Valuation Storm Brewing

"Something wicked this way comes…"
  — Ray Bradbury

We have just survived our annual audit season and it is clear to me that things are going to get increasingly murky, confusing and ugly for valuations in the venture capital world. For those of you not well versed in the intimacies of the portfolio company valuation methodologies, I’ll give you a quick overview.

As the SEC and accounting worlds continue to dig deeper into our post-SOX world, they are trying to find more appropriate ways to mark investments to market. Traditionally, VC’s have kept their investments at cost until a third party transaction (financing, sale, etc) has indicated a change in value. Conservatively, VC’s have marked investments down (say 50% of cost or $1) if they believed the investment was impaired. So, we pro-actively took write-downs and only took write-ups when a clear market transaction occurred (no guessing if something felt like it was worth more).  First the accountants targeted the publicly traded companies with their efforts in the hopes of avoiding the next Enron debacle from hidden factors. Then they started to look at privately held businesses owned by buyout shops. These firms usually have cash flows, predictability and clear public market comps. Now, they are turning their guns on the venture market and it is not going to be pretty.

In September, 2006, FASB published SFAS 157 (Statement of Financial Accounting Standards) with the goal of establishing a framework for measuring fair value. PWC drafted a nice 4 page summary (Please Welcome SFAS 157…). It defines fair value 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."

Okay. How do you expect this to work for the venture world? They give more guidance…use one of three helpful approaches: market, income or cost. So let’s see how these work.

Market Approach: observable prices and information generated by market transactions. Huh?? So, three video sharing sites are launched. One gets a $75m pre-$ valuation because of some traction, brand name VC’s and such. Another gets a $20m valuation because it doesn’t seem to have the buzz of number one and a third one struggles to get a $2m valuation. You tell me which is the right comp. As I wrote in my post, The Black Art of Deal Pricing, valuation techniques for VC is art and has even alluded the academics who can’t get CAPM to work.

Income Approach: thank goodness. This one works well for PE deals. Figure out the profit/EBITDA, etc, determine market comps and voila, you have your answer. Wait, what do mean these companies don’t have earnings? What, you say many don’t even have revenue? And, the comps range from 10x EBITDA to 100+x EBITDA? What about DCF…can’t predict cash flow? Okay, let’s use Black-Scholes pricing…too volatile and no clear market comps?

Cost Approach: this one has to work. All you have to do is figure out replacement cost. Isn’t that just a couple of servers, some labor and a website? How could the VC’s possibly pay $25m pre-$ on this one when replacement was only about $1 million? Okay, these weren’t too helpful…maybe there is another way.

On top of the fact that none of the traditional valuation approaches work well here, you have the quantum issue with early stage companies. They are many different states concurrently at the same time depending on who is doing the looking and how much Coolaid is in the glass. Let’s say you have a company burning $300k/mo and has $600k left in the bank. What is that company worth? Well, if it can raise capital in time, it can close x, y & z deals, get to breakeven and you’re off to the races. However, if it can’t raise the capital, then you are selling servers and office furniture. This creates a rather boolean and Draconian gap in just the next two months. If you feel good about how things are going with the raise, then you are more likely to price closer to the likely term sheet valuation. If you aren’t, then you take it to a $1. Have any of you entrepreneurs ever been able to guess where your term sheet was eventually going to come in? Could be anywhere from $30-60m depending on how the senior partners are feeling that day at the partners’ meeting.

So, we get to sit down with our auditors and go through this drill for everyone of our companies. We have always said that we have no idea how the market will received certain developments or milestones. Is the sector hot (couple of big exits) and VC’s are climbing all over each other or is it stone cold? Does management wow investors or leave them unimpressed despite a solid underlying business? Has the market inflected or is it just a head fake? Does the technology scale or can we only make a couple million dollars worth?

Better yet, if the reporting date is December 31st, but your audit is April 10th, the auditors now want you to apply all information you know as of April towards figuring out December 31’s value. So, your company receives an acquisition offer in January or February. Clearly, the firm had much of that value in December as well. So, use the Feb acquisition price in December even though the deal might still fall through.

Please let the venture world go back to the old ways. They are more conservative. We subjectively mark down our assets and will only mark them up when we get a third party transaction. Don’t make us do mark-ups based on imperfect comps or implied future transactions. I remember my physics teacher saying: you can’t multiply an imprecise number with another imprecise number and get anything but a really imprecise result. And please do not make us do $10,000 appraisals on each of our companies each year ($200-300k cost per fund) just to check your SFAS 157 box…

5 thoughts on “Valuation Storm Brewing

  1. Disclaimer – I’m a business appraiser so please apply that to the context in which you read these comments.

    With that put up front, I’d like to offer an alternative view from a technical perspective.

    A couple of comments may be helpful. First, any honest practitioner of valuation will tell you that the valuation of any asset (including public securities) is imprecise. That doesn’t mean the exercise is useless, only that you’re putting a stake in the ground inside some “range of error”. The hope is that the range of error is relatively small.

    Second, a good valuation process uses multiple approaches to value the asset. Even with much more known quantities, there is no right answer. If multiple approaches give you more or less the same answer, then that provides some comfort. If the answers from multiple approaches diverge significantly, that should prompt a very useful thought process to understand why (for example) the income and market approaches diverge greatly.

    Third, we apply lattice option pricing models to estimate the value of early-stage companies. For early-stage companies, this works fairly well because of the boom-bust nature of such investments. the framework is intuitively synchronized with the investment model. These also yield fairly convincing implied discount rates, and incorporate the inherent volatility of such investments rather well.

    I won’t offer an opinion on the merits or lack thereof of the reporting requirements because frankly, I benefit from them economically. (FAS 123R is commonly known as the Appraisers’ Full Employment act)

    I will offer an opinion, however, that the imprecision inherent in assessing the value of privately-held assets is not the reason to abolish the reporting rules. By that standard, most of GAAP goes out the window. You want to say they are a pain and divert your attention from managing the fund? Fair enough. Tired of paying $10K (or more) for a competent valuation? That’s fair too. Your L.P.s don’t care about interim value so if the consumers of the valuation don’t care, why do it? That’s a great argument.

    I have some thoughts on why I think the disclosures make sense, but again, they will seem self-serving so I’ll keep them to myself unless asked.

    Whoever is assisting you with your valuation efforts should be able to give you an intellectually convincing argument to support the findings of value for your holdings, and they should be working as your partner and advisor, not as your adversary.

    — mike

  2. The sad reality is that accountancy post-Enron has moved from a conservative methodology to an estimated accurate or else methodology. Its a shame because many items can’t be reasonably estimated and are based on too many intangibles. If you receive an invoice in February for services received in December then its simple – accrue for that amount. But let’s say you never receive that invoice. You know its out there so you see how much you spent on it last December and add small increase because you’ve seen a small upward trend in such invoices. Seems reasonable. Seems conservative. But that’s when the questions start:

    Why 10% increase and not 20%? Can I compare September last year to September this year to see a price increase comparison? How accurate was this estimate last year? Can you call the company for an estimate? Did you receive that invoice yet? and so on. The auditors bill their hours to justify their fee increase from last year and management wastes excessive time on its audits. And all because management believed that it was doing something simple, reasonable, and conservative.

  3. All good points. Regarding your comments, Michael, I am a fan of transparency. However, this is a question around what is the benefit and what is the cost. Nobody knows a given company better than the investors themselves and even we struggle with a huge beta on how to value certain companies.

    Example One:
    If a company goes from $1.5m in revenue (burn $500k/mo) to $4.5m in revenue (burn $700k/mo), is it worth 1.5x, 2x, 3x what it was before? Depends…did Microsoft just enter into the space, did they land the key influencer in the industry, did the CEO just quit, are they continually missing budget, is the potential exit still $100m value or has reality set in? It is next to impossible to truly characterize these factors.

    Example Two:
    Appraiser come in for 409A purposes and puts a $15m value on the company to help set an appropriate option price. VC comes in one month later and does a $30m pre-$ valuation or a strategic buys it for $75m two months later. Did the value go up 5x in two months? These actually scenarios have taken play in the past two years. Venture redefines “imprecise”

    Example Three:
    Strategic makes an offer to buy the company. First, there is a 50/50 chance it closes. Second, it has 5 different earnout components including a revenue or royalty arrangement. It can swing the final value by 2-4x. However, the corporate will be burying the company into a division and running it (hopefully). How do you value the earnout? I have seen corporate kill new companies ($0 rev) and hit budget. No one I know can give any kind of % probability of success for Monte Carlo purposes.

    In the end, it will simply increase the carry value of the portfolio as we already take subject, suppored write-downs. We just don’t feel comfortable goosing ourselves up. So, this policy will lead to portfolio value inflation which strikes me as counter to what is desired. We will see…

  4. Matt,

    I’d love to see further valuation analysis done on macro factors such as liquidity of markets and where in the asset cycle (undervalued, bubble valued or nominally valued) the current markets are. I think we would find that all assets (stocks, bonds, real estate, private companies, commodities and precious metals) regardless of what they are tend to move up or down based on not only micro factors of their particular sector but also macroeconomic factors – particularly liquidity. What happend in 1999/2000 is likely to happen again at some point because asset bubbles now tend to inflate and deflate from one type of asset to the next. We went from tech stocks to real estate after 2001. Now that asset bubble is unwinding and likely will create a new one. Right now I’m guessing private equity is the next asset bubble.

  5. We are unfortunately already there. Look at inflows into PE and VC (especially PE) as well as the average EBITDA multiple in PE. Goldilocks can’t continue forever (low rates, record profits, low inflation) which allows the PE guys to borrow at very low rates. Average EBITDA multiple as of Q3 & Q4 of last year was north of 10x…

    Seeing inflation on VC valuations in the expansion and late stage rounds but not so much on the seed/early.

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