Freedom of Information Litigation Puts the Spotlight on Valuation Practices

VC concern over efforts to compel public pension funds to disclose information regarding their private equity partners has largely focused on the release of internal rate of return statistics. A recent court ruling, however, suggests that the legal grounds for protecting the confidentiality of such data are tenuous at best. The more significant question is whether public pension funds can be forced to disclose their venture fund investees' valuations of individual portfolio companies. Public dissemination of that information would reveal the inconsistent (and possibly arbitrary) methods use to value companies.

Question: Will the recent lawsuits and disclosure requests for public pension funds to publish information on the rates of return earned on venture fund investments have any effect on the way venture funds value portfolio companies?

Answer: Hopefully, but don't count on it. Mere mention of these lawsuits in the presence of a VC provokes fury and fulminations about breaches of confidentiality agreements by public limited partners. However, most of the fuss is over disclosure of fund internal rate of return (IRR) statistics. The result is more heat than light.

If a venture fund decides to take money from a limited partner that is a governmental body or public agency, it has no one to blame but itself if someone (like the San Jose Mercury News) files a request for disclosure under the applicable Freedom of Information Act. The legal argument that aggregate fund performance data (e.g., its IRR) is a "trade secret" is hard to sustain.

The real (and perhaps only) argument against disclosure of fund performance data is not legal but perceptual: such data is subject to misinterpretation. For example, the IRR of a ten-year fund is negative in the early years; this isn't because the fund is performing poorly, but because losses are normally realized before gains—the lemons ripen first. Although valuations are prepared and distributed to limited partners on a quarterly basis, the performance of a ten-year fund must obviously be observed over a period of years. Since the legal arguments against disclosure of aggregate fund IRR data by public funds are flimsy at best, the venture industry would have cast itself in a better light by acquiescing up front to these requests.

Instead, the information had to be extracted, painfully. After a judge ruled last month, in litigation brought by the San Jose Mercury News against the California Public Employees' Retirement System (CalPERS), that IRRs are not "trade secrets" protected from disclosure under the California Public Records Act, many of CalPERS' venture fund investees reluctantly expressed willingness to disclose such information. (See "The Value of Me-Too's in the Context of OTC Switches," IN VIVO, December, 2002 (Also see "The Value of Me-Too's in the Context of OTC Switches" - In Vivo, 1 Dec, 2002.)).

The controversy over IRR data has, in fact, overshadowed the more significant question: whether public pension plans can be compelled to disclose their venture fund investees' valuations of individual portfolio companies. So far, the news for VCs is good: the tentative ruling in the CalPERS case was that this type of information did constitute a trade secret immune to disclosure. This is fortunate, since it would be very damaging to venture funds as well as their individual portfolio companies if quarterly portfolio company valuations, which are distributed confidentially to its limited partners, were also to be subject to mandatory disclosure to the public. Why?

Because there is no uniform system by which venture funds value private companies. An effort by the National Venture Capital Association (NVCA) to promulgate standards failed over 10 years ago. The result was a set of "proposed guidelines" developed by a subcommittee of the NVCA in 1989 which, according to a 2002 survey of venture funds conducted by the Amos Tuck School of Business Administration at Dartmouth, only about 30% of US venture funds actually follow (ironically, over 50% of the funds polled stated that they were in favor of industry standard valuation criteria). So, a company could be in the embarrassing predicament of being valued differently, and publicly, by two or more venture fund shareholders.

Public disclosure of inconsistent (and possibly arbitrary) valuations by its shareholders could harm a private company in M&A negotiations, or in trying to put together a new financing round. A company facing tough times could find such information being used against it by a competitor; it would be even worse if the value of an investment stake in the company was marked down by different venture investors in differing amounts.

Venture fund valuation practices could be improved; everyone would benefit from some degree of standardization. For example, the NVCA guidelines logically suggest that it doesn't make sense for a group of venture investors to write up an investment if they do an "inside" round at a stepped-up valuation (i.e., drinking your own bath water). However, 20% of the funds polled in the Tuck survey felt that this was a fine idea. The NVCA guidelines also note that the valuation paid in an investment round comprised solely of a strategic investor (e.g., a pharma company) should be discounted to reflect the grant of strategic rights (in addition to stock). But 30% of the Tuck respondents felt that this was unnecessary. It was somewhat reassuring to read that most of the Tuck survey population at least restricted write-ups to financing rounds or other external validating events; still there appeared to be a stalwart few who thought it appropriate to write up their private equity investments based on some internal, subjective assessment of company progress or fulfillment of unspecified internal milestones (taking the glass half-full predilection to an embarrassing extreme).

The practices noted by the Tuck survey for writing down the value of an investment were equally interesting. Basically, most survey respondents would not write down the value of an investment unless a "down round" of financing had occurred. Perhaps this is why one sees so many "flat" financing rounds and so few true down rounds.

One of the most impressive patterns of survey response showed that venture capitalists were not lacking in either confidence or perspective. Over 61% of the venture funds surveyed felt that their valuation policies were more conservative than those of their peers.

What to make of this? The only refuge is in the words of the immortal Pogo: "we have met the enemy and he is us." Michael Lytton is a General Partner of Oxford Bioscience Partners. E-mail any comments directly to [email protected].