Jan 24 2007 by Jason

How Do Limited Partners Feel About "Fair Valuation" Guidelines?

Question: How widely accepted are the PEIGG valuation guidelines? I saw some stats from the Dartmouth/Tuck School survey that indicate increasing acceptance, but just how willing are the LP’s to accept write-ups?

Our Take: This is a great question and one that, frankly, we wish we had a better answer for. We invite comments to this post (as we do all of our posts). Just to quickly level set, let’s take a quick look at the issue and then respond to your question.

When we raise money from limited partners (LPs), one of the things we have to agree on before they give us money is how our investments will be valued. In general, most VCs and LPs agree to a “valuation policy” and most times it values a particular company like this:

1.  The first time we invest in the company, following the completion of the investment, the company is valued at the valuation we invested;

2.  If another financing is completed by and between the company and a new / outside investor, our valuation is changed to the valuation of that follow-on financing, regardless if the valuation is higher or lower;

3.  If a follow-on financing is completed by us and / or other insiders, the valuation is marked down if the valuation has decreased. If the valuation increases, we still leave the company valuation at the last round completed. This is so we can’t artificially pump up the values of the companies by investing at higher valuations; and

4.  If the company doesn’t complete any new equity financings, then we don’t change the valuation.

Over the past year, there has been a push in the accounting world to go to a “fair value” approach to valuing portfolio assets. (This is also referred to as FAS 157). Fair value is loosely defined as what price a third-party purchaser would be willing to acquire the entity for. In this paradigm, we, as managing directors in our fund, would take into account each company’s particular condition, revenue, product progress, etc. and feed this information back into our valuation analysis along with the current state of the M&A market for that company. The argument is that the company can experience both positive and negative effects between financings and this additional information will make our valuations more accurate.

There is a hot debate between the accounting world and those of us who run funds. While it is certainly a noble idea to have more accurate valuations, there is nothing in this proposed change which most of us believe will actually improve this accuracy. Trying to figure out what a company will sell for is hard enough for professional investment bankers and valuation experts. If they have such a hard time, I’m not sure that we, as VCs, are any more adept. Finally, the idea of discretionarily increasing valuations of our portfolio isn’t something that we are necessarily comfortable with.

As for your original question regarding what VC investors think about the new fair value world, so far we’ve seen little interest in them wanting to move to this paradigm. We took a small poll of 3 other funds currently in fundraising mode and none of them reported that LPs want to move to this new methodology. Also after a conversation with our auditors yesterday on the subject, they indicated that none of their venture firm clients will be on a true fair value system until 2008.

So, maybe there is some movement toward fair value, but we aren’t hearing much and not seeing much either. For now the question is how easy it will be for us to keep two sets of accounting books – one for the accountants based on fair vale and one based on our agreed upon valuation policy with our investors.