"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…