Valuation Policies Are A Mess

Every venture firm reports the “value” of each of its underlying investments. Typically, this is updated quarterly and sent to each of the fund’s investors. The idea is that investors will then have a definitive view of the value of the firm’s investments. Simple, right? But what is the “value” of a private company? Turns out the answer to that question is not so easy to determine, and, as a result, valuation reporting in venture is a mess.

Prior to 2007, most firms held company valuations at the price of the most recent round. This was relatively straightforward and generally pretty consistent across funds. The rationale for this approach was that the best indicator of value was the last “market” price someone was willing to pay for the asset (this approach has some limitations, which I describe below). Under this methodology, GPs did have some discretion to write companies up or down (meaning to say that their value was more or less than the last round

had indicated) due to performance or changing market conditions – especially if the last round was a while ago and the valuation mark was “stale.” Typically the threshold to do this was quite high, meaning that something with the business, the market, or the company’s prospects had to have clearly and materially altered to warrant a change in valuation. While definitely not perfect, this methodology made for relatively uniform reporting (it was uncommon for companies held in different portfolios to be reported at different values – that typically only happened in edge cases with businesses that hadn’t raised in a while, although quite a few funds had policies that held all companies at a maximum of the last round price). There was certainly some incentive for perverse behavior – raising money to establish a new valuation benchmark, or unjustified discretionary mark-ups (say around the time a fund was going out to maket with a new fund), but these were actually relatively uncommon, and most funds only had discretion to write down assets, not write them up.

But there was a concern that this methodology wasn’t rigorous enough and – especially in the wake of the Enron scandal, where the company manipulated its balance sheet by misrepresenting the underlying asset value of various entities it had interests in (among many other things) – there was a desire to make sure that assets of all kinds were valued “accurately.” And some LPs didn’t like that high-performing companies that didn’t have a need to raise capital were “artificially” being held a lower valuation based on their last round price. 

Enter FAS 157 (Fair Value Measurements), adopted in the fall of 2006 and enforced for reporting periods after November 15, 2007. The idea behind FAS 157 made a lot of sense: GAAP provided varying methodologies for establishing the fair value of assets and investors and regulators wanted greater consistency and transparency in reporting. FAS 157 (and subsequent modifications) established an “exit value” concept for valuations – basically asking reporting entities and their auditors to establish the price at which an independent 3rd party would purchase an asset. In 2009, FAS 157 was integrated into ASC 820 (Accounting Standards Codification) which classifies assets based on their liquidity (level 1 assets have publicly quoted market prices; level 2 assets aren’t directly quoted but can be relatively easily valued based on market prices; and level 3 assets are those whose value cannot be compared to market prices and which rely on a firm’s internal methodologies for establishing a valuation benchmark). To be clear, FAS 157 and ASC 820 (from here, I’ll start referring to this as ASC 820 as that’s the standard currently in effect) cover many different types of assets – the reporting by venture and other private funds is just one type of asset that is subject to this standard. 

However, inside the venture industry, the adoption of ASC 820 caused significant changes in how portfolios were valued. Funds could no longer rely on their existing valuation policies and instead had to establish the “fair value” of each underlying position using varying methodologies approved under the new standard. This was expensive, but more importantly, it caused surprising divergences between how the same asset was reported from one fund to another, depending on the methodology used, the inputs to the valuation model, and the requirements of the audit firm that had to sign off on the fund’s valuations. This only highlighted that company valuations are more art than science. But the accounting standards treated them as the latter and fund LPs required more and more “rigorous” back-up and reporting. All of this, in my view, has made fund reporting less accurate and more subjective, despite its intention to do the opposite. And while valuation reporting used to be more uniform across the venture industry, it has now become much less so. 

I recently helped a fund with their valuation policy, and we asked several of their LPs for a “best-in-class” valuation policy. No one could come up with one. The reason is that, under the ASC 820 standard, there doesn’t seem to be one. I understand why LPs want to understand the current value of a portfolio and that they may not have either the technical expertise or access to the right data to go through each of their underlying portfolios and value them in the way they would like. However, in an attempt to create clarity and truth, all we’ve done is obfuscate value even further by introducing more variables, more subjectivity, and more inconsistency into the process. I sincerely believe that most venture firms do their best to come up with a fair value for each asset they own (we certainly do at Foundry) but given the number of variables and the different accepted methodologies for valuing private assets, it’s not surprising that FAS 820 has introduced even more variability and subjectivity into the process. 

I know this won’t happen but I wish we would just go back to the simplicity of valuation policies that only allowed mark-ups on price rounds and allowed modest discretion for GPs to write down under-performing assets. This would massively simplify valuation procedures and make them much more uniform. It wouldn’t, in my opinion, materially obscure fund performance. The chaos caused by 157/820 has not been worth it. We’re not closer to reporting the exact “value” of our portfolios…we’re further from it than ever.