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How to Hide A VC Write-down

A good VC knows that nothing ruins a fundraising pitch like taking a big write-down on an existing investment in the middle of raising money. So it’s no surprise then that with a large number of VC firms back in the fundraising market for the 1st time since 1999/2000 write-down “avoidance” has become a hot, if somewhat forbidden, industry topic.

Valuing a VC portfolio has always been a little bit of a black art thanks to the fact that most VC investments lack any kind of objective valuation measure other than the price per share of the last round of financing. This situation is complicated by the fact that most companies only sell stock once every 2-3 years providing precious few opportunities to truly “mark to market” a particular investment.

The result of such infrequent pricings is that the valuations of existing VC investments tend to lag the public market by 18-24 months. This lag is why most VC’s had dismal performance in late 2001 through early 2003 even though the worst of the public market’s decline had already occurred.

The Last Temptation
With no public market to enforce daily valuation discipline, VCs can sometimes be tempted to “manage” their portfolio valuations, usually by neglecting to cast a critical eye on valuations that have become permanently impaired or by supporting “inside” rounds of new financing at unrealistically high valuations.

While many VCs initially attempted such portfolio “management” in the early stages of the Internet bubble’s collapse, by the middle of 2002 most had capitulated to the market and began to mark down their most egregiously overvalued investments. Some farsighted firms took a particularly aggressive “kitchen sink” approach in which they undertook wholesale write-downs across their entire portfolio in an effort to reset LP expectations to a valuation baseline from which there theoretically could only be good news (surprisingly, some limited partners opposed aggressive write-downs because they hurt their own performance/compensation).

While no VC likes to take write-downs, two important factors made the period of 2001-2003 relatively write-down “friendly”. These factors were A) the fact that everyone else in the VC business was taking big write-downs and therefore relative performance was not suffering dramatically (indeed it’s still possible to be a “top quartile” Vintage 1999 fund and have a negative IRR) and B) Few firms needed to raise money during that period (the VC industry actually had net negative fundraising in 2002) so the write-downs did not threaten to disrupt the marketing of anyone’s next fund.

What A Difference A Year Makes
As we enter the second half of 2004, the two factors that made 2001-2003 relatively write-down “friendly” have largely evaporated. With many firms having already taken their lumps, the overall performance of VC funds has stabilized and in some cases is improving. In addition, with many firms approaching the new commitment time limit on their 1999 and 2000 funds, a large number of established firms are now back “in the market” looking to raise new funds.

Added into this mix is the fact that many funds, even the ones that didn’t really clear the decks, claim to have put the write-downs of 2001-2003 behind them, making any new write-downs of existing investments particularly glaring. With the write-down stakes thus raised, the temptations to revert to portfolio “management” tactics are particularly rich.

The Tricks of the Trade
While creativity and invention is often the order of the day when it comes to hiding a write-down, there are several tell tale signs that should generally raise suspicion levels. These tricks of the trade include:

Insider Rounds: The easiest, but most blatant way of hiding a write-down is to conspire with fellow co-investors to do an inside round at an artificially high valuation. The argument for such behavior is actually quite compelling when all of the existing investors are participating pro-rata and already own a significant chunk of the company. In such cases, the relative ownership percentages really don’t change much no matter what valuation is used for the follow-on round and thus the only real impact of a down round is that it forces all the VCs to take a write-down. It doesn’t take much peer pressure on the average VC funded board to get everyone to go along with the plan and the common investors are usually in favor of it because they are technically getting less dilution. One of the giveaways that insider rounds are priced artificially high is that while the price per share remains the same, the liquidation preferences are increased dramatically. While insider rounds are easy to accomplish, the problem with them is that most LPs are hip to the fact that insider rounds are a warning sign, especially in the relatively active mid/late stage financing market that exists today, and thus are likely to ask some uncomfortably probing questions.

Debt Financing: Venture debt financing was basically non-existent in 2001-2003, but the market has recently come back with a vengeance. Thanks to plethora of new venture debt funds as well a number of new finance company players and (the latest craze) public investment companies, there’s a lot of debt out there getting deployed at terms relatively favorable to completely uncreditworthy start-ups. The fundamental investment thesis of the debt companies is that the VCs have too much money/face invested in a deal to let it go under just because of a few million in debt, so they are really lending against VC’s vanity/unwillingness to take write-downs more than anything else. For those lucky companies that have at some business traction but lots of “legacy” cap table issues, the VCs can get the best of all possible worlds. They get to extend a company’s runway without taking additional dilution and without taking a write-down. Of course the bill will come due in a couple years, but the next fund will be raised by then.

Convertible Bridge Notes: For those companies who are not worthy of venture debt and who are unable to convince even their own investors to invest additional equity, there’s always a convertible bridge note. VCs used to issue convertible bridge notes only in the brief period between signing a term sheet and closing a round. Those standards got heavily relaxed in the post bubble crash as many VC’s used “drip feed” convertible bridge notes as life support for ailing companies. The survival rate for these bridges was dismal and that appeared to have killed off convertible bridges for awhile, but recently they have been popping up again. From a write-down perspective, convertible bridges are highly risky because they have a huge mortality rate, but if a VC can extend the runway of firm just 6-9 months it might be enough to get their new fund closed without having to explain yet another write-down.

Do Nothing: The final way to avoid a write-down is to simply do nothing when you could do something. For example, let’s say a VC firm knows that one of its investments is headed no-where fast and should probably be sold off to one of its competitors. Normally this kind of strategic level “deal management” is why VCs get paid the big bucks. However, when such deal management will result in a major write-down that could hurt fundraising efforts, it’s often hard for a VC to get excited about doing the right thing. These are the most difficult “hidden” write-downs to spot because there’s no obvious paper trail to follow. These can only be discovered by hard core, deal specific diligence, the kind of diligence that few LPs have the time to do.

You Can Fool Some People Some of the Time…
Of course no matter what machinations VCs come up to hide a write-down, “truth will out” as they say and eventually the true market value of company will come to light when it either dies or achieves some kind of liquidity event.

Even without some kind of external event, the best limited partners can still ferret out overvalued portfolio deals by asking the right set of questions, doing some basic diligence, and comparing notes. Some LPs have even discovered “hidden” write-downs by simply comparing the carrying values of the same investment held in two different funds.

However they find them, venture LPs had better shine up their magnifying glasses and put on their gum shoes because in this environment hiding write-downs is so tempting that it may be impossible for some VCs to resist.

July 8, 2004 in Venture Capital | Permalink

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The thoughts and opinions on this blog are mine and mine alone and not affiliated in any way with Inductive Capital LP, San Andreas Capital LLC, or any other company I am involved with. Nothing written in this blog should be considered investment, tax, legal,financial or any other kind of advice. These writings, misinformed as they may be, are just my personal opinions.