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| Private Equity |
A House of Cards
Eileen P. Gunn
04/01/2004
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Most venture
capital firms get around this by holding the company at “cost,” or the value
ascribed during the most-recent funding round, until there is another round.
They argue it is the most conservative strategy and the best way to manage
investor expectations. In an up market, it is. After all, if a venture capital
firm has been understating a company’s value, and it is actually worth more than
it has indicated, what investor is going to complain? But, “if a company is
declining in value and you’re understating that, then you’re fooling people,”
notes Antoinette Schoar, an assistant professor of finance at MIT’s Sloan School
of Business.
“When venture capital firms come around to raise money, people are going to
consider whether they’ve
done right by their investors.”
— Andrew
Craighead
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For the past few years, that has been the more likely scenario.
Three-year net returns were running at negative 20 percent, according to the
most recent data available from Thomson Venture Economics, and the shuttered IPO
and acquisition markets have prevented the quick markups and exits on which some
venture capital firms had been counting. All in all, we have been justified in
wondering how many companies were being held at cost too optimistically because
the venture capital firms overpaid for them to begin with.
The Association of
Investment Management and Research (AIMR), an international trade group for
investment professionals, and the Private Equity Industry Guidelines Group, a
U.S. organization put together to address the valuation issue, are developing
reporting guidelines that encourage firms to more actively use fair value
instead of cost. But both groups acknowledge that using fair value is tricky.
AIMR notes in a recent report, “The move toward a fair value basis has been
gathering momentum in most areas of financial reporting. Particularly for early
stage venture investments which may not achieve profitability for a number of
years, practical problems remain and the utility of the fair value basis must
win over greater support before a consensus on detailed guidelines is likely to
be possible.”
According to Reyes (a member of AIMRs standards committee) and
John Taylor, director of research at the National Venture Capital Association,
the really pernicious problem is that valuing a company that has no profits—and
perhaps no revenues or even products—is more art than science. Across-the-board,
hard standards are not realistic for the proverbial three guys in a garage with
an idea, so we are always going to have to trust our venture capital firm’s best
effort.
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