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Starting over

Everyone knows venture capital portfolios have lost value. But how much? Lacking objective accounting measures, no one in the venture capital business is quite sure. That's a problem.

Everyone knows venture capital portfolios have lost value. But how much? Lacking objective accounting measures, no one in the venture capital business is quite sure. That's a problem.

By Steven Brull
June 2002
Institutional Investor Magazine

Caspian Networks has star power, a hot product and access to venture capital , all the ingredients for Silicon Valley success. Founder Lawrence Roberts was one of the architects of the Internet, and newly appointed CEO L. William Krause headed 3Com Corp. during its heyday in the 1980s. Engineers at Caspian have spent three years developing a much-anticipated optical networking technology that promises to vastly im- prove the efficiency of the Internet. When Caspian went out into an already distressed market in December 2000 for a third round of financing, it successfully raised $85 million from the likes of Merrill Lynch & Co. and U.S. Venture Partners. Better yet, the start-up was valued at more than $400 million.

So it came as a shock to Caspian managers and employees to discover just how much high-tech valuations had changed in the months that followed. In need of one last capital infusion before the launch this year of Caspian's Apeiro IP Superswitch, executives of the San Jose, California,based company began to talk to venture capitalists late in 2001 about a fourth financing round. In February they got their money , at $120 million, the biggest venture deal of the year so far , but Caspian also had to acknowledge that all of its previous financing was nearly worthless.

Although Caspian officials won't talk about the financing, Gary Morgenthaler, head of Morgenthaler Ventures, which co-led the latest round, says, "It's human nature to be disappointed, but they concluded this was a market phenomenon, not a company failure." Adds Morgenthaler: "They were very realistic in proposing terms that we felt were attractive to new investors."

Caspian is lucky: It raised a substantial sum at a time when venture money was scarce. But across the wider world of venture capital, the destruction of tens of billions of dollars of private equity in the past few years will be reverberating for some time to come. And unless there are significant reforms in the venture industry's traditionally subjective and opaque methods of financial reporting, measuring that impact won't be easy.

While an entrepreneur like Roberts or a venture capitalist like Morgenthaler has an insider's knowledge , or at least an approximation , of what their holdings are currently worth, many other investors have only vague notions at best. They know that the signals are bad: The median valuations of venture capital portfolios fell 20.5 percent between 1999 and 2001. With the Nasdaq composite index , a proxy for technology and growth companies , having fallen 67 percent from its peak in early 2000, it stands to reason that venture capital valuations must fall farther , and cause much more pain , to truly reflect market reality.

Those valuation disparities amid the general market decline are causing tensions between venture capital firms and their limited partners. "Investors don't trust the reporting out of their venture portfolios," says Peter Moran, general partner of Doll Capital Management in Palo Alto, California. The distrust has produced demands for refunds of invested capital and for lower management fees. But the complaints may have even greater policy repercussions, particularly in light of the government's inquiries into Enron Corp. and its auditor, Arthur Andersen.

The flap is serious enough that it's likely to change the character of the largely unregulated venture capital market. Once the secretive preserve of wealthy families, like the Rockefellers, willing to risk significant sums to diversify their holdings and possibly achieve huge returns, venture capital has in recent years become an institutional market. Some of these new investors, experiencing the painful downside of venture capital for the first time, are questioning the nonstandardized reports they receive. They see portfolio-company valuations that are largely arbitrary and subjective , a point that even venture capitalists don't dispute.

Nothing will bring back the billions squandered on Internet investments, but a growing number of investors want less subjectivity and more transparency. Who, or what, will force the issue? Many venture capitalists believe that over time the market will revalue everyone's portfolios. Others suggest that venture capital firms are taking necessary steps to become more diligent about valuations and reporting. But is that enough? Is some form of regulation on the horizon?

No one is calling for government intrusion. As bad as the venture capital climate has gotten, it hasn't fallen into scandal and disgrace , yet. But more formal self-regulation is a real possibility, and it could be a necessity if the venture capital community wants to keep the government off its back.

Europe has already gone that route: The European Private Equity and Venture Capital Association, or EVCA, issued detailed valuation guidelines in 1993 and revised them in May 2001. The EVCA tells its members to call in independent appraisers, provides guideposts for estimating "fair value" when public market benchmarks are unavailable and suggests that write-downs be taken in harsh 25 percent increments. Christopher Brotchie, chief executive of London-based Barings Private Equity Partners, says that he expects U.S. firms will eventually follow similar rules.

To date, the U.S. National Venture Capital Association has shunned such policymaking. "The issue has come up repeatedly, but there hasn't been a will among VCs to take action," says Jeanne Metzger, the NVCA's vice president of business development and public affairs. "Many VCs feel that the EVCA's guidelines are onerous and not necessarily appropriate for the U.S."

Lacking firm rules or guidelines, American venture capitalists set valuations based on generally accepted accounting principles, which means they are making "best-guess" assessments of things like management performance and intellectual property portfolios. "The EVCA's guidelines have produced significantly greater uniformity," says Richard Testa, co-founder and chairman of Testa, Hurwitz & Thibeault, a Boston-based private equity law firm. "[The Europeans] went from nothing to something , a tremendous improvement. In this country we still have nothing."

Adds Barings' Brotchie: "The VC industry in Europe is ahead of the U.S. without a doubt on the valuation question. If the industry in America doesn't move in that direction itself, it's going to be dragged there, mainly by big institutional investors."

Even under the best circumstances, getting a firm grip on the values of every company in a venture capital portfolio is a slippery , and, many would argue, impossible , task. Of course, valuations get assigned anyway, but who's to say how realistic they are?

Private investments are by nature illiquid and therefore defy precise measurement. The most scientific valuations are based on "events" , such as Caspian's new financing round, an initial public offering, a merger or a bankruptcy transaction , which demand that values be marked to market. But these occur infrequently, and venture firms often revise their valuations for quarterly or annual reports to limited partners. When times are bad, the firms may want to avoid write-downs altogether.

In line with GAAP, venture capital firms factor in various measures, such as the value of comparable public companies. They also use discounted cash flow analyses that rely on company projections of future profits. But when these standard methodologies are applied to illiquid private companies competing in volatile technology markets, subjectivity almost always rules in the end. For example, a company's valuation could soar if it obtains a government patent or sour if it is denied one. "Whoever wins the race to the patent office wins the whole enchilada," notes Bruce Bingham, a partner of accounting firm BDO Seidman and vice chairman of the American Society of Appraisers.

To be sure, venture firms have become more attentive and conservative in addressing valuation concerns. Many firms took write-downs at the end of last year. Still, nearly all resist calling in objective help from outside. One reason: Even a cursory appraisal of a single company by a third party could cost $25,000 to $30,000 , far too pricey for funds with dozens of portfolio companies to review each quarter.

What's more, there's the matter of pride. "It's our job to know what our portfolio is valued at," says Gary Tsao, an investment manager at H&Q Asia Pacific in Palo Alto. "We don't need other people to tell us how to manage our portfolio."

Bingham, who heads BDO Seidman's business valuation group in New York, sympathizes: "The predictability of VC funds is so uncertain that if [general partners] came to me, I might throw my hands up like they do."

Some venture capitalists simply regard revaluations as a waste of time and will hold values steady even amid extreme market volatility. "While some firms have been very aggressive in marking down everything to prove their mettle with limited partners, that doesn't necessarily get anyone closer to the truth," argues Morgenthaler. "If you have a good company doing well and the next financing is 12 to 18 months away, it's honestly quite hard to know what the value is going to be."

Still, investors at least occasionally want to know the score, and subjectivity can be disorienting. Different venture capital firms investing in the same start-up will sometimes assign different valuations to it. That happens because these partnership deals do not require public disclosures. The agreements do typically require venture funds to present audited annual statements and in some cases unaudited quarterly or semiannual statements. However, says Ravi Chiruvolu, general partner at Charter Venture Capital in Palo Alto, "VCs have no incentive to market down their portfolios , but LPs are fighting back."

It's no wonder that firms resist taking haircuts. A lower valuation can cut into general partners' earnings and lower a fund's internal rate of return, making future fundraising more difficult. Though limited partners are pushing for better reporting, they, too, can feel pain when substantive revaluations impact their responsibilities, compensation or bonuses. And for entrepreneurs a write-down can be demoralizing, making new funding more expensive or impossible and dashing hopes for options-related riches.

Traditional market forces, of course, are hard at work. Calculated on the basis of event-driven transactions alone, the median valuation of companies receiving follow-on financing last year fell 33 percent, to $16.7 million, according to San Francisco-based research firm VentureOne. This year could be worse. "Paper valuations have come down a lot in the last couple of years, but I'm not sure they really fully reflect what's out there," says Jonathan Silver, founder of Core Capital Partners in Washington, D.C. "I suspect there's still some distance to go."

How much distance? Credit Suisse First Boston recently concluded that dollar-averaged private equity investments are currently valued at a 40 percent premium to the Nasdaq composite index. "Due to the declines in public company valuations, the expectations for private company exits have also declined," explains Stephen Can, CSFB's head of secondary funds. He adds that venture capital portfolios in the secondary market are trading at discounts of 10 to 70 percent below cost. "If there's no exit available for a company or the product isn't being developed right, it's hard to realize value," he says.

Another complication is the legions of "walking dead" , hundreds of start-ups still on the books of venture capital firms at their initial valuations. According to VentureOne, nearly 3,400 private companies that were funded before 2001 remain in operation but have yet to raise additional funds. Not all will fail, but many are sure to be starved for capital.

The most vulnerable venture funds are those that invested their capital in 1999 and 2000, especially if they bought into dot-com or other Internet-related ventures. "More than 80 percent of the companies funded in those years will not survive," says Sanjay Subhedar, general partner with Palo Alto-based Storm Ventures.

The squeeze has led some general partners to give money back to investors. Palo Alto,based Accel Partners recently trimmed its $1.4 billion Fund VIII to $950 million, returning the capital and accumulated management fees to limited partners, after the latter had rejected an offer to cut the fund in half and set the unused $700 million in reserve aside , free of management fees , for a future fund.

Barings' Brotchie says that as institutional investors grow more vocal, discipline and consistency , and perhaps European-style self-regulation , will follow. But some restive limited partners aren't waiting; they are taking investment firms to court. Lawyer Testa notes that "there is an alarming and significant trend in contentious litigation." In one high-profile reaction to the Internet crash, Dell Computer Corp., T. Rowe Price Science & Technology Fund and several other investors in Idealab, the once-high-flying incubator of EToys and other e-flops, have filed a $1 billion lawsuit to recover losses and damages from self-dealing and other alleged misdeeds. In addition, the Connecticut state pension fund is suing New York,based Forstmann Little & Co., and Millennium Partners is suing MeVC, an affiliate of Silicon Valley's Draper Fisher Jurvetson. "A few years ago no one would have brought lawsuits like this," says Testa. "When people lose money, there's a change in attitude."

For their part, venture capital firms are seeking to lower costs and mitigate risk by making their term sheets with entrepreneurs tougher , so tough that in some cases teamwork may be jeopardized. The biggest point of contention is the liquidation preference, or the returns that investors get before anyone else gets paid. For example, if a portfolio company were sold, investors who had a 3x liquidation preference would triple their money. Only after these payouts would management or later-stage investors get their portions. Once 1x liquidation preferences were normal, but now 3x is common, and 6x or even 7x is not unheard of. At those high rates, entrepreneurs may lose motivation and push to sell their ventures faster and less profitably than they otherwise might.

"This is pitting investors against management and employees of a company," says venture capitalist Morgenthaler. Liquidation preferences can also turn venture firms against each other. Notes Doll Capital's Moran, "Sometimes third- and fourth-round limited partners want earlier investors to give up their preferences."

That's what happened when IReady Corp., a Santa Clara, California, start-up with technology for high-performance computer networking, closed its latest round in April. The $19 million financing, led by National Semiconductor Corp., sliced IReady's valuation from $120 million to $48 million, says the company's founder and CEO, Ryo Koyama. In the process IReady's preferred investors, who had previously put in $43 million, took a haircut to $9 million. To keep them in the game , and to gain their approval for the latest financing , IReady structured its liquidation preferences and other terms so that the investors would have a reasonable chance to recover their original $43 million if the company is acquired or goes public.

Although Koyama says the financing was "extraordinarily positive," he, like his counterparts at Caspian, can't hide his disappointment: "If you told me in '99 that we'd be doing a $19 million round in 2002, I'd have said, That's just not cool." He adds, only half in jest, "I thought we'd be doing billions of dollars."

Now Koyama faces an increasingly common plight: He'll have to get by with less.