How VC firms can save the venture capital system, part 2

"Writing up" positions in a venture fund leads to the fund reporting imaginary gains. Instead, funds should report on Fair Value, which gives LPs an accurate view of the fund's performance.

In our last piece, we explained how overvaluing VC funds threatens investor confidence, and therefore the venture capital system. But how can VC firms improve their reporting to preserve their fundraising ability?

“Writing up” positions can overinflate valuations

Let’s examine a fictional scenario:

A seed stage firm raises a $10M fund from wealthy individuals, family offices, and other institutional investors to invest in 20 seed-stage companies by writing twenty $500K checks. It does so and closes fund 1.

Two years later, five of those investments have died, 10 are surviving, and five go on to raise a Series A at a ~4x valuation.

The fund sets its valuation as (investment) * (value adjustment):

  • Died: 5 * $500K * 0 = $0
  • Surviving: 10 * $500K * (1+20% premium) = $6M
  • Raised Series A: 5 * $500K * 4 = $10M

The fund reports that it achieved a value of $16M in two years, a 27% unrealized “annual rate of return,” and that five companies have raised new rounds of capital.

After the fund makes such rosy assumptions, which on the surface may seem reasonable, it will attempt to raise fresh capital for its next, $50M, fund 2.

In reality, there are some serious issues.

When companies seek a new round of financing, new investors get completely different securities with different rights and preferences. In the above example, the Preferred Series A at $5/share also gets a $5/share liquidation preference, whereas the Preferred Series Seed only gets its $1/share liquidation preference.

So if the fictional VC above casually “writes up to their next round,” they are incorrectly saying they have something they actually don’t.

The WeWork situation confirms the shakiness of this approach. If T-Rowe Price, Fidelity Investment, and Hony, which purchased large sums of Series D, Series E, and Series F, at $16, $32, and $50 per share, respectively, all wrote up to the Softbank Bank $110/share price, they would have all vastly overvalued their positions, even before the IPO fiasco.

The $110/share gave Softbank a $110/share liquidation preference (i.e. some downside protection), whereas those previous shares only have their own liquidation preference. Writing those shares “up to $110/share” assumes only a success scenario.

Or a firm may claim there is “no new data” to either keep the value at cost or cost plus a premium. However, the absence of data is not the absence of a change in value.

Many fund controllers and CFOs chalk these decisions up as industry standards. Until recently, auditors have been OK with writing up their positions to the next round of financing. Not to mention, writing it up gives the funds the highest price.

Auditors are getting stricter: the AICPA announced new guidelines in 2018 that recommended much more scrutiny on valuation practices at funds, and the audit community is listening.

It’s well-known that financial statements of early-stage private companies don’t paint the whole picture. Companies and investors have to dig deeper to understand how—if at all—the value of the company has changed, and if the value of the investments has deteriorated, stayed the same, or increased.

If funds keep reporting inflated valuations to their investors that don’t pan out at exits and thereafter, they’re risking the possibility that their LPs will lose confidence in the VC system. Without happy LPs, funds won’t be able to continue to bring in the capital they need to keep making investments. It’s possible this state of affairs would lead to a significant reduction in the number of new companies VC funds can back. In turn, that reduction could have major consequences for the market as a whole.

How can VC funds do better?

The best way for VC funds to keep the venture ecosystem from overinflating and risking a popped bubble is to focus on understanding the actual value of investments. “Writing it up” doesn’t cut it if everyone does it.

But the demand needs to start from the top: institutional investors need to be much more stringent when verifying track records. If every VC is inflating its numbers, the first one to do it right might seem like a loser. The best VCs, then, should be more transparent about their valuation practices. This will weed out the wannabes.

This may be more work at the onset, and it may be unpleasant in some cases to see numbers go in the wrong direction. But if everyone is changing the cholesterol numbers on the lab report, ultimately, people are going to die, regardless of what the lab report says. To the same token, if everyone misrepresents their portfolio valuation numbers, ultimately, trust will erode.

Investors need to prepare proper scenario analysis and waterfall modeling to accurately show the value of the securities they own, given the current and potential capital structure, and spell out how they are thinking about potential exits.

Newer funds and inexperienced CFOs may say, “Why would I do a waterfall analysis, though? Doing so makes my position look worse.”

Answer: Properly reporting a believable Fair Value isn’t just key to maintaining investor confidence (and therefore continued investments in VC); it can also help highlight the funds and firms that really and truly are good at picking winners. Yes, there are potentially a lot of WeWorks, and Blue Aprons out there. But there are also many companies that do deliver growth and profits with positive unit economics that are or will be fit to perform admirably on the public market.

The best VC funds understand the relationship between a savvy, well-executed business model and a house of cards propped up by a raft of investors writing up their valuations to the next round. They’re actively investigating the true drivers of value, which means digging into financials and performance to understand what key value drivers look like.

That work, which translates directly into the kind of Fair Value reporting we’re describing here, is critical to identifying companies that will actually create value that the fund and its investors can capture. If funds commit to reporting transparently on the duds, they’ll also be opening up a means to differentiate themselves when they’re right about the bombshells.

At Preferred Return, we know that having access to public and private valuation data, dynamic waterfall analysis, and other valuation tools where investors can easily perform option pricing models will help alleviate some of these issues.

To that end, for the next 30 days, we’re providing free access to our waterfall analysis tool so funds can start getting a realistic view of what their positions are worth.

We believe this will be the norm going forward, and institutional investors will require higher scrutiny as to the reported value by VCs. Blue Apron et al. are already shaking confidence, and confidence is a necessary precondition for the continuation of the VC system at its current scale. Looking honestly at value drivers and reporting believable valuations can restore that confidence, prevent overinflated rounds, and lead to sustainable results for both funds and their investors.

Blue Apron is the bathwater. We shouldn’t have to throw the venture capital ecosystem out the window with it.

Want to do a better job reporting on your fund’s performance?

How VC firms can save the venture capital system, part 2