A VC - Latest Comments in The Valuation Blues (aka How FAS157 Is Tortuous)

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

sb — Tue, 10 Feb 2009 09:36:06 -0000

FAS 157/161 Complimentary Webinar for CTP/CCM Recertification Credits from FXpress Corporation: http://www.fxpress.com/regI...

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

Kris Brown — Tue, 20 Jan 2009 11:36:17 -0000

I remember the old days well. My how times have changed.

Nice article Fred.

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

Gregg Smith — Mon, 19 Jan 2009 00:12:32 -0000

We did the same thing. We issued tax basis financial statements that allowed us to use LCM. This was 4 years ago though (got back in to running companies).

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

fredwilson — Sun, 18 Jan 2009 11:26:12 -0000

This is starting to make sense to me now

I agree that the more transparency we have on the value of private companies
the better for everyone

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

mleffers — Sat, 17 Jan 2009 16:17:56 -0000

Good point and for now I agree. Low volume equities MAY end up in the same place, though.

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

CCoulson — Sat, 17 Jan 2009 15:20:34 -0000

I am one of the brave soles operating a secondary market that does not require SEC registration. So take my words with a grain of salt, but we are trying to create a new platform for pre-NASDAQ companies to become publicly traded without SEC registration.

Part of the value of having an independent secondary market do the valuation is that it creates a credible valuation source for investors and employees. Right or wrong as investors can be, it is an independent source that makes the accounting and performance score keeping simpler. FASB has recognized this in 157 as well as Statement 115, Accounting for Certain Investments in Debt and Equity Securities, by recognizing exchange prices, and the prices from public OTC markets such as mine.

With the SEC'S recent changes to Rule 144, many non-SEC reporting companies can now have shares held by non affiliates become publicly traded on the OTC market one year after making the investment without SEC registration.

My company, Pink OTC Markets www.pinkotc.com, has in taken our Pink Sheets market tier fully electronic and provides a valuable service to the broker-dealer community in helping them get best execution for their customers in securities that are not listed on exchanges and efficiently trade over 100 billion of dollar volume. However the Pink Sheets is a broker-quoted market and by its nature has a huge variability in quality of securities traded.

Thus we created our OTCQX market tier that added an issuer listing process so OTC traded companies could give investors the trading transparency, information availability, broker access and quality control of an exchange listed security without SEC registration. We have designed OTCQX to fit U.S. laws using the London Stock Exchange AIM market's sponsored listing process as a model.

The AIM took over 10 years of hard work to be called a success, and now with markets out of favor, there are still critics. But it has helped many sub-NASDAQ companies access capital in the past and will help in the future. We have two U.S. companies that raised capital on the AIM and are using OTCQX to start building U.S. investor trading after the one year 144 holding period.

We hope that the value of what we are creating with OTCQX will create a better, more informed and trusted market for investors that opens up a new opportunity for companies to grow into a NASDAQ listing.

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

CCoulson — Sat, 17 Jan 2009 14:29:04 -0000

I would disagree that the SEC had any intention of of allowing exchange prices to be ignored because public markets are depressed.

The SEC clarification specifically excluded exchange markets and other active OTC markets, Level 1 pricing sources under FASB 157, such as NYSE, NASDAQ, FINRA's OTC Bulletin Board and Pink OTC Markets' (my company) OTCQX and Pink Sheets market tiers. Active markets are exchange prices or OTC markets where the broker quotes are firm and reflect actual transactions.

The SEC clarification was regarding inactive markets in which they stated "A quoted market price in an active market for the identical asset is most representative of fair value and thus is required to be used (generally without adjustment). Transactions in inactive markets may be inputs when measuring fair value, but would likely not be determinative. If they are orderly, transactions should be considered in management's estimate of fair value. However, if prices in an inactive market do not reflect current prices for the same or similar assets, adjustments may be necessary to arrive at fair value."

The full SEC release is available at:
http://sec.gov/news/press/2...

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

jdrive — Sat, 17 Jan 2009 13:42:21 -0000

We definitely feel your pain, Fred. FAS 157 can lead to all kinds of unintended consequences. Frankly, we don't put in the same effort as it sounds like you guys do; we go old-school at lower of cost or market, with some adjustments where directly attributable data points exist. We'll do the FAS stuff as required for reporting purposes (within reason), but neither we - nor most of our LP's - put much stock in it. Hence we give them what we really think.

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

bernardlunn — Sat, 17 Jan 2009 12:22:23 -0000

A market research veteran (not financial specialist) once said to me - there is "data to know" and "data to tell". It seems that all this "pain in the butt" is about "data to tell". And it does seem like a lot of make-work. LPs should focus on actual past returns and ignore the rest. There are no "widows and orphans" to protect in VC world. Why all this work as if you are public company? Looks like a huge distraction from the real job of picking and nurturing winners

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

fredwilson — Sat, 17 Jan 2009 11:56:32 -0000

I totally agree Hank. You made my point better and quicker than I did.

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

fredwilson — Sat, 17 Jan 2009 11:55:14 -0000

We outsource the 409a work to third parties that specialize in it

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

fredwilson — Sat, 17 Jan 2009 11:52:11 -0000

That last line is so true andrew

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

fredwilson — Sat, 17 Jan 2009 11:49:14 -0000

Jack thanks for stopping by and letting us know what a portfolio company
CFO things. Very helpful and interesting perspective too.

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

NMM — Fri, 16 Jan 2009 14:25:13 -0000

Wait it's ok if its a registered security. Yeah I'd like to know the rules of "legal tender". I don't care if they are in charge, they just can't manipulate it. Places will have the option to take this currency. Should be interesting.
-DV

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

Drama 2.0 — Fri, 16 Jan 2009 12:51:46 -0000

Can you please run the following numbers for me:

Annual Revenue: $105,000.
EBIDTA: Negative, Roger.
Unique Visitors: 975,000/month.
Pageviews: 10 million/month.
Comparable M&A in the past 6 months: none.

Thanks in advance.

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

kidmercury — Fri, 16 Jan 2009 10:02:03 -0000

yes, no doubt. biggest problem i foresee is regulation banning virtual currencies, or requiring it to be declared a security, or basically some way for govt to make sure they have monopolized the market for money supply.

though IMO virtual currencies will win in the end. at least that is what i am hoping for.

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

NMM — Fri, 16 Jan 2009 06:31:58 -0000

Very interesting idea. Also what about those virtual Linden Dollars. Wondering if those are keeping their value relative to the USD or if that could be a place to hedge against inflation, lol. Wondering wtf that currency backs anyway. Virtual currencies is where it's at though and money is basically transferred over the internet anyway. We'd pay for things with an e-card like at gas stations.

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

Hank Barry — Fri, 16 Jan 2009 03:09:06 -0000

Unrealized gains are not gains.

In the FAS 157 context "market" means "the last round of financing." But here is the problem: just because a company raises a round of capital where it sells 10% of the company for $10M does not mean that the company could be sold any time soon for $100M. The "valuation" paid by a venture investor is simply the arithmetic product of a deal that says "I will buy X fraction for Y dollars." It is NOT valid to imply from that event that the whole company is worth Y divided by X. In other words, the "post-money" value is not the "street" value.

And yet, in the financial statements of all US venture firms, and therefore in the financial statements of our university endowments and retirement and pension funds, all of these investments are being carried at the "whole company" value. Because the companies are still private or have not yet been purchased, the differences between the implied whole company price at the time of the original investment and the implied whole company price at the date of the statement is reported as a "gain". Of course, because there is no gain (in the old-fashioned "real" sense), it is called an "unrealized" gain. This reporting is mandated by law, but makes no sense.

And this rule leads to abuses. One is to make a very large investment at one valuation, which is shortly followed by a very small investment by a new investor at a much higher implied valuation. All of the money invested in the early large round is then "marked up", and unrealized gains reported, simply because there has been some market event. And of course there are venture firms who simply "follow" other (leading) firms, "paying up" whatever the more successful firm wants for later round stock in a portfolio company, just to be able to say they invested alongside the more prestigious firm. In the baroque manifestation of this, if there has not been any market event financing for a period of time, some firms will mark up an investment and report "unrealized gains" simply because time has passed and the company has not gone out of business - so something good must be happening.

None of these practices result in an accurate report of the condition of the money/value invested.

Until FAS 157 was mandated, the most successful and conservative investors always carried investments at the LOWER of cost or market, until there was an actual (REALIZED) gain, as in $$$. This is how they do it in Europe and it makes eminent sense.

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

Yokum — Fri, 16 Jan 2009 03:05:50 -0000

Fred - If you're doing this much valuation analysis, will you also be doing the 409A valuations for your portfolio companies, as it seems like you would meet the "significant knowledge and experience" requirement for preparing written valuation reports under 409A?

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

Guest — Fri, 16 Jan 2009 01:55:36 -0000

I could be wrong, but from what I've read/understand this reeks of "short termism" and puts an unnecessary burden on VC firms.

I don't think there should be such an emphasis on the valuations carried in the books. If anything it should only be mark down rules that apply. i.e. In the cases where you are "uncomfortable" marking up companies to the comps that you find in the market, you should be able to carry them at cost.

Erring on the side of conservative is always better, but it's stupid to apply such short term rules in an asset class like VC where the comps are often hard to really justify and the outlook is often much longer term.

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

Doug Redding — Thu, 15 Jan 2009 16:41:59 -0000

Next fund for sure!

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

Misty faucheux — Thu, 15 Jan 2009 16:41:23 -0000

Thanks for the explanation. These are some confusing times, but thanks for breaking it down for us.

Misty Faucheux
Social Media/Community Relations Manager, www.Viscape.com

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

andrewparker — Thu, 15 Jan 2009 15:03:03 -0000

I'm all in favor of this. Definitely something to consider for a future fund if it's a realistic option.

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

andrewparker — Thu, 15 Jan 2009 15:01:43 -0000

Fred accurately captured our valuation process and methodology. I think the new FAS 157 guidelines in defining fair value are annoying for two reasons:

1) FAS 157 (as interpreted -- i have not read it directly) encourages comparing two companies at a snapshot in time, and do not account for growth rate. If company A and company B both have 20MM in revenue, but company A is growing revenue aggressively and company B is growth is flat, A should be worth more than B, but often times these valuations exercises don't value growth well. We try using different methodologies (such as forward rev comps instead of current rev comps) in different circumstances to best capture the value of growth, but it's a bit of a black art, and rather subjective.

2) It's simply takes too much time. We spent too many hours discussing valuations or aggregating the necessary materials for the purpose of valuations... and that's time that could be better spent sourcing new opportunities, working with existing portfolio companies, networking, etc... I think there's an opportunity to create a private market valuation consulting firm that handles the valuation of a VC portfolio for less than the cost of our time.

I can appreciate the silver lining that Fred mentioned above, but I'm not quite as optimistic as him about the value of all the work we are doing. All this work is pegged against current public market comps.... so I think this corpus of private company valuations says more about the state of the public market at the time of the valuation than it does about the company being valued.

Re: The Valuation Blues (aka How FAS157 Is Tortuous)

Doug Redding — Thu, 15 Jan 2009 14:17:04 -0000

Hi Fred - Long time reader, first time commenter. When we closed our latest fund about a year ago, in our LP agreement, we expressly excluded an audit in accordance with GAAP to get around the FAS157 issue. Our auditors do everything except value the assets. For those, they do a "report on agreed upon procedures" that tells our LPs that the assets are valued in accordance with our valuation policy which is basically LCM as you described early in your post. I don't think there would be any reason you couldn't modify your existing LP agreement if you could get all LPs to go along.

Doug