVCA, but they have since become the de facto standard for the US venture capital industry.
3 Source: How Did it Happen, MJ Brennan, Professor Finance, UCLA, February 2004
The NVCA guidelines acknowledge the subjective nature of valuing illiquid securities, but recognizes that it is better to be “approximately right rather than precisely wrong.”5 The essential elements and operative language of the NVCA guidelines which allow for such wide spread variances are cited in the following 10 words underscored in the mid point of the following paragraph:
“Valuation of Partnership Assets: The General Partner (or, if a Partner other than the General Partner, the Liquidating Partner, either being the "Valuation Partner"), shall value the Partnership's assets each time items of Profit or Loss are allocated pursuant to Section 4.1, upon the Dissolution of the Partnership, and whenever otherwise required or determined by such Partner in its sole and absolute discretion. The Valuation Partner shall also value distributed assets in accordance with the provisions of Section 4.1(e) and shall value distributed assets that are subsequently returned to the Partnership upon receipt by the Partnership.”6
Of course, there are several other suggested guidelines, one of which include an advisory board member review of valuations, consisting of at least one Limited Partner member.
Also, when a portfolio company performs poorly, fails to meet milestones or gets a new round of financing, those material valuation events call for re-pricing, according to the guidelines. However, given the Venture Capitalist’s total freedom in judgment and the NVCA's less than rigid guidelines, inequities in valuations are certain to, and often do occur.
The European Venture Capital Association and the British Venture Capital Association followed suit by developing and formally adopting their own set of valuation guidelines. Those valuation guidelines mirror many of the concepts of the NVCA guidelines but also added guidance on the type and amount of information to be disclosed to Limited Partners (LPs). It is the type of information, and the application of that information to portfolio company valuations, which is foremost on the minds of the Limited Partner community today.
The NVCA guidelines are listed on industry web sites and are followed by some, but, certainly not the majority of USA venture capital firms, despite the fact they haven't been officially endorsed by a recognized body.
Other efforts to come up with policies and standards for venture capital financial reporting are currently under wide industry discussion, but, despite such initiatives, it is not clear where venture capital firms stand on many of the issues and what the industry wants to see developed, if anything.
4,5,6 Source: International Private Equity and Venture Capital Valuation Guidelines (www.privateequityvaluation.com) AFIC (Association Française des Investisseurs en Capital), BVCA (British Venture Capital Association) and EVCA (European Private Equity and Venture Capital Association)
The Challenge of Establishing a Valuation Standard
Even though there is strong agreement about the importance and need for valuation standards, there seems to be less agreement about what exactly should be done and the challenges of getting it accomplished. The biggest challenges are seen as the low likelihood of agreement within the industry and the difficulty of designing the specific components of a standard.
One of the most difficult obstacles to developing standards may be the small but significant portion of the industry expressing outright opposition to standards, with 22% opposed to establishing any industry valuation standard at all.
Perhaps most sensitive is the fact that twice as large a portion of the large firms express such opposition as do small- and medium-size firms (32% vs. 16%).
Some explanation for this sentiment can be seen in written comments submitted by respondents, where a sizeable number indicated that inefficiency and lack of transparency are good for the industry and a standard would either be restrictive or uselessly vague.
Most Venture Capitalists argue that valuing closely held companies is more art than science. A fledgling start-up has too many unknowns, from an inexperienced management team to an insignificant customer base to an uncertain market for initial public offerings.
With the average rate of return for venture funds formed in the 1998 through 2002 period at negative 27%, fund investors expect considerably more assurance that fair valuation metrics are being applied. They say they need accurate information as they report numbers to their financial chiefs or consider how much money to put into VC or private equity funds.
Overwhelmingly the industry believes that if a standard is to be developed it should be developed by an industry association. More than half of the respondents expressed this preference, compared to no more than 14% for alternatives.
Larger firms see more value in broadening the participation to include LPs, with 18% of those firms saying that the standard should be developed by LPs. Just 12% of small- and medium-sized firms share that opinion.
Perhaps most encouraging to the possibility of developing standards is the expression by nearly one-half of the responding firms (48%) that they would like to be part of the process of developing industry standards, with the largest firms expressing the most interest (55%). Most encouraging to the possible development of a standard is that half of respondents expressed interest in participating in that development.8
Conflicts in Fairly Assessing Portfolio Valuations:
There are various portfolio valuation policies and liquidity restrictions venture capitalists use. As stock-market conditions change, some venture firms will reduce back to its purchase price, or actual "cost," the value of an investment that earlier had been written up. Others value a company at what they think it would sell for in today's market. Still others will leave a company valued at cost if it has enough cash to carry it 12 or 18 months, an approach that should raise questions regarding the true viability of the company, as it could be deemed that Venture Capitalists are avoiding or delaying the real valuation issues.
The result of such infrequent pricings is that the valuations of existing venture investments tend to lag the public market by 18-24 months.
This lag is why most Venture Capital firms reported poor performance in late 2001 through early 2003 even though the worst of the public market’s decline had already occurred. With no public market to enforce daily valuation discipline, Venture Capitalists can sometimes be tempted to distort their portfolio valuations, usually by neglecting to cast a critical eye on valuations that have become permanently impaired or by supporting insider rounds of new financing at unrealistically high valuations.
Some of the more obvious problems causing inconsistent portfolio valuations are that experienced Venture Capitalist are further conflicted with disclosing write-downs during a fund raising campaign. So, it’s no surprise then that with a large number of Venture Capital firms now actively in the in the fundraising market for the first time since the 1999 period, avoiding these portfolio write-downs has become a sensitive, if somewhat forbidden, industry topic.
In the world of venture capital the time-honored methodology had been to hold investments at the cost of the previous round of financing. The problem with this approach is that it did not recognized material changes in invested companies between financing rounds. Investors were not particularly concerned because each subsequent round of financing was at an enhanced valuation. No one was really worried if this made any sense even though the basis for valuation was deceptive. Driven by the allure for new issues on NASDAQ, valuations bore no relationship to the potential profitability of the enterprise.
While many Venture Capitalists initially attempted to assess artificially high portfolio valuations in the early stages of the Internet bubble’s collapse, by the middle of 2002 most had accepted the market’s depressed values and began to mark down their portfolios accordingly.
Some farsighted firms took a particularly aggressive approach in which they undertook wholesale write-downs across their entire portfolio in an effort to reset their investor’s expectations to a valuation baseline from which there theoretically could only be good news.
While no Venture Capitalist likes to take write-downs, two important factors made the period of 2001-2003 relatively write-down “friendly”. These factors were a) the fact that everyone else within the venture capital business was taking large write-downs and therefore relative performance was not suffering dramatically (indeed it’s still possible to be in the top quartile vintage 1999 fund and have a negative IRR) and b) few firms needed to raise money during that period (the VC industry actually had net negative fundraising in 2002) so the write-downs did not threaten to disrupt the marketing of anyone’s next fund.
As we pass the midway point of 2005, the two factors that made 2001-2004 relatively easy to write-down values have largely been eliminated. The majority of Venture Capital firms have, by now, already taken their corrective valuation adjustments, the overall performance of venture funds has stabilized and, in most cases, seems to be improving. In addition, with many firms approaching the new commitment time limit on their 1999 and 2000 funds, a large number of established firms are now entering the investor market looking to raise new funds.
Added into this series of events is the fact that many funds, even those that didn’t fully correct their portfolio’s values, claim to have recognized the write-downs of 2001-2003 and put them behind them. With the write-down stakes thus raised, the temptations to revert to portfolio “management” tactics remain tempting. There are numerous deceptive practices available and used by the less than scrupulous General Partner of Venture Capital firms. A few examples include:
Deceptive Valuation Practices:
Insider Rounds: The easiest and most obvious way of hiding a write-down is to discuss and agree with fellow co-VCs to do an inside round at an artificially higher valuation over the previous round. The argument for such action is actually very compelling when all of the existing VCs are participating pro-rata and already own a significant stake of the company.
In such cases, the relative ownership percentages really don’t change much no matter what valuation is used for the follow-on round and thus the only real impact of a down round is that it forces all the VCs to take a write-down. It doesn’t take much peer pressure on the average VC funded board to get everyone to go along with the plan and the common investors are usually in favor of it because they are technically getting less dilution. One of the giveaways that insider rounds are priced artificially high is that while the price per share remains the same, the liquidation preferences are increased significantly. While insider rounds are easy to accomplish, the problem with them is that most investors are aware of the fact that insider rounds are a warning sign, and thus are likely to ask some uncomfortably probing questions.
Debt Financing: Venture debt financing was basically non-existent following the dot.com crash, but market activity in debt financing has since re-emerged.
There have been dozens of new venture debt funds formed as well as a number of new finance companies and, newest in debt fund variants, the public investment companies. As a result, there’s a great deal of debt being deployed on favorable terms to completely uncreditworthy start-ups. The fundamental investment theory of the debt companies is that the Venture Capital community has too much capital invested in a startup to let it go under just because of a few million in debt, so they are really lending against the Venture Capital firm’s unwillingness to take write-downs more than anything else.
The net result is that the startup extends its life with needed capital without taking additional equity dilution and the VCs gains as a result of not needing to take a write-down in value.
Convertible Bridge Notes: For those companies who are not worthy of venture debt and who are unable to convince even their own investors to invest additional equity, a convertible bridge note is sometimes the answer.
Venture Capitalist would sometimes issue convertible bridge notes only in the brief period between signing a term sheet and closing a round. Those standards got heavily relaxed in the post bubble crash as many Venture Capital firms used small infusions of capital via convertible bridge notes as life support for failing companies. The effectiveness of this strategy was very low and thus few convertible bridge loan transactions occurred, but recently they have regained their usefulness. From a write-down perspective, convertible bridge loans are highly risky because they have a significant mortality rate, but it can extend much needed time for the inevitable. Most Venture Capital firms use this approach of extending the life of a startup as a means of closing the next fund raising campaign, and avoiding a complete write-off of the investment for a period of time.
Doing Nothing Approach: The other way to avoid a write-down is to simply do nothing when one could do something. As an example, let’s assume that a venture firm knows that one of its investments is headed no-where fast and should probably be sold off to one of its competitors.
Normally this sort of strategic level portfolio management is a general aspect of the venture capital business.
However, when such deal management will result in a major write-down that would hurt fundraising efforts, it’s often difficult for a Venture Capitalist to do the right and equitable thing.
These are the most difficult write-downs to uncover because there’s no funding event of any sort to examine.
These can only be discovered by diligently reviewing each portfolio company, the kind of diligence that a full, independent accounting firm audit uncovers.
Unlike Mutual and Hedge Fund managers, Venture Capital General Partners earn their carried interest based on realized gains only, and not on unrealized appreciation. Most investors in these funds recognize that total return is the true measurement in private equity, and not year-to-year changes in values. Despite that, it is still critically important to General Partners and investors to have accurate, interim portfolio valuations.
For General Partners, the timing of their carried interest distributions or the amount of their management fee may be affected by the interim values. Calculating internal rates of return based on unrealized appreciation and depreciation is a time-honored practice when raising money from investors. From the investors' point of view, year-to-year valuations affect their asset allocation decisions, compensation and bonus calculations, and spending and distribution decisions.
Even without some kind of external event, the best LPs can still ferret out overvalued portfolio deals by asking the right set of questions, doing some basic diligence, and comparing notes. Some LPs have discovered hidden write-downs by simply comparing the carrying values of the same investment held in two different venture capital funds.
As an example, a venture backed startup company, Santera Systems, was founded in the early 1990s and funded by numerous venture capital firms. Santera produced a telecommunications switch that efficiently routed calls through telephone networks.
Like many start-ups of that period, Santera found that the business environment was overwhelmingly competitive and challenging. Like other technology companies within this industry sector, the value of its closely held stock declined and the company was subsequently acquired by a public company for a price of $ .42 cents a share.9 Santera, which received over $200 million in five syndicated private equity financing rounds, received a value of 46 cents per share on the valuation report of one prominent venture firm and $4.42 in the valuation report by another.
Therein lies the crux of the valuation issue: different Venture Capital firms value companies within their funds in divergent ways. The effect is that some funds, by not marking down valuations sufficiently, may be making their funds' performances look better than they actually are.
Investors should worry that it also means that the value of the hundreds of billions of dollars invested in venture funds in the late 1990s may be overestimated, long after the technology bubble crash and significantly reduced the value of many public stocks by 90% or more.
Rather than assess the value of each individual company in a portfolio, Austin Ventures now recalculates the estimated value of an entire portfolio. Only at the end of the year do they change valuations of individual portfolio companies. 10
Still, with the down market, venture capitalists recognize that they may need to agree to rules that narrow the differences in placing valuations on portfolio companies.
Valuations Do Matter
Venture Capital equity, as an asset class, is maturing and becoming populated with an ever increasing array of new entrants. As a result, the need for more detailed and comprehensive information by General Partners of Venture Capital funds is clearly going to increase.
The focus on valuation decisions is just one example of the need for more transparency. The US venture capital industry can address the transparency issue, and allay the concerns of LPs, by formally adopting a comprehensive set of valuation guidelines and disclosure standards in compliance with the Sarbanes-Oxley Act. The new guidelines should address the transfer of information to LPs, go into greater portfolio company detail and provide more guideposts, than the informal guidelines currently in use.
The Need for Sarbanes-Oxley Compliance in the Venture Capital Industry
It is very clear from history that US government policy has an extraordinarily strong effect on the health and viability of the venture capital business. Now, more than ever, venture capitalists must make the most of scarce resources, develop “team-oriented” sharing practices, do*****ent activities and at the same time respond to ever-increasing demands for improved portfolio performance, tracking and reporting management. Looming on the horizon is Sarbanes-Oxley’s inevitable enforcement on the Venture Capital industry. Up until recently, venture capital operations have been private, removed from the oversight of governmental authorities such as the Securities and Exchange Commission, with little investment information being conveyed to LPs.
Without a doubt, the Sarbanes-Oxley Act is the single most important piece of legislation affecting corporate governance, financial disclosure and the practice of public accounting since the US securities laws of the early 1930’s6. It is clear that the Venture Capital industry will soon need to follow the strict requirements of this legislation. It is only a matter of time.
9 Source: Little VC Secrets: Value Lies in the Eye of the Beholder, Wall Street Journal, Ann Grimes, November 4, 2002
Evidence that change is around the corner occurred earlier this year when the Securities and Exchange Commission (SEC) approved the adoption of rule and form amendments that implement the certification requirement of Section 302 of the Sarbanes-Oxley Act of 2002 with respect to registered management investment companies. Though not considered a Registered Management Investment Company, Venture Capital firms are a close hybrid to the SEC target.
The amendments will require mutual funds and other registered management investment companies to file shareholder reports on Form N-CSR and will require each registered management investment company's principal executive and financial officers to certify the information contained in these reports in the manner specified by Section 302.
In addition, the SEC voted to adopt rule and form amendments that will require mutual funds and other registered management investment companies to include new disclosures on Form N-CSR and Form N-SAR in order to implement the "code of ethics" and "financial expert" disclosure requirements of Sections 406 and 407 of the Sarbanes-Oxley Act of 2002.
One of the healthiest consequences of the growth in institutional investments in Venture funds has been the increase in scrutiny that venture firms have come under. The watchfulness of these investors and advisors, and the feedback and suggestions they provide, are helping to increase the sense of professionalism and discipline in the industry.
Some of the things Institutional investors require, such as better record keeping, are simply sound business practices. Others, while perhaps annoying to administer, are important for maintaining discipline, focus and investor confidence. In essence, they require a clear and consistent investment strategy, and to do*****ent and explain to investors in detail any departure from that strategy. These are very similar reporting systems that have served the public markets, and with the recent passage of Sarbanes-Oxley11, are just now becoming an important aspect for the Venture Capital industry.
To understand why the SEC would want to consider Venture Capital firms under the Sarbanes-Oxley (SOX) umbrella, one needs to explore the requirements and rational behind the Sarbanes-Oxley Act.
11 PriceWaterHouseCoopers: Sarbanes-Oxley Act, Will Reporting Requirements Enhance Investor Confidence? Update 2005, HTTP://WWW.PWCGLOBAL.COM
Impact of the Sarbanes-Oxley Act on Venture Capital Firms
The Sarbanes-Oxley Act (SOX) came as a result of the US Congress enactment of The Public Company Accounting Reform and Investor Protection Act, which went into effect on July 2002, and is commonly referred to as Sarbanes-Oxley, named after its authors.
SOX came about largely in response to major corporate accounting scandals involving several prominent companies in the United States. These scandals resulted in an erosion of confidence in the financial markets and a loss of public trust in corporate accounting and reporting practices. The act has brought about the most extensive reform that US financial markets have seen since the enactments of the Securities Act of 1933 and the Securities Exchange Act of 1934.12
The impact of SOX has been felt throughout the financial markets, and will continue to be felt in every industry sector for years to come. Scandals in Europe and Asia have prompted similar mandates overseas, even as those regions move closer to acceptance of International Accounting Standards (IAS).
Since the passing of SOX, Venture Capital firms have been questioning and re-assessing their manual systems and accounting processes with a view towards compliance of SOX financial reporting. While SOX has 11 titles, Sections 302 and 404 have the greatest impact in terms of ongoing compliance obligations. Section 302, pertaining to corporate responsibility for financial reports, requires the certification of disclosure in quarterly and annual reports contain a discussion of the effectiveness of internal controls.13
These two sections place significant responsibility on the company’s CEO and CFO, the firm’s key compliance gatekeeper, and the firm’s external auditors, who for the first time must provide an opinion on the reliability and effectiveness of the internal control representation made by a company’s CEO and CFO. Finally, Section 409 mandates significantly expanded disclosure requirements, with disclosures made as quickly and completely as possible after pertinent events affect company performance.14
For the Venture Capital firm the burden of full disclosure and compliance is shouldered directly to the firm’s General Partner, its CFO and external auditor.
12 SEC Adopts Measures to Certify Management Investment Company Shareholder Reports, January 22, 2003 HTTP://WWW.SEC.GOV/NEWS/PRESS/2003-8.HTM
13 American Institute of Certified Public Accountants, Summary of Sarbanes-Oxley Act 2002 http://www.aicpa.org/info/sarbanes_oxley_summary.htm
14 Piper, Rudnick, Gray, Cary: Taking Control of Internal Control Reporting to Improve Disclosures and Reduce Costs Article by John H. Heuberger and Barbara J. Nepf, May 2005
SOX has already gone into effect; Section 302 has been in effect as of 2002, and Section 401 as of 2004. Companies have begun to comply with the initial requirements mandated by these sections. Public companies, Mutual Funds, and Registered Investment firms have spent a great deal of effort in the past few months developing compliance policies, processes procedures, and do*****entation. However, the real challenge is only beginning. SOX compliance is not a one-time compliance event, but rather an ongoing process that must be constantly monitored and managed. As all public companies, mutual funds and registered investment firms move from addressing the initial requirements to instituting ongoing compliance efforts, many will be implementing systems to ensure better ongoing controls, enforce compliance processes, and, above all, reduce the risk of non-compliance.15
It is inevitable that Venture Capital firms will be held accountable to these same standards as registered investment firms.
In addition to satisfying SOX compliance, implementing a portfolio management reporting system can provide comprehensive understanding of the future profit potential of portfolio companies. Other benefits of might include improving cash flow management, i.e., timing of LP capital calls, and future profit potential of portfolio companies. Also, with this comprehensive view of the business, Venture Capitalists would be better positioned to take proactive steps that can yield potentially better returns for the firm’s general operations, such as identifying areas of opportunity for merger & acquisition, liquidity opportunities, required portfolio management changes, or understanding the key reasons behind underperforming businesses. Being able to track and report these trends to LPs is a critical function of SOX’s transparency mandate.
For the Venture Capital firm, portfolio valuation plays an instrumental role in the full scheme of SOX compliance. A company raises capital and debt and calculates the feasibility of projects based on its current operating value and the value of its growth opportunities.
For publicly traded companies, the market price of similar companies can sometimes provide a basis for fair market valuation. However, the valuation of private companies, and in particular early-stage companies or projects, which we label together as portfolio companies, is much more complicated. The main reason for this is that these portfolio companies are plagued by more uncertainties than are publicly traded companies. By definition, they are in an earlier phase of their life cycle than are publicly traded companies, so they do not have a track record to base any estimates. There may be uncertainties clouding the technological feasibility of the company's plans or the skill set of the managers.
15 SEC Adopts Measures to Certify Management Investment Company Shareholder Reports, January 22, 2003 http://www.sec.gov/news/press/2003-8.htm
Sometimes, it is not even clear that the market for the company's products will exist when they are ready to be launched.
The Venture Capital Valuation Method
The current venture-capital method is based on valuations according to the multiples method. Venture capitalists can sometimes also use other methods of valuation, such as the discounted-cash-flow method. Underlying the method is the desire to project the company's value based, not on a forecast of the cash flows it is expected to generate, but rather on an estimate of the company's terminal value (TV) at the time of exit for the venture capitalist. Typically, that is around the time of the IPO or sale of the company. The present value of the company is subsequently calculated based on the terminal value.
VCs are interested in achieving average returns of 25% to 50% on their investments. Since some of their investments will be lost or may not succeed at the anticipated level, investors aim to make investments that could potentially earn them very high rates of return, generally in the 100% or great range. This reflects both the need to cover for unsuccessful investments and the internal risks that could cause a delay in performance and therefore, also in the exit.
Experienced VCs will try to take combined action. On the one hand, they will make "conservative" investments in advanced start-ups that are close to an exit and are led by experienced and well-known teams.
On these investments, they will make do with returns of 40% or less but have a good chance of succeeding. On the other hand, on riskier investments, in earlier-stage start-ups, they will look for a return of 100% or better.
Perhaps the most common valuation technique is the discounted cash flow method. The starting point is based on forecasting the company's free cash flows available to shareholders or to its entire set of capital investors. These cash flows include earnings adjusted for expenses and income items that are not in cash (for example, depreciation) and for required investments and changes in the company's working capital. The series of forecasted free cash flows is then brought to current value by discounting it using the company's cost of equity (or overall cost of capital).
A conceptually equivalent method is based on forecasting the company's excess earnings (essentially, net income after charging for the cost of the capital employed to achieve it). In a method similar to the free-cash-flow method, the series of forecasted excess earnings is brought to current values by discounting it using the company's cost of equity. The principle of this method is that a company creates wealth only if it provides earnings that more than compensate VCs for the risks taken.
The quality of the valuation according to the discounted-cash-flow (DCF) method basically depends on the quality of the projections of the company's future cash flows. Particularly in start-ups, small changes in the assumptions used in the financial model during the company's first years of activity, while seeming negligible, may have a critical effect on the company's value. For instance, in a valuation of CISCO17 in 1995, a change of 1% in its projected growth rate would have resulted in a difference of hundreds of percents in the company's value.
Since most of the value in the valuation of companies in their early phases of development lies beyond the projected period, negligible changes in each of the early years (which affect the periodic cash flows after the projected period), as well as negligible changes in the assumptions on the growth rates after the projected period, could have an immense effect on the outcome.
When you forecast the company's cash flows, it is important to examine the logic underlying the model.
Arbitrary assumptions about growth rates that are dissociated from the growth rates in the industry in which the company operates may sometimes lead to scenarios in which the company's share in the target market is increased to disproportionate dimensions.
VCs tend to value a company based on the direct cash flows arising from the investment, examples being dividends and capital gains. Strategic investors are either those who derive additional expected cash flows from the investment in the firm. Examples might be the products of the company can enhance the marketability of their own product offerings, or those whose investment brings additional value to the corporation such as reputation, sales capabilities, etc. Companies are typically worth more to strategic investors than to VCs. On the other hand, the value of one investor to the company may be higher than the value of another investor. Therefore, the company may agree to an investment by a VC based on a lower valuation, since the VC is expected to enhance the company's value better than strategic investors would.
The company must always remember that its goal is to raise its value in the long run and not in any specific round of investment. The reasons for a company's being worth more to strategic investors than to VCs are varied. There is, for example, the better exposure that the company's customer base could have to sales of other products by the strategic investor, and also the possibility that the products developed by the company in which the investment is made will fit into the mosaic of products manufactured and bought by the strategic investor.
17 Source: Businessweek, June 30, 1997, Cisco Valuation www.businessweek.com/1997/34/roster34/csco.htm
An extreme case of valuation for strategic investors is the case of valuation by a strategic buyer. The value of a company to strategic buyers is the company's value to a VC, chiefly, its value as an independent company, plus the value of the synergy between the company and the strategic buyer, less the independent-value component that will be lost as a result of the acquisition. Historically, companies that buy other companies tend to overvalue the synergy with their business, as is visible in the market reactions to announcements of such acquisitions.
This reaction is common in industry sectors in which a slight change in growth rates does not materially affect the value of the company, allowing it to regain market strength after the acquisition. In the high-tech or fast-growing industries, the "defensible" synergy component is larger, and payments reflecting an acquisition premium that is high in proportion to the value that the company has to VCs are therefore more likely.
Strategic investors make specific estimates of a company's value to them. However, when the investor valuates a company, what is desirable and even essential for that investor is to try to estimate the possibilities of exiting the investment via an acquisition or merger. In the late 1990s, more than five mergers or acquisitions of high-tech companies took place for every IPO. This figure clearly reveals the importance of a valuation of the company to potential buyers. In the year 2000, for instance, many fiber-optics start-ups were founded; the exit hoped for by entrepreneurs was an acquisition by one of the companies competing for dominance in this field, dense with better-financed competitors (Cisco, Nortel, Covad, etc.).
Statistical data of acquisitions in close fields usually indicate the various multiples according to which acquisitions were made and may facilitate an estimate of the company's value to strategic buyers. For instance, many independent Internet-service providers (ISPs) in attractive locations were valued according to the value-per-subscriber in similar acquisitions and not to the value-per-subscriber of public companies. One of the reasons for that was that this field is very sensitive to economies of scale, and using the value-per-subscriber of public companies could therefore lead to unreasonably high values.
After the company's added value to potential strategic buyers has been assessed, the probabilities of such a scenario should be assessed and that scenario priced according to the value to financial investors. It should always be kept in mind that exiting an investment via an acquisition provides a cash flow to the financial investor. This is similar in nature to an operating cash flow that the investor could derive from the company through other channels (such as dividends or sales of his shares following an IPO) but with a different risk profile.
Discounted Rate Typically Used by VCs20
Investors lower the discount rate they use as the company matures. The reason for this lies in several factors. Essentially, the bigger the company is, the smaller is its systematic risk, since its growth rates are more moderate and its expenses lower in relation to the turnover.
20 Source: Graph, Discount Rate Used By Venture Capital Investors, Alternative Assets, www.altassets.com
Maximizing the value of companies depends on their ability to combine the components of their business models in a perfectly orchestrated manner. Therefore, it is not crucial that a firm excel in each of the factors; it is more important that it will combine its factors in an efficient manner.
In principle, in every valuation method that is based on the discounting of future anticipated flows (free cash flows, earnings, dividends, or residual income), the discount rate has a significant impact on the derived value and influences the decisions regarding investments. The discount rate used by venture capital funds to discount the future value of cash flows also has an effect on the value of the assessed company, and therefore on the percentage of ownership that the funds require.
Historically, the discount rate by which venture-capital funds are used to calculate the value of companies lies in the range of 20 to 80 percent per year, based on where the company stands in its lifecycle. This rate is materially higher than the customary discount rate used by investors for the valuation of risky investments.
Basic Concepts of Best Practices:
The valuation of portfolio companies at the end of 2001 posed many difficult issues for General Partners, especially in light of ‘down rounds,' revised deal structures and the financial outlook for companies in particular sectors of the economy. Consequently, the spotlight has been focused on the valuation methodologies used by General Partners and, more importantly, the transparency of information provided to their investors, the LPs.
While there are no hard and fast rules that can apply to all valuation questions, it would appear advisable to implement certain Sarbanes-Oxley best practices to the process of placing values on portfolio holdings.
Recommendations that should be incorporated into industry guidelines include:
Adoption of an internal written valuation guideline which mirror the industry standards applicable to public market companies within the sector the fund invests, i.e., technology, medical devices, etc.
These guidelines should be sufficiently detailed to cover a variety of common situations, particularly in declining markets. A review of US Treasury IRS revenue rules 59 - 6021 (discussed in greater detail later) is an excellent example of consistency in valuation metrics.
Create an internal committee within the firm to make valuation decisions. The internal committee should include the firm’s Chief Financial Officer and at least one LP investor of the fund.
In the more difficult cases, all other venture investors of the portfolio company should be consulted on the value they placed on the same security. This does not mean that co-investors must value the same security equally. Even GAAP (Generally Acceptable Accounting Principles) recognizes that different values are possible. Instead, it should be used as another data point for consideration.
Review valuation decisions in detail with the Venture Capital fund's limited partner advisory committee. That means providing members of the advisory committee with financial and other information (cash burn rate, revenue rates) with respect to each portfolio company which is more detailed than otherwise provided to the limited partners as a whole.
The basic concept in portfolio valuation is to determine the discounted cash flow, present value today of the future benefits to be received from a business over the life of the investment, which, in the Venture Capital industry tends to be 5 – 8 years.
Most valuation discussions begin with an analysis of US Treasury IRS Revenue Ruling 59-6022, which was issued as an explanation of guidelines to follow in valuation of stock of closely-held corporations for purposes of determining the appropriate gross estate for estate tax purposes.
It outlines the approach, methods and factors that should be considered in valuing businesses where a public stock market quotation is not available or does not result in fair market value.
The use of Revenue Ruling 59 - 60 has been broadened in the tax area for income taxes, partnerships and other business entities. In addition, its "factors to be considered" have become the foundation (especially at a time when virtually no other foundation exists) for business valuation.
21, 22 Source: Internal Revenue Service - http://www.irs.gov/pub/irs-drop/rr59_354.pdf
The following factors, it is suggested in the Revenue Ruling, while not all inclusive, requires careful analysis and consideration in each valuation.23
1) The nature of the business and the history of the enterprise from its inception.
2) The economic outlook in general and the condition and outlook of the specific industry in particular.
3) The book value of the stock and the financial condition of the business.
4) The projected earning capacity of the company.
5) The dividend-paying capacity, if appropriate.
6) Whether or not the enterprise has goodwill or other intangible value.
7) Sales of the stock and the size of the block of stock to be valued.
8) The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.
Assessing Valuations of Privately-held Companies
With investments in privately-held companies, the investments are generally held at cost, but the valuation may be increased or reduced in certain cir*****stances.
If there has been a significant investment by a third party at a higher or lower valuation, then this revised valuation is generally applied.
If more than 12 months has passed since the new investment by a third party, the historic valuation is reconsidered in the light of current venture market conditions particularly if the company will require further funding. 29
In certain cir*****stances the price paid by a new third party investor may be discounted.
A reduction in valuation will also be made through a provision if, in the opinion of the Board, the performance of the portfolio company is such that it is unlikely that the Venture fund’s holding will be realized within the expected holding period, for at least that value. For a company that is approaching profitability and generating sustainable revenues the fund’s General Partner may recommend a valuation based on a multiple of revenues and profits using as a benchmark other comparable quoted companies.
23 Source: Internal Revenue Service - http://www.irs.gov/pub/irs-drop/rr59_354.pdf
Corrective Adjustments to Valuation Guidelines:
The basic valuation approaches for even “hard to value” companies have not changed. The challenge is preparing measurement and accurate estimation of the company’s future results, which of course, is difficult in the best of cir*****stances. Given that, what follows is a set of guidelines which I believe provides a solid foundation for applying consistent, valuation metrics for “hard to value” privately held companies and which should be employed by our firm.
To provide specific criteria and guidance clarifying procedures for valuing portfolio investments of Geneva Venture Partners portfolio investments.
Recommended Valuation Guidelines:
The following is a recommended Investment valuation process which is intended to comply with our fund’s LP expectations of valuing portfolio companies, compliance with the spirit of Sarbanes-Oxley, and a philosophy of “doing the right thing”.
Partnership investments in non-marketable securities of privately held companies will be valued for each reporting period, as follows:
1. Investments will be valued at cost upon acquisition.
2. For subsequent reporting periods, the fair market value per share will be adjusted upwards or downwards, if appropriate, from initial cost to reflect the price in the latest round of preferred stock financing, or the price at which there was a sale of a significant number of shares of common or preferred stock, in an arms-length transaction to an independent third party, or the price as determined through an independent third party valuation of the portfolio company’s securities.
3. If the portfolio company reasonably believes it is within a year of its initial public offering and, as a result, has adjusted its common stock price for employee option purposes upwards to minimize the spread between preferred and common stock or on advice of its investment bankers, attorneys, or accountants, then the portfolio company’s common stock price, as declared by its Board of Directors, may be used as the fair market value for the partnership’s investment in such company’s securities.
4. Should none of the situations in criteria 2 be applicable within twelve months of the date on which an investment is made, the portfolio company’s current financial statements are to be reviewed to assess the company’s status compared with expectations as of the prior financing. Should results substantially exceed prior expectations, the General Partners may make an upwards adjustment to the fair market value per share.
The reasonableness of such an upwards adjustment to the fair market value of a portfolio company should be assessed by considering the implied portfolio company valuation obtained by dividing the partnership’s ownership percentage into the aggregate fair market value of the partnership’s investment, as adjusted.
Should results substantially fail to meet prior expectations, the General Partners may make a downwards adjustment to the fair market value per share.
5. Should results be fairly consistent with prior expectations, the fair market value shall remain at the amount as of the prior reporting period.
6. If the portfolio company is traded on one or more securities exchanges or quoted on the US NASDAQ National Market System, the value will be deemed to be the securities’ average closing bid price as reported in the Wall Street Journal or another publication or service nationally recognized in the US that reports such data.
7. If there is no active public market, the General Partner will make a determination of the fair market value, taking into consideration the purchase price of the securities, developments concerning the issuing company subsequent to the acquisition of the securities, any financial data and projections of the issuing company provided to the General Partner, and such other factor(s) as the General Partner may deem appropriate.
8. Valuation of Partnership Assets. The General Partner will value the Partnership's assets each and every time items of Profit or Loss are allocated to any portfolio holding. The General Partner will also value distributed assets that are subsequently returned to the Partnership.
9. In determining the value of Partnership holdings or any interest in the Partnership, no value shall be placed on the goodwill, going concern value, name, records, files, statistical data or similar assets. However, consideration may be taken of any items of income which is earned but not yet received, expenses incurred but not yet paid, liabilities fixed or contingent, and prepaid expenses to the extent not otherwise reflected in the books of account. Also, allowed to be considered is the Fair Market Value of options or commitments to purchase or sell Securities pursuant to agreements prior to the valuation date. An appropriate adjustment shall be made for any control premiums associated with the securities.
10. Should the General Partner in good faith determine that, because of special cir*****stances, the valuation methods described here does not fairly determine the value of a security, the General Partner shall make such adjustments or use such alternative valuation method as it deems appropriate to arrive at a Fair Market Value for the asset. Such special cir*****stances will be fully do*****ented to support the adjustment.
11. The General Partner will be responsible for diligently setting and reviewing with the LPs, along with an independent accounting firm, the Fair Market Value of any assets and liabilities of the Partnership. The General Partner's valuation of Partnership assets will be construed in such as fashion as to follow the "Fair Market Value" guidelines of such assets.
12. The LPs will receive a notification of the Valuation process and results for each portfolio holding. If a Two-Thirds-Interest of the LPs notifies the General Partner of an objection to the valuation of one or more assets, then the General Partner shall re-determine the value of the assets and will notify the LPs of the results of the re-determination.
13. Should a Two-Thirds-Interest of the LPs notify the General Partner of their continued objection to the re-determined value, and the General Partner declines to adjust such value in a manner that eliminates the continued objection by a Two-Thirds-Interest of the LPs, then the value of the assets will be determined in accordance with the Appraisal Procedure.
The Appraisal Procedure will involve the following steps:
14. A "Valuation Committee" composed of at least one, but not more than three LPs shall be appointed by a Two-Thirds-Interest of the LPs specifically to address the valuation of the asset(s) under review.
15. All actions to be taken by the Valuation Committee will be made on the basis of a majority vote of the Valuation Committee members.
16. The General Partner and the Valuation Committee shall each provide the other with their proposed value for the asset(s) under review. The General Partner and the Valuation Committee will each select an independent third appraiser acceptable to the other party.
16. The third appraiser will determine which of the proposed values is closest to the actual Fair Market Value of the asset(s) under review or propose another value for the asset.
17. With the third appraiser’s assessment, the General Partner and the Valuation Committee will agree and arrive at the Fair Market Value which will be deemed to be the Fair Market Value of the asset(s).
18. Should an agreement not take place, then the Fair Market Value will be deemed to be the average of the three valuations. Thereafter the Valuation Committee will automatically dissolve.
19. All determinations, will be made on the basis of a majority vote of the Valuation Committee members.
We began this report by suggesting that portfolio valuation has to be based on a thorough analysis of the company's business model. While we see that there are no hard and fast rules that can apply to all valuation questions, it appears that there is a clear necessity to implement certain Sarbanes-Oxley best practices to the process of placing values on portfolio holdings, as well as sound business processes.
Maximizing the value of companies depends on their ability to combine the components of their business models in a perfectly orchestrated manner. Therefore, it is not crucial that a startup company excel in each of the factors; it is more important that it will combine its factors in a perfect manner. The formulation of these components and their combination into a business model alter the firm's ability to create value for its shareholders.
By refining our current valuation assessment process with the19 step guidelines and rules, our valuation system will incorporate the spirit of Sarbanes-Oxley while enhancing our reporting accuracy and providing the needed transparency of Geneva Venture Partners. I believe this set of guidelines which provides a solid foundation for applying consistent, valuation metrics for “hard to value” privately held companies. The implementation of these refinements will serve to provide credible and accurate information to investors, holding true to the philosophy of “always do the right thing”
Igor Sill is the Managing Director of Geneva Venture Partners (GVP, GVPII, GVPIII), a San Francisco based early stage software investment firm. He was the seed investor in Salesforce.com (along with Larry Ellison and Halsey Minor), seed investor in Siebel Systems, and investor in Weblogic (BEA), Tumbleweed, Gigabit (ELX)NetObjects, Red Hat Software, Seer and Encirq.
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