Q: Do venture capitalists require audited financials from the companies they’re considering for an investment? Will “reviewed” financials suffice? For that matter, how do acquirers think about audited financials? Will they help speed an acquisition or is it overkill?
A: (From guest writer, our partner, Chris Wand).
We have a requirement that all of the companies that we’ve invested in get full year-end audits from an audit firm we’re comfortable with. It doesn’t necessarily have to be one of the big national firms (such as PwC, Ernst & Young or KPMG); in many cases we’re comfortable with a reputable regional firm with strong capabilities and resources. However, a small shop with a handful of people or a solo practitioner isn’t like to make the cut from our perspective.
Most entrepreneurs who have grown their business beyond a basic startup stage (i.e. they’re generating more than nominal revenues and have more complex or significant operating expenses) will find it helpful to have audited financials when talking with venture capitalists, since that just takes the entire issue off the table. However, not all venture capitalists will require audited financials before investing in a company (even though virtually all venture capitalists will require their companies to be audited after the investment).
Ultimately it’s a judgment call as to whether we (or any other venture firm) would require audited financials before making an investment. If it’s a small, early stage company with a handful of employees, a relatively low expense base and nominal revenues, we’re probably not really valuing the business (and hence our investment in the business) based heavily on the company’s historical financial metrics, so audited financials aren’t that important to us.
On the other hand, if a meaningful part of the valuation dynamic of the business is the company’s historical financial metrics (i.e. the company is arguing for a certain valuation based on market multiples and the company’s revenues), then we need to make sure that the financials are properly presented in order to get comfortable making the investment. The same could probably be said if a company had weird expenses (i.e. issues of capitalizing vs. expensing certain expenses, etc.) but that’s less of a specific concern for us given the types of businesses we invest in and the fact that we view cash outflows as more indicative/important than expenses (using the accounting meaning of that term) for early-stage companies.
As for being prepared for an acquisition, you definitely want to have audited financials before you embark on an M&A process. We find that very few acquirers (and certainly not large public acquirers) are eager to acquire a company without seeing audited financials before signing the deal. While I’m sure there are exceptions, it’s generally too significant of a diligence item for an acquirer to overlook. So it becomes a question of whether you want to get your financials audited now or whether you want to be under the gun getting an audit when you’re in the midst of an M&A process.
If you think an M&A process is likely at some point in the near-to mid-term, then you should get audited financials rather than reviewed financials, since again that keeps it from becoming a distraction (at best) or a barrier (at worst) to a deal.
Matt takes on the following question: What are some of the best ways you’ve seen to sensibly estimate and/or calculate capital and/or operating cash flow, and how do you like to see this presented to an investor?
Cash is the life’s blood of any company. It comes from either the company’s operations or from raising capital. There are a number of definitions of cash flow. I prefer to focus on what the core operating business is generating or burning net of any financing activity. As a result, I look at Operating Cash Flow minus Cap-X. A gross generalization of this includes (apologies to all of my accounting & finance profs):
plus depreciation, amortization and other non-cash cash income statement items
minus working capital needs
minus core, recurring capital expenditures (exclude large one time charges)
Since both working capital and cap-x can vary significantly monthly, you should average across a period of time that smooths out the swings such as the average monthly cash flow for a 3 or 6 month period. You should also understand how this changes as your business ramps since it will impact your financing needs.
I define capital as debt plus equity. Should your business consume cash (as defined above), you will need to finance it through either raising equity or taking on debt. This can include facilities such as working capital lines to finance receivables and inventory or lease lines to finance capital expenditures.
In the end, cash flow and capital are two sides of the same coin.
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.
What on earth is 280G? What is a parachute payment?
Question: My lawyer mumbled something about 280G and parachute payments. I thought this was only for big public companies and acquisitions? How does this affect VCs?
Our Take: Jason spent some time this year co-authoring an article on this with Ed Zimmerman and Brian Silkovitz of Lowenstein Sandler. It’s every thing (and most likely more) that you’d want to know on the subject.