The acronym stands for Net Asset Values. Be forewarned: this is the more boring installment in the VC Money Pump series of columns (see part 1 and part 2 ). Worse than spreadsheets and compound interest calculations, today’s topic forces us to deal with FASB (Federal Accounting Standard Board) regulations. Expensive futility as far as we are concerned.
For perspective, let’s go back to the previous crisis: the Internet Bubble. Fortunes were lost when Cisco’s stock went down by 90% — with the entire high-tech sector. But new fortunes were about to be made.
First, there were the political fortunes of posturing solons. Seeing the damage done by accounting fraud at Enron and WorldCom, canny politicians seized the opportunity to harness the public’s ire to their career’s progress. Paul Sarbanes and Michael Oxley begat what we now call Sarbox (the Sarbanes-Oxley Act of 2002), a new set of much stricter accounting rules. To the angry investing public, to the recently fired as a result of the downturn the senators’ message was clear: We’re here for you, we’ll throw the Armani-suited thieves in jail and we’re putting in place the safeguards needed to avoid a repeat of such catastrophe.
What nobody wanted to hear then was we didn’t need new regulations. Existing laws and accounting rules were amply sufficient to catch and punish the thieves. We didn’t have a problem of rules, we had a problem of lazy policing, of understaffed regulatory agencies and, above all, of much too much coziness between our elected officials and industry lobbyists.
Further, in order to placate the irate public, a crime was committed: Arthur Andersen, Enron’s auditor, was effectively lynched. Not told to pay a fine, not forced to come up with financial compensation. Killed. As a result, tens of thousands of Arthur Andersen employees who had had no role whatsoever in the very real auditing scandal lost their jobs as the firm was wiped from the face of Earth.
Humor being what the French call despair’s politeness, Sarbox is now called the CPA Perpetual Employment Act (CPA for Certified Public Accountant). Or, as another wag put it, the out-of-work investment bankers sold their Ferraris to members of the rising audit profession.
We’ve now turned to the second type of fortunes.
Sarbox put new, expensive compliance burdens on companies of all sizes. Such compliance comes with high fixed costs that disproportionately weigh on small companies. Our start-ups are among those. Every year, compliance with the new regulations adds hundreds of thousands of auditing fees to the expenses of young companies.
Above all: did these stainless steel new regulations prevent the current meltdown?
Let’s just hope we’ll learn from the past, get a better police and elect more honest officials who’ll what we send them to Washington for: defending the common wealth instead of selling our hide to K-Street lobbyists.
VCs, too, have to waste money on increasingly complicated compliance requirements. In principle, audits are healthy: our LPs (Limited Partners) entrust large amounts on money into our hands, hundreds of millions if not billions for the larger firms. LPs are naturally entitled to have an independent entity, an auditing firm, look into our books and certify our accounting.
But, beyond the simple principle lies a contorted reality. Accounting is a mixture of art and science: the numbers must add up correctly but, when it comes to certain assets, every business has to rely on estimates, hence my use of the word art. Some accountants won’t like the way the word resonates, no one looks forward to “artistic accounting”; but how do you know the value of the invoices you wrote but haven’t cashed yet. Will all customers actually pay? This causes businesses to estimate the amount of likely bad debt, unpaid invoices. The same goes for other assets such as the buildings the company owns, or the machinery it uses. The building ages, the value comes down, but the commercial real estate market is hot, the value goes up. And so on. In order to avoid excessively “artistic” estimates, rules were developed and constantly modified. That’s why we have a Federal Accounting Standards Board.
You won’t be surprised to hear these rules reach a tragicomical level of absurdity, of Byzantine or Talmudic complexity. Paradoxically, these arcane writs bite the very constituency they’re supposed to protect, owners, shareholders and, instead, they generate work and fees for the auditing profession. We end up with a much needed profession becoming a parasite of the business owners whose interests they’re suppose to safeguard.
LPs own a percentage of each company in our portfolio. To them, this is an asset. How do they, how do we value such assets? How do we compute the Net Asset Value, the NAV of each stake?
If we’re lucky, that is if a financing round just occurred, the valuation used for said round is a credible estimate – as long as it wasn’t an insider round. If a third party without a previous interest in the company decides to invest, we have a usable valuation for the NAV reported to our LPs.
If we didn’t get a third party to put fresh money (along with our participation) into the company, this is a sign of trouble. But, in spite of a lack of outside interest, we decide to keep the company alive, we see something outsiders don’t see, we persist. Great. What valuation do we use? Do we see the company as having increased in value because it made progress, albeit unseen by outsiders? Or, did we have trouble, did we bring a new CEO, did we go back and take a new technical path, thus having only a little experience for all the money spent so far? In the previous round $2M bought 20% of the company, what will another $2M buy this time? 15% or 30%? As this is an insider round, there is always the risk of us investors taking advantage of the situation — and why shouldn’t we if there are no takers outside? But non-participating investors and founders could object or, worse, sue. Or, conversely, we want our portfolio to look good to our worried LPs. In this case, what prevents an insider round to be priced artificially high as we prepare to go out and raise a new fund? With rising NAVs, we look good, with sinking valuations, we show a portfolio, a venture firm in trouble.
But wait, the Feds are coming to the rescue.
Our Limited Partners have their own sets of constraints, their accounting rules. Their stakes in our (their, actually) portfolio companies have to be accounted for, reported using the appropriate rules. Enter FASB 157, an accounting rule they must comply with, forcing us to do the same. If you read FASB 157, you’ll see a number of things. First, it cannot be comprehended by normal business persons (even less by normal humans). It makes numerous references to other FASB Statements (115, 124, 133, 107, 155), Concepts and EITF Issues. As a result, “flattening” the Statement, that is writing a single document including the full text of the external references turns out to be not merely complicated but altogether impossible. Why? Because the external references themselves contain external references, and so on, ad infinitum. This is neither new, unusual nor avoidable. But, in the real world, FASB 157 is no help in justifying the “fair value” of a portfolio company.
Let’s say the company is three years old, two rounds of financing already.We decide to report a decrease in valuation: -30% when compared to the last round. A 27-year old CPA, just recruited by the audit firm, freshly out of business school asks: How do we justify the -30% number? (The audit firm actually charges us to train him.) This is a valid question without a clear answer. Industry comparables? None, this is a very innovative company creating a new market. Revenue? None, we’re still developing the product. Again, why -30%, why not -50%? Sure, let’s put -50% instead, we’re two or three years away from a transaction, from an exit, so we can use a range of numbers, it doesn’t not really matter. But the valuation has to be justified says the mystified MBA, that’s what FASB rules demand, you can’t just pull a number out of your hat (he’s polite). And round and round we go as the meter runs.
For young companies, in new technology or market sectors, without past nor comparables, the whole exercise is an expensive charade, kabuki accounting.
We’d prefer a simple rule: the NAV is what the last financing round said it was, unless our judgment says otherwise — in one paragraph. Future results, hard numbers from transactions will confirm or destroy our reputation.
But we’re realists, the audit happens only once a year and we’ve learned to smile and calmly go through the expensive motions. —JLG