Last year was a difficult one in the back offices of US venture capital firms – they were required, for the first time, to comply with Financial Accounting Standards Board (FASB) Statement No. 157, Fair Value Measurements (FAS 157). The definition of fair value as laid out by the FASB is as follows: the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions.
This meant firms not only had to spend more time determining the appropriate assumptions and methodologies used to value their investments, but they had to comply with new documentation requirements around inputs, assumptions and methodology in support of their valuation.
Until recently, venture firms had focused on the latest round of financing in order to value their investments. Firms mainly held investments at cost until the next round of financing. But as deal flow slowed, venture firms were forced to apply other methodologies to determine the fair value of their hard-to-value assets. Complicating this, the public markets saw unprecedented volatility in the fourth quarter, sending CFOs scrambling to keep their public company comparables up-to-date.
The challenges and lessons learned from implementation of FAS 157 were among the topics discussed at a recent roundtable organised by PEI Manager. Held at Institutional Venture Partners’ (IVP) offices in San Francisco, the conversation included chief financial officers from venture firms IVP, CMEA Capital and Western Technology Investments, as well as two valuation professionals from KPMG LLP, the KPMG International member firm in the United States.
With their K-1s out the door, the CFOs in the room finally had a moment to breathe after months of concentrated effort. They agreed that the most recent reporting cycle was a tough one. But they all agreed that there is a silver lining to the added workload: complying with FAS 157 requires firms to be more disciplined and consistent in their portfolio analysis and management.
The new regime
John Haag, CFO and COO of CMEA Capital, says he sat down before the fourth quarter of 2008 and looked at all of his firm’s active funds. He estimated how much of a discount he would have to apply to each fund, just based on historical experience and market knowledge. After going through the whole year-end valuation process, he found that his estimates had been within three percentage points for each of the funds.
But even if you know what your companies are worth, you’ve still got to support those values. The challenge, then, is to provide enough documentation of the thought process behind your analyses for your auditors to be able to sign off on your valuation.
“You have to be familiar with the portfolio company cap[italisation] table to be able to apply FAS 157; it’s a real change from what we used to do before when we generally priced everything based on the last round,” Haag says. “Valuations based on convertibility have been replaced by valuations driven by liquidation preferences.”
Because venture-backed companies are often early stage, innovative, and not generating revenue yet, venture firms in many ways have a tough time valuing these companies. It’s hard to value some of the intangible assets of a young company, or find appropriate public company comparables.
The day-to-day uncertainty that new businesses face also tends to produce highly variable valuation results. Haag said CMEA had a young life sciences company that was almost out of cash at year end. CMEA thought the most likely outcome would be bankruptcy, so it prudently wrote the investment down to $1 at year end. But at the eleventh hour the company “threw a Hail Mary pass” and won a development contract with a major pharmaceutical company worth around $350 million, with a significant amount of upfront cash. At the end of the first quarter, CMEA wrote the investment back up to $8 million, creating what Haag calls “valuation whiplash”.
For its part as a venture debt provider, Western Technology Investments gets caught up in other grey areas of FAS 157, says Marty Eng, the firm’s CFO and VP of administration.
“As a venture debt firm, our situation is considerably different from that of a typical VC firm,” he said. “We receive warrants on every single deal that we do and a fund can have as many as 150 positions, and so for a variety of reasons it can be difficult and time-consuming to perform the valuations. For example, since we don’t take board seats, we’re not privy to boardroom conversations that might influence valuations. Additionally, because it’s sometimes difficult to get a copy of the 409A valuation, we have far less information than anybody who has a board seat. While we do receive cap tables, valuations can still be a challenge in situations where a company hasn’t raised equity in more than nine months and where we don’t have any other information.”
“These things considered, we’ve been forced to use Black-Scholes to calculate the initial option value of the warrants and the quarterly valuation of those positions,” Eng explains. “The application of Black-Scholes isn’t without complication. The discussion that occurs each quarter is always about the appropriateness of the inputs used in the Black-Scholes model. Beta, during the last year was the big issue. In order to arrive at an appropriate beta value we constructed something similar to a mutual fund, a benchmark by industry sector containing comparable industries and used those to calculate beta. The problem we encountered last year was a significant increase in beta, which caused the model to suggest a higher value than was appropriate. Is it right then to accept results of the model at face value? Absolutely not.”
Of course aside from the issues inherent in Black-Scholes, valuing debt is particularly tricky and contentious these days.
“Determining the fair value of debt can be challenging,” said Jennifer Koondel, a senior manager in KPMG’s Economic and Valuation Services practice. “We’ve seen this issue a lot with our clients as their plan is typically to hold the debt until maturity. As such, some clients take the position that debt investments should be carried at par value. Although companies may plan to hold the debt until maturity, the measurement attribute is fair value, which is the amount that the debt instrument could be sold in an orderly market transaction at the measurement date. As a consequence, companies still need to assess the fair value of their debt instruments at a particular measurement date to appropriately estimate the fair value of their investment as defined under FAS 157.”
Eng argues that because WTI always holds the debt to maturity, it’s not discountable. There also isn’t likely to be a market for this kind of debt.
“It’s not likely that anybody would buy the loans in our portfolio as they’re too difficult to value,” he said. “So, if there’s no true secondary market for these assets, some might argue that you mark them to a zero value, but that’s inappropriate since the loans continue to perform and amortise, which gives rise to value, so that’s not the right answer. That said, we do mark down impaired debt.”
The burden of proof
“We find that generally, our non-audit valuation services clients’ estimates of fair values are reasonable and supportable because they’re in that business, they understand it, they’re dealing with it every day,” said Jim Yerges, a principal in KPMG’s Economic and Valuation Services practice. “For us, the challenges tend to be with respect to documentation of the support for the inputs used in the valuation model. Do we have third-party analyses, or do we have the analyses prepared by the company’s staff that gives us something that can be audited, and that we can incorporate into our work papers to show that the valuations received the degree of rigor needed to support the assertions regarding fair value in the financial statements?”
The documentation burden can be quite heavy. Eng said his firm had to write up a short justification for the valuation they applied to every single loan in the portfolios of two funds with a longer narrative for those situations where the assets were either marked up or down. As both active funds have more than 150 positions, the explanations ran over 200 pages.
WTI also has to provide documentation anytime they change the companies in the indices they use to calculate or estimate beta.
“The issue that we have with regard to the indices is that sometimes, for various reasons, companies fall out,” he says. “So you always have to pay attention, as some of the companies have gotten larger in terms of cap size or they’ve been acquired so they need to be replaced with another company that you believe is appropriate for the index. Then you’ve got to convince the auditors as to why the replacement company is appropriate for that particular index. They’re of course concerned that you’re not managing your beta figure. As you might expect, that’s where the conversations can be long and where some of the friction arises.”
WTI hired an external provider to calculate a valuation of one significant position, simply because it made up such a significant portion of the overall fund portfolio. But the cost of a valuation – at $20,000 to $25,000 – exceeds the value of most of the firm’s investments.
Haag found that CMEA’s auditors didn’t place much value on 409A valuations that the external provider came up with.
“I found that the auditors didn’t like 409A valuation as a data point in the 157 valuations, even if it had been done two days prior to the reporting date,” he said. “They made the threshold of evidence a lot higher for those. They literally asked, ‘How do you know this group did a good analysis?’ The implication being that I would have to audit what had been done.”
Melanie Chladek, CFO of Institutional Venture Partners, said she received similar feedback from auditors.
“They really seem to hold certain groups doing 409As in higher regard than other groups. They actually used very few of those 409As. They much preferred and had more confidence in our associates running current comps with guidance from the partners in determining what were the appropriate companies for comps. Current comps were those from the day before or the week before, not even the month before, because things were changing so quickly in the fall. So they pretty much did away with 409As, and we had a team of the associates coming up with really current comps. Also, the liquidation preferences were factored into the final valuations.”
Koondel indicated that valuation professionals who specialise in valuing alternative investments help satisfy the “burden of proof”, as they are familiar with the appropriate methodologies, inputs and assumptions and level of documentation required to value these assets. Additionally, Koondel noted that a prior valuation analysis can be considered as a data point to assess value in a current valuation analysis. However, Koondel indicated that before this prior valuation project can be considered, the valuation professional will want to review this analysis to determine that the engagement was performed for a similar purpose and that the assumptions and methodology in the prior analysis are reasonable and something the valuation professional can rely on in supporting the analysis. Like the others at the table, Chladek said she has heard stories in the market of widely varying interpretations of FAS 157 by auditors.
“That’s what I think is so peculiar, it seems like people are treating [FAS 157] so differently. The audit firms are treating it differently, even the same audit firm is treating its clients differently. I’m shocked at what some people have had to go through to satisfy FAS 157; it was a lot of work for us, but it wasn’t totally overwhelming. Some of the things you hear are just horror stories. I’m really perplexed about why there is such a difference in practice.”
Yerges explained that auditors don’t necessarily go into an audit preferring one method over another, but rather look for the best valuation method for each situation.
“There are going to be times when the option pricing model is the most appropriate, and there are going to be other times when the probability weighted return model is appropriate, and even at this day and age there are times when the current value method is still appropriate, even though we think of that as old school,” Yerges said. “So we really don’t go into any one assignment with a preference one way or the other. Having said that, we probably see the option pricing method used the most. And maybe that’s because if we were to draw a bell curve and were to look at most venture class companies we would find a significant portion of them fall within the circumstances that dictate that the option pricing method is the most reliable.”
All three CFOs at the table said they incurred significant additional costs associated with FAS 157 compliance this year. Chladek said she hired a CPA to work three days a week on valuation, fund accounting, the audit process, and producing K-1s. Eng said he hired a former audit manager to handle those tasks, and also rearranged the existing team members’ workloads. He tried to cut back on costs in other areas, though.
Though Haag didn’t hire anyone new, his staff ended up working a fair amount of overtime.
“The busy season felt like it essentially went from November with the interim audit all the way through May with the issuance of the first quarter reports. When you stack everything up with annual meetings and first quarter reports, I don’t think it was until May 15 that we felt like we could actually look up,” he said.
What LPs want
“We had a review committee session at our annual meeting in April. I was very curious to see what kind of reaction we’d get from the review committee members on the valuation adjustments,” Haag said. “Some thought that we were being too conservative. Particularly some of the strategic investors that have co-investment positions along side of us; they have to go through their own valuation process and, of course, this is a data point for them.”
More generally, Haag said the reaction he generally gets from LPs after explaining the valuations is something along the lines of “Thank you, however this means less to us than realised value”.
Chladek says IVP’s LPs are similarly apathetic about FAS 157, though they are asking for more information than ever before.
“We are queried by LPs more often than we used to be,” she said. “We get at least weekly emails asking for a customised response to their concerns and more in-depth pinging of companies and their status. We’ve developed a response that’s concise, consistent, replicable, and abides by the confidentiality provisions of the LPAs. But few of them ask about FAS 157. They’ll ask about the status of different portfolio companies, their line of business, their location, and their carrying value. They might ask, ‘What’s your valuation policy?’, and we say that we use FAS 157. But that term is rarely used or addressed to us. They’re interested in the direction of the fund as a whole.”
But LPs who need to apply FAS 157 at the fund level might find the valuations useful, Koondel says.
“If [the LPs] do apply FAS 157 at the LP level, then they should incorporate [the fund valuations] into their analysis,” she says. Once they get up to the LP level when they have to calculate their own interest in a specific limited partnership, they need to consider some of the following factors to determine if a NAV discount should be applied due to any liquidity restrictions in the partnership. Some of these marketability provisions include: lock-ups, redemption fees, notice periods, holdbacks, potential gates (to limit or suspend redemptions), sale/transferability of their interest, history of fund distributions and potential for future fund distributions based on the fund’s underlying assets invested across various types of asset classes and industries.”
The upside
“So often with accounting rules there’s a whole lot of hubbub to get to something of questionable utility,” Haag said. “I think we’re seeing that [FAS 157] is not necessarily that useful as far as the LPs are concerned who are naturally more focused on liquidity and realised value; however, I’m finding a silver lining in the cloud with the GPs. It helps them address the intrinsic value of the company and the allocation of reserves.”
“I don’t mind having gone through this,” Chladek agrees, “because I think it made all of us look at things – portfolio company balance sheets, external valuations, etc. – more closely than we did before. It did inject additional rigor into the back office.”
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