2014 National Venture Capital Association Yearbook | 121
APPENDIX I US Accounting Rulemaking and Valuation Guidelines In the United States, a venture capital fund is usually organized as a limited partnership. The institutional investors providing capital to a fund typically become the limited partners (LPs). The venture firm itself becomes a general partner (GP) in the limited partnership. In most of the limited partnership agreements defining the GP-LP relationship, the GPs are required to provide financial reports quarterly (unaudited) and annually (audited) prepared according to United States Generally Accepted Accounting Principles (“GAAP”). GAAP calls for the use of investment company accounting, which mandates that a Fair Value be assigned to the individual investments (portfolio companies). This is consistent with the LP’s need for Fair Value of their investments, as well as third-party or regulatory requirements, e.g., ERISA-regulation. In recent years, the GP-to-LP financial statements have been subject to numerous rule “clarifications,” convergence with non-U.S. accounting, expanded disclosures, and more formal presentations. Industry groups (PEIGG a decade ago and IPEV today) have released guidelines that, if adopted, can reduce questions from LPs and provide a basis to respond to questions posed by auditors.
Guidelines fall into two categories. The first is portfolio performance presentation formats, calculations, and disclosure. Examples of such Guidelines are the Private Equity Provisions of the Global Investment Performance Standards (GIPS), developed by the CFA Institute and the IPEV Investor Reporting Guidelines. While many of the specifications and terminology line up with current practice in the United States, the NVCA has not endorsed or otherwise commented on these Guidelines. Neither NVCA nor Thomson Reuters has determined how widespread the adoption of those guidelines is or will likely be. These documents and accompanying guidance can be currently found at http://www.cfainstitute. org/centre/codes/gips/ and www.privateequityvaluation.com.
require the venture firm to provide quarterly and annual financial statements using Generally Accepted Accounting Principles (GAAP). GAAP requires Fair Value measurement for portfolio positions. Therefore, most GPs must issue financial statements using Fair Value.
The second important category of guidelines is focused on valuation.
The Evolution of Reporting and Valuation Guidelines
Why Valuation Guidelines Matter What ultimately matters to investors and private equity practitioners is the cash that has been distributed to the investors during the life of the fund compared with the original money put in. However, the specified life of a typical venture fund is at least 10 years and often longer in the life sciences arena. During that period, the venture capital fund reports progress to the limited partners. In many cases, this means quarterly portfolio updates and a complete annual audited financial statement. For a typical venture fund, very little money is paid out in the first four or five years. Also, while every portfolio company receives funding with high expectations, it can take several years to determine if a particular company is a likely winner. Therefore, understanding progress in the portfolio requires some estimate of the success of the investee companies by the venture capital or private equity firm. While many investors and fund managers agree that financial measurements mean little for the first three or so years of a fund, investors are required to report the Fair Value of their fund positions on a quarterly or annual basis. This is where specific valuation rules and processes become important. The agreed valuation procedures for individual portfolio companies become the basis for progress assessment as the fund matures and ultimately distributes cash to the investors. Thus, while portfolio company valuations are more of an art than a science, especially for pre-revenue or even pre-EBITDA companies, most limited partner agreements (LPAs) establishing a venture capital fund
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Most important, if industry-created valuation guidelines are not used, those outside the industry, such as auditors or regulators could impose their view on the industry. A non-industry view could adversely impact the LPs desire and ability to invest if interim values are not representative of the way the industry sees value, and costs for determining valuation could increase.
To understand the pressure on valuation and reporting in today’s environment, a historical background review is instructive. • 1940 – United States Investment Company legislation (“the 40 Act”) required investment companies to report the Fair Value of investments. While the application of accounting standards has evolved over the past 70+ years, the underlying basis of reporting has always been Fair Value. • 1989-90 – A group of investors, private equity fund managers, and fund-of-fund managers formed a group to develop a set of portfolio company valuation guidelines for financial reporting. Contrary to a very persistent rumor, the NVCA did not endorse, adopt, bless, publish, or otherwise opine on the guidelines. Using the principle of conservatism, these non-endorsed guidelines used cost or the value of the last round of financing to approximate Fair Value. • Decade of the 1990s – Two noteworthy developments occurred in the 1990s. Despite no endorsement by the NVCA, these guidelines became accepted practice by much of the United States industry, especially in the venture capital side of private equity. These guidelines were referred to by many as being issued by the NVCA but in fact they were not. The second development is that international venture associations created localized guidelines based heavily on these guidelines. These were created in Europe and other international regions. In fact, by 2005, there had been multiple iterations of the European and British guidelines, again generally focused on cost or the value of the last round of financing.
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