Another Accounting Law Designed To Increase Transparency Does The Opposite

from the unintended-consequences dept

With all of the financial mess out there, it's likely that we'll soon see calls for new regulations to help "protect" against fraud. However, before we rush into doing so, it's worth looking at how damaging previous attempts to do the same thing have been. We've already covered the massive amount of damage done by Sarbanes-Oxley, which basically made it extremely difficult for a private company to go public and significantly increased costs for any public company -- all while doing next to nothing to actually cut down on fraud.

And, now, FAS 157 has come into play -- a new rule impacting many venture capitalists, forcing them to figure out what the "fair market value" of their investments are, and provide that number to their investors. This has many different VCs complaining about what a stupid process this is. It raises similar questions as the legal change a few years ago that required companies to put stock option valuations on their books as well. The problem is that these things are impossible to accurately value. Not difficult, but impossible. You're asking people to value a totally illiquid asset as if it were liquid.

Even if the venture capitalists use a rigorous process, the result will be wrong. There's simply no way to accurately value something like a private startup until another transaction happens where the value is actually set. And, that's the way it should be for a private investment (it's also why not everyone is allowed to invest in such endeavors, because it is inherently more risky). But forcing companies to make up bogus (no matter how well meaning) valuations for companies has dangerous unintended consequences. No matter how bogus the numbers are, since they're there, people will use them as if they're real. And that will lead to more bad investing, rather than less. So, once again, we have a law designed to stop bad investing, which will most likely cause the opposite to occur.
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Filed Under: accounting, fas 157, regulations, sarbanes oxley, unintended consequences

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  1. identicon
    Anon2, 23 Jan 2009 @ 8:00am

    more fraud likely

    Forcing privately held investment funds that invest in start-ups to mark their portfolio companies to "market" is an oxymoron. I've scratched my head many times in recent years about the whole concept of marking to market completely illiquid investments. I'm very much a strong supporter of as much transparency as possible in the capital markets, but this is just silly.

    That said, I do not think this new rule will necessarily lead to more fraud litigation, though I do think there may be some rise in actual fraud as a result of it. Honest VCs and early round private equity investors will simply undervalue their portfolios -- to their own detriment in terms of formation of future funds -- while more aggressive or even dishonest ones will make up numbers, paper it over as best they can with documentation from valuation "experts" and opinion letters from accountants and attorneys, and it will be left to courts to try and sort the wheat from the chaff.

    That said, I'm not sure how many of these lawsuits will get very far, because most of these cases will be dismissed at a very early stage. Investments in venture capital funds and private equity funds are not "securities," at least not if they are structured properly, and they have always been documented out the wazoo with caveats about the extremely high risks, assumptions and unknown/unpredictable factors that could affect fund performance. It's almost always a matter of private contract, and generally speaking neither the Securities Act or the Securities Exchange Act apply (or, if they are "securities," they are subject to exemptions such as SEC Rule 144A (the private placement rule) -- meaning that the securities are sold to relatively few wealthy, sophisticated and typically very private people and institutions who don't file lawsuits unless there truly are indications of a serious problem that can't be resolved quietly and privately.

    The litigation that may arise from this new accounting rule will, with respect to these private funds investing in start-ups, will be very difficult to pursue without serious indications of real fraud. In both federal and state courts, although the pleading rules vary, you have to allege actual facts with a level of particularity not required in other kinds of litigation -- i.e., you need to provide sufficient details so that a court would find that a reasonable person would believe those facts to give rise to a strong inference of fraud. With respect to privately managed funds that invest in illiquid investments, this is a nearly impossible standard to meet except in extraordinary circumstances. That's why you rarely see litigation even when it involves actual securities issued by extremely large public corporations when the securities at issue were private placements (unregistered and highly restricted in terms of resale).

    When the investments at issue are in brand new enterprises, with either no cash flow or at such an early stage that any cash flow is meaningless in terms of predicting value, I would be amazed if many cases will be filed, let alone survive a very early motion to dismiss.

    Last -- as to firms that specialize in private company valuations, they've been around for a very, very long time, and there most definitely are accounting firms with people who do nothing but that, as well as small accounting firms and solo accountants who are competent to do it. Not typically for something like what we're talking about here, but frequently when there is a change of control transaction involving a private business, someone has to be retained to provide a valuation analysis, and often both counterparties retain their own people to do it. If you own a small business, and you want to acquire or merge with another small business, it's highly likely that neither you nor the owner of the other business has any real idea what your respective companies are worth. You each know how much you've been taking out as profits each year, and you each will have your accountants look over the books of the other company so that you both have some comfort that the numbers are all correct -- but how to you value the transaction? Do you use a cash-flow method? An annual distributable profits method? Do you measure it in some way by EBITDA? Some other way? What about comps -- how do you even access that information for similarly situated companies? Even if you can access comp data, do you look only in your local market, more regionally, nationally? Are there any public companies you can look at for any guidance? (Not very likely).

    There are a number of different methodologies for valuing private companies, and it depends in part on what industry or industry sector you are in, in part on what the company's size is relative to various external factors, and in part on other variables and factors. I'm not sure there's ever been a time when there were not competent people whose job it was to come in and provide advice on all of that.

    But it's pretty much an impossible job when the company is brand new, may not even have any meaningful cash flow, is still getting situated in the market and undertaking huge costs and obligations, and otherwise simply making all the available data on the balance sheet and, if there is one, the P&L, inherently unreliable as a predictor of current or future value.

    So, were I a VC faced with this scenario, I'd probably take the safe road and simply book those investments at zero value, or if there is some way to place some value on it, I'd select the very lowest number on the range, and maybe even discount that by some percentage. I'd disclose it all in my private placement memos, my reports to investors, and all the ways I communicate with current and prospective investors. And I'd probably sleep well at night, knowing that I've been as honest as I can be in terms of "fair market" valuation of my portfolio companies.

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