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Applying Sarbanes-Oxley to venture capital04/07/2005. Source: Geneva Venture Partners. Igor Sill 
Reporting venture capital performance to investors has always been a sensitive issue for venture capital funds, even in good times. But recent, challenging market conditions along with the passage of the Sarbanes-Oxley Act has made it an even more contentious issue. Without a doubt, the Sarbanes-Oxley Act is the single most onerous legislation impacting governance, financial disclosure and the practice of public accounting since the US securities laws of the early 1930s. The lack of a universally accepted standard for financial reporting, as well as a lack of consensus on what would constitute a set of best practices, creates a potentially dangerous financial scenario for the entire venture capital industry. In this article, I will explore the issues surrounding portfolio performance, specifically the valuation metrics, which are used to demonstrate a fund's success or lack luster performance. We'll explore the inequity in the current methods used, their inherent conflicts and flaws, and, an approach for improving the fairness within the valuation reporting process. I believe that there is a clear necessity to implement certain Sarbanes-Oxley best practices to the process of setting these values on venture capital holdings, as well as implementing sound business processes.
By refining the current venture capital portfolio valuation process with the19 step guidelines discussed here, Venture Capital firms are able to implement a valuation system which incorporates the full spirit of Sarbanes-Oxley. The implementation of these refinements will serve to provide credible and accurate information to private equity investors, holding true to Sarbanes-Oxley's philosophy of "always do the right thing."
Venture Capital History
It is said that the Venture Capital industry was created in the rnid-1950s when the US government wanted to speed the development of advanced technologies. This was partly in response to Cold War fears about the growing technical prowess of the Soviet Union. In 1957, the US Federal Reserve System conducted a study that concluded that a shortage of entrepreneurial financing was a chief obstacle to the development of what it called "enterprising businesses." In order to correct this, the US Congress passed the Small Business Act of 1958.
This legislative act created the Small Business Investment Company program within the U.S. Small Business Administration. The legislation allowed SBA-licensed SBICs to "leverage" their private capital up to three-to-one (and, starting in 1976, up to four-to-one) by borrowing from the federal government at below-market interest rates. To make certain the program got off to a fast start, Congress allowed commercial banks to form SBICs. Within four years of the legislation, nearly 600 SBICs were in operation.
At around the same time, a number of venture capital firms were forming private partnerships, outside the scope of SBIC's format. For instance, private funds are not subject to limitations on the sizes of portfolio companies, as are SBICs. Within a decade, private venture capital partnerships passed SBICs in total capital under management.
The Venture Capital industry grew tremendously with investor commitments to venture funds hitting a record of approximately $21 billion. Private Venture Capital funds raised a record $4.5 billion in 2004.
There are several reasons why this is happening:
Some of the most successful and innovative companies were created with Venture Capital funding. They include: Adobe, Amazon, Amgen, Apple, BEA Systems, Business Objects, Digital Equipment Corp, eBay, Federal Express, Genentech, Google, Intel, Microsoft, Oracle, Red Hat Software, Siebel Systems, Storage Technology, Sybase, 3COM, Salesforce.com, Symantec, Weblogic (BEA) Veritas and Zantaz, to name but a few.
Given the current US interest rate situation, large institutional investors are on an avid search for high-yielding investments. They have come to the conclusion that public market securities won't perform as well in the second half of this decade as they have in the past decade. Since 1991, the Standard and Poor's 500 Index has appreciated at an annual rate of about 14%. That compares with a 60-year average of about 10.5%. Investors have concluded that the return on public market securities will return to the historical mean, which means that they would have to be less than 10.5% for the next few years. Venture Capital investments have averaged returns of 23% since 1984.
Current Venture Capital Valuation Guidelines:
Establishing fair market valuations for portfolios have always been a little bit of a black art. This is due to the fact that most venture capital investments, whether in the USA, Europe or Asia, lack any kind of objective valuation measure other than the price per share of the last round of financing. This situation can be further complicated by the fact that most companies only sell stock once every 2 to 3 years providing precious few opportunities to truly "compare to market" a particular investment.
In the US, venture capitalists typically follow valuation guidelines developed in 1990 by a committee of general partner and limited partner representatives under the auspices of the National Venture Capital Association (NVCA). This has become the closest thing to a standard valuation guide. Controversial at the time, these valuation guidelines were never formally adopted by the NVCA, but they have since become the de facto standard for the US venture capital industry.
The single, key phrase in the NVCA guidelines which says it all is found in Section 4.1, which passes the valuation decision directly to the fund's administrator, its General Partner, akin to having the "fox look after the chicken coop. The exact language as it relates to valuation assessment states: that upon the Dissolution of the Partnership, and whenever otherwise required or determined by such Partner in its sole and absolute discretion.,
Also, when a portfolio company performs poorly, fails to meet milestones or gets a new round of financing, those material valuation events call for re-pricing, according to the guidelines. However, given the Venture Capitalist's total freedom in judgment and the NVCA's less than rigid guidelines, inequities in valuations are certain to, and often will occur.
Other efforts to come up with policies and standards for venture capital financial reporting are currently under wide industry discussion, but, despite such initiatives, it is not clear where venture capital firms stand on many of the issues and what the industry wants to see developed, if anything.
Most Venture Capitalists argue that valuing closely held companies is more art than science. A fledgling start-up has too many unknowns, from an inexperienced management team to an insignificant customer base to an uncertain market for initial public offerings.
There are various portfolio valuation policies and liquidity restrictions venture capitalists use. As stock-market conditions change, some venture firms will reduce back to its purchase price, or actual "cost," the value of an investment that earlier had been written up. Others value a company at what they think it would sell for in today's market. Still others will leave a company valued at cost if it has enough cash to carry it 12 or 18 months, an approach that should raise questions regarding the true viability of the company, as it could be deemed that Venture Capitalists are avoiding or delaying the real valuation issues.
The result of such infrequent pricings is that the valuations of existing venture investments tend to lag the public market by 18-24 months.
This lag is why most Venture Capital firms reported poor performance in late 2001 through early 2003 even though the worst of the public market's decline had already occurred. With no public market to enforce daily valuation discipline, Venture Capitalists can sometimes be tempted to distort their portfolio valuations, usually at unrealistically high valuations.
Some of the more obvious problems causing inconsistent portfolio valuations are that veteran Venture Capitalist are conflicted with disclosing write-downs during fund raising.
In the world of venture capital the time-honored methodology had been to hold investments at the cost of the previous round of financing. The problem with this approach is that it did not recognized changes in invested companies between financing rounds. Investors were not particularly concerned because each subsequent round of financing was at an increased valuation. No one was really worried if this made any sense even though the basis for valuation was deceptive. Driven by the allure for new issues on NASDAQ, valuations bore no relationship to the potential profitability of the enterprise.
Some farsighted firms took a particularly aggressive approach in which they undertook wholesale write-downs across their entire portfolio in an effort to reset their investor's expectations to a valuation baseline from which there theoretically could only be good news.
Even without some kind of external event, some astute venture fund investors can ferret out overvalued portfolio assessments by asking the right questions, doing some basic diligence, and comparing notes. Some LPs have discovered hidden write-downs by simply comparing the carrying values of the same investment held in two different venture capital funds.
As an example, a venture backed startup company, Santera Systems, was founded in the early 1990s and funded by numerous venture capital firms. Santera produced a telecommunications switch that efficiently routed calls through telephone networks.
Like many start-ups of that period, Santera found that the business environment was overwhelmingly competitive and challenging. Like other technology companies within this industry sector, the value of its closely held stock declined and the company was subsequently acquired by a public company for a price of $ .42 cents a share. Santera, which received over $200 million in five syndicated private equity financing rounds, received a value of 46 cents per share on the valuation report of one prominent venture firm and $4.42 in the valuation report by another.
Therein lies the crux of the valuation issue: different Venture Capital firms value companies within their funds in divergent ways. The effect is that some funds, by not marking down valuations sufficiently, may be making their funds' performances look better than they actually are.
Investors should worry that it also means that the value of the hundreds of billions of dollars invested in venture funds in the late 1990s may be overestimated, long after the technology bubble crash and significantly reduced the value of many public stocks by 90% or more.
The Need for Sarbanes-Oxley Compliance in the Venture Capital Industry
It is very clear from history that US government policy has an extraordinarily strong effect on the health and viability of the venture capital business. Looming on the horizon is Sarbanes-Oxley's inevitable enforcement on the Venture Capital industry. Up until recently, venture capital operations have been private, removed from the oversight of governmental authorities such as the Securities and Exchange Commission, with little investment information being conveyed to LPs.
Without a doubt, the Sarbanes-Oxley Act is the single most important piece of legislation affecting corporate governance, financial disclosure and the practice of public accounting since the US securities laws of the early 1930's. It is clear that the Venture Capital industry will soon need to follow the strict requirements of this legislation. It is only a matter of time.
Evidence that change is around the corner occurred earlier this year when the Securities and Exchange Commission (SEC) approved the adoption of rule and form amendments that implement the certification requirement of Section 302 of the Sarbanes-Oxley Act of 2002 with respect to registered management investment companies. Though not considered a Registered Management Investment Company, Venture Capital firms are a close hybrid to the SEC target.
The amendments will require mutual funds and other registered management investment companies to file shareholder reports on Form N-CSR and will require each registered management investment company's principal executive and financial officers to certify the information contained in these reports in the manner specified by Section 302.
In addition, the SEC will require investment companies to implement a "code of ethics" and "financial expert" disclosure requirements (Sections 406 and 407 of the Sarbanes-Oxley Act of 2002).
One of the healthiest consequences of the growth in institutional investments in Venture funds has been the increase in scrutiny that venture firms have come under. The watchfulness is helping to increase the sense of professionalism and discipline in the industry.
Some of the things Institutional investors require, such as better record keeping, are simply sound business practices. Others, while perhaps annoying to administer, are important for maintaining discipline, focus and investor confidence. In essence, they require a clear and consistent investment strategy, and to document and explain to investors in detail any departure from that strategy. These are very similar reporting systems that have served the public markets, and with the recent passage of Sarbanes-Oxley, are just now becoming an important aspect for the Venture Capital industry.
Impact of the Sarbanes-Oxley Act on Venture Capital Firms
The Sarbanes-Oxley Act (SOX) came as a result of the US Congress enactment of The Public Company Accounting Reform and Investor Protection Act, which went into effect on July 2002, and is commonly referred to as Sarbanes-Oxley, named after its authors. It was a response to accounting scandals involving several prominent companies in the US, resulting in an erosion of confidence in the financial markets and a loss of public trust in corporate accounting and reporting practices. The act has brought about the most extensive reform that US financial markets have seen since the enactments of the Securities Act of 1933 and the Securities Exchange Act of 1934.
The impact of SOX has been felt throughout the financial markets, and will continue to be felt in every industry sector for years to come. Scandals in Europe and Asia have prompted similar mandates overseas, even as those regions move closer to acceptance of International Accounting Standards.
Since the passing of SOX, Venture Capital firms have been questioning and re-assessing their manual systems and accounting processes with a view towards compliance of SOX financial reporting. While SOX has 11 titles, Sections 302 and 404 have the greatest impact in terms of ongoing compliance obligations. Section 302, pertaining to corporate responsibility for financial reports, requires the certification of disclosure in quarterly and annual reports and mandate effective internal controls.
These two sections place significant responsibility on the fund's General Partner and CFO, the firm's key compliance gatekeeper, and the firm's external auditors, who for the first time must provide an opinion on the reliability and effectiveness of the internal control representation. The burden of full compliance is shouldered squarely on the General Partner, the CFO and external auditor..
In addition to satisfying SOX compliance, Venture funds who implemented such redesigns would be far better positioned to take proactive steps that would yield potentially better returns, such as identifying areas of opportunity for merger & acquisition, liquidity opportunities, required portfolio management changes, or understanding the key reasons behind underperforming businesses. Being able to track and report these trends to its investors is a critical function of SOX's transparency mandate.
Basic Concepts of Best Practices:
The valuation of portfolio companies at the end of 2001 posed many difficult issues for General Partners, especially in light of 'down rounds,' revised deal structures and the financial outlook for companies in particular sectors of the economy. Consequently, the spotlight has been focused on the valuation methodologies used by General Partners and, more importantly, the transparency of information provided to their investors, the LPs.
While there are no hard and fast rules that can apply to all valuation questions, it would appear advisable to implement certain Sarbanes-Oxley best practices to the process of placing values on portfolio holdings.
Valuation guidlelines should mirror the industry standards applicable to public market companies within the sector which the venture fund invests, i.e., high technology, software, medical devices, biotechnology, etc.
The objective of setting Valuation guidelines should hold true to Sarbanes-Oxley's mandate, which is to provide specific criteria and guidance clarifying procedures for valuing portfolio investments.
Recommended Valuation Guidelines:
The following is a recommended Investment valuation process intended to comply with the spirit of Sarbanes-Oxley, and its philosophy of "doing the right thing".
Partnership investments in non-marketable securities of privately held companies should be valued for each reporting period, as follows:
1. Investments will be valued at cost upon acquisition.
2. For subsequent reporting periods, the fair market value per share will be adjusted upwards or downwards, if appropriate, from initial cost to reflect the price in the latest round of preferred stock financing, or the price at which there was a sale of a significant number of shares of common or preferred stock, in an arms-length transaction to an independent third party, or the price as determined through an independent third party valuation of the portfolio company's securities.
3. If the portfolio company reasonably believes it is within a year of its initial public offering and, as a result, has adjusted its common stock price for employee option purposes upwards to minimize the spread between preferred and common stock or on advice of its investment bankers, attorneys, or accountants, then the portfolio company's common stock price, as declared by its Board of Directors, may be used as the fair market value for the partnership's investment in such company's securities.
4. Should none of the situations in criteria 2 be applicable within twelve months of the date on which an investment is made, the portfolio company's current financial statements are to be reviewed to assess the company's status compared with expectations as of the prior financing. Should results substantially exceed prior expectations, the General Partners may make an upwards adjustment to the fair market value per share.
The reasonableness of such an upwards adjustment to the fair market value of a portfolio company should be assessed by considering the implied portfolio company valuation obtained by dividing the partnership's ownership percentage into the aggregate fair market value of the partnership's investment, as adjusted. Should results substantially fail to meet prior expectations, the General Partners may make a downwards adjustment to the fair market value per share.
5. Should results be fairly consistent with prior expectations, the fair market value shall remain at the amount as of the prior reporting period.
6. If the portfolio company is traded on one or more securities exchanges or quoted on the US NASDAQ National Market System, the value will be deemed to be the securities' average closing bid price as reported in the Wall Street Journal or another publication or service nationally recognized in the US that reports such data.
7. If there is no active public market, the General Partner will make a determination of the fair market value, taking into consideration the purchase price of the securities, developments concerning the issuing company subsequent to the acquisition of the securities, any financial data and projections of the issuing company provided to the General Partner, and such other factor(s) as the General Partner may deem appropriate.
8. Valuation of Partnership Assets. The General Partner will value the Partnership's assets each and every time items of Profit or Loss are allocated to any portfolio holding. The General Partner will also value distributed assets that are subsequently returned to the Partnership.
9. In determining the value of Partnership holdings or any interest in the Partnership, no value shall be placed on the goodwill, going concern value, name, records, files, statistical data or similar assets. However, consideration may be taken of any items of income which is earned but not yet received, expenses incurred but not yet paid, liabilities fixed or contingent, and prepaid expenses to the extent not otherwise reflected in the books of account. Also, allowed to be considered is the Fair Market Value of options or commitments to purchase or sell Securities pursuant to agreements prior to the valuation date. An appropriate adjustment shall be made for any control premiums associated with the securities.
10. Should the General Partner in good faith determine that, because of special circumstances, the valuation methods described here does not fairly determine the value of a security, the General Partner shall make such adjustments or use such alternative valuation method as it deems appropriate to arrive at a Fair Market Value for the asset. Such special circumstances will be fully documented to support the adjustment.
11. The General Partner will be responsible for diligently setting and reviewing with the LPs, along with an independent accounting firm, the Fair Market Value of any assets and liabilities of the Partnership. The General Partner's valuation of Partnership assets will be construed in such as fashion as to follow the "Fair Market Value" guidelines of such assets.
12. The LPs will receive a notification of the Valuation process and results for each portfolio holding. If a Two-Thirds-Interest of the LPs notifies the General Partner of an objection to the valuation of one or more assets, then the General Partner shall re-determine the value of the assets and will notify the LPs of the results of the re-determination.
13. Should a Two-Thirds-Interest of the LPs notify the General Partner of their continued objection to the re-determined value, and the General Partner declines to adjust such value in a manner that eliminates the continued objection by a Two-Thirds-Interest of the LPs, then the value of the assets will be determined in accordance with the Appraisal Procedure.
The Appraisal Procedure should involve the following steps:
14. A "Valuation Committee" composed of at least one, but not more than three LPs shall be appointed by a Two-Thirds-Interest of the LPs specifically to address the valuation of the asset(s) under review.
15. All actions to be taken by the Valuation Committee will be made on the basis of a majority vote of the Valuation Committee members.
16. The General Partner and the Valuation Committee shall each provide the other with their proposed value for the asset(s) under review. The General Partner and the Valuation Committee will each select an independent third appraiser acceptable to the other party.
17. The third appraiser will determine which of the proposed values is closest to the actual Fair Market Value of the asset(s) under review or propose another value for the asset.
18. With the third appraiser's assessment, the General Partner and the Valuation Committee will agree and arrive at the Fair Market Value which will be deemed to be the Fair Market Value of the asset(s).
19. Should an agreement not take place, then the Fair Market Value will be deemed to be the average of the three valuations. Thereafter the Valuation Committee will automatically dissolve.
20. All determinations, will be made on the basis of a majority vote of the Valuation Committee members.
By refining the industry's current valuation process with these19 steps, our valuation system will incorporate the spirit of Sarbanes-Oxley while enhancing the reporting accuracy and providing much needed investor transparency. I believe this set of guidelines provides a solid foundation for applying consistent, valuation metrics for "hard to value" privately held companies. The implementation of these refinements will serve to provide credible and accurate information to investors, holding true to the philosophy of "always do the right thing."
Igor Sill is the Managing Director and co Founder of San Francisco-based Geneva Venture Partners, an early stage software venture capital firm. He was the seed investor in Salesforce.com, along with Larry Ellison, Halsey Minor and Marc Benioff, as well as the seed investor in Siebel Systems. He participated in numerous early investments which included Cloudscape (Informix), GigaNet (ELX), Google (through Angel Investors), Ingres, NetObjects, Red Hat Software, Seer, Sapiens, Tumbleweed, and Weblogic (BEA). He received his MBA from Oxford University, SBS, Merton College.
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