This is the fifth in our series of ten frequently asked questions from investors in venture capital partnerships.

Susan Mangiero, CEO of Investment Governance’s Fiduciary X, asked me the following:

Question: Please differentiate between the governance of a VC fund versus the governance of companies in a VC fund’s portfolio? Is one more important than the other?

Answer: This is a very important question, and it starts with recognizing that VC funds, as partnerships, are governed very differently from portfolio companies, which are corporations.  The VC fund may have one managing partner that sets the tone and controls the entire firm, or it may have a collegial distribution of governance among several senior partners.  The best way to understand how a VC fund is governed begins with an analysis of the fund’s investment committee, its deal due diligence process, and the specific allocation of the fund’s investment capital among the individual partners.  An important question to ask is, do the partners evaluate themselves and each other on an annual basis or at all? You might be surprised to learn that many VC funds lack an internal feedback loop, that the partners may not communicate openly among each other, and that the partners themselves may lack a formal measure of accountability among each other, even though the economics are divided formally in the management company agreement.

Turning to portfolio companies, the board of directors is responsible for the governance of the company, and here we have a very interesting dynamic which often leads to board dysfunction—the VC directors have inherent conflicts of interest as representatives of their funds and as fiduciaries who must act in the best interests of all of the shareholders.  In addition there is a major tension and conflict between the management team and the VC directors—the management wants more share ownership, and the common equity is at the bottom of the seniority stack behind the various series of preferred equity rounds.  The VCs want capital efficiency, which means they want management to do more with less.  Compounding the complexity is the fact that most VC-backed companies replace their CEOs twice between the founding and the liquidity event.  So you can imagine that the VC boardroom governance equation is very complex and rife with opportunities for problems.

This is the fourth in our series of ten frequently asked questions from investors in venture capital partnerships.

Susan Mangiero, CEO of Investment Governance’s Fiduciary X, asked me the following:

Question: Are there ways to mitigate the team risk when in fact VC funds often back a particular team or particular CEO?

Answer: When we back serial entrepreneurs, it is critical to assess where they are today in their lifetime achievement and performance potential curve.  By that, I am reminded of the fundamental risk in looking at track records—“past performance is not indicative of future returns.”  It amazes me how many investors chase performance and don’t pay attention to the current team composition at the VC manager, to the current dynamics of the partnership.  Ideally you want to back a proven winner who is still hungry enough to deserve a seat at the table.  Venture capital is totally a hits- driven business, but there are very few hitters, either VCs or entrepreneurs– who are able to hit multiple home runs.  When you look at VC’s, you want to find VC’s who are magnets for great entrepreneurs, whether they are first timers or veterans, and rely on the VCs’ pattern recognition ability to make that judgment call in picking a winner.  One way to mitigate risk is to assess how deep the team is in the VC organization—remember that you are making a 10 year bet on a team, and few teams stay together through an entire cycle.

This is the third in our series of ten frequently asked questions from investors in venture capital partnerships.

Susan Mangiero, CEO of Investment Governance’s Fiduciary X, asked me the following:

Question: Given recent instances of VC-backed company fraud and questions about the management team, how can institutional investors protect themselves from key person risk?

Answer: You are asking a fundamental question here about trust, which relates to your prior question.  I could restate your question by saying, how do I know that I’ve backed someone as a GP who is trustworthy?  The answer is, you have to do your homework on that person, which means that you have to make a full range of reference calls to people who are not on the person’s reference list.  This takes resources and time.  If you are not equipped with the resources to do the work, then you need to rely on someone else’s process—but again that has to be an independent third party whose due diligence credentials are also trustworthy.

Let me turn the table on you a little bit because I sit in your shoes all the time– as a venture capitalist who bets on entrepreneurs, my greatest challenge is to sit across the table from a very enthusiastic person and judge their credibility—will they actually do what they say they are going to do?  Will they work 24/7 to get the job done?  How will they behave when unforeseen challenges occur—which they always do?  Institutional investors have to do the same thing because they are betting on people, and they need to establish a considerable measure of trust if they are going to sign on to a 10 year commitment to invest in illiquid assets.  This is the toughest part of our jobs—as I look back over my the 14 years I have spent in venture capital as part of my 29 year finance career, the biggest mistakes I have made have always been related to key person risk, as opposed to picking the “wrong” technology.

This is the second in our series of ten frequently asked questions from investors in venture capital partnerships.

Susan Mangiero, CEO of Investment Governance’s Fiduciary X, asked me the following:

Question: At a time when transparency is so important to institutional investors, how can fiduciaries reconcile that there is limited information available with a private company?

Answer: Actually there is plenty of financial information available from private companies, but that does not mean that it is available to institutional investors as passive investors who are Limited Partners in venture capital or other private equity partnerships.

Putting that point aside, for a moment, what is absent is a quoted liquid market in their equity and debt securities, which means that the determination of the book value of those private companies is necessarily subjective. Institutional, or any other investors, for that matter, who choose to invest in illiquid securities, presumably do so because they expect to obtain superior returns from the illiquid securities at the end of the investment period than they would from liquid securities over the same period—otherwise it’s not worth giving up the liquidity and taking the risk of the longer holding period. To get to the core of your question, providing passive institutional investors with more financial information about illiquid securities isn’t going to make them more liquid.  They key is whether you can rest assured that the general partner who is responsible for managing your investment is honoring the trust that you have placed in that manager.

There has been a multi-year move among auditors, driven by demand for greater transparency in understanding the process behind the book valuation of private, illiquid investments, to bring more of a “mark to market” approach in the way the general partners of private equity partnerships value their portfolios.  Before I discuss this in more detail, I should fully answer your question:  the main reason why general partners, particularly in venture capital, should legitimately limit the amount of information they disclose to their investors about their private investments is (1) competitive considerations, particularly for disruptive emerging technologies where protecting intellectual property and market competition from large companies are defining elements in the company’s potential for success.

Having said that, if a sophisticated institutional investor insists on having the right to inspect the details about specific private investments, see business plans, and otherwise get details about the company, if they are prepared to sign a confidentiality agreement and have a good reason for wanting to see this information, it certainly exists and can be made available.

To address the broader point about accuracy in book valuation, I am concerned that the developing industry standard for venture capital is at risk of going too far while providing no real benefit to investors. I see the auditors forcing excessive quarterly compliance burdens on the general partners, and this trend has been developing since the institution of 409a valuations for common stock.  The reason I feel this burden is unnecessary is because, in my view, the additional information may be very precise without being accurate.

The fact remains that you don’t know the value of a private asset unless you actually intend to sell it.  And in venture capital, the second you become a forced seller of a company, you have given it the equivalent of the kiss of death.  For many emerging companies, the moment that you become a bona fide seller and are perceived to have to sell the asset, the value will be diminished—so you can imagine why the lack of an IPO market is the single greatest source of distress for venture capital in the U.S.  To conclude on this question, I’d like to emphasize that, in my view, for early stage companies with little or no revenue, valuation models driven by public equity or option inspired equity models simply make no sense.

It’s that time of the year again– time to send out audited financial statements and K-1’s to your limited partners– which means it’s also a great time to address some of the common questions that investors raise about VC partnership governance and disclosure issues.

I recently spent some time answering a series of such questions posed to me by Susan Mangiero, the founder and CEO of Investment Governance, Inc., whose site Fiduciary X, is an emerging “one-stop best practices information portal for investment decision-makers and their service providers.” Fiduciary X, on whose advisory board I serve, combines peer networking, research, productivity tools, proprietary data sets,  and a governance-focused knowledge base with a documents archive to serve fiduciaries and risk managers.

In the interests of sharing this interview with a broad group of interested readers, I am going to be posting one question and my answer each day for ten days, including today.  For access to the full interview, which will be published March 15, please go to the Fiduciary X Ezine registration site.

Question:  How much information are limited partners (pensions, endowments, foundations, etc.) entitled to receive from a VC fund?

Answer: Section 17-305 (b) of the Delaware Revised Uniform Limited Partnership Act, which governs LP information rights according to DE law, specifically allows the GP to withhold from LPs “any information the GP reasonably believes to be in the nature of trade secrets or other information the disclosure of which the GP in good faith believes is not in the best interest of the Fund or could damage the Fund or its business or which the Fund is required by law or by agreement with a third party to keep confidential.”  This would include the GP’s fiduciary duties and confidentiality obligations with respect to not disclosing portfolio company information without the consent of such company.  The Act provides for a specific list of information that LPs are entitled to, and funds historically disclose that same information to their LPs—the top law firms in Silicon Valley model their LP agreement forms to be pretty consistent with Delaware law.

Specifically, Section 17-305 of the Act provides for the following:

(a) Each limited partner has the right, subject to such reasonable standards (including standards governing what information and documents are to be furnished, at what time and location and at whose expense) as may be set forth in the partnership agreement or otherwise established by the general partners, to obtain from the general partners from time to time upon reasonable demand for any purpose reasonably related to the limited partner’s interest as a limited partner:

(1) True and full information regarding the status of the business and financial condition of the limited partnership;

(2) Promptly after becoming available, a copy of the limited partnership’s federal, state and local income tax returns for each year;

(3) A current list of the name and last known business, residence or mailing address of each partner;

(4) A copy of any written partnership agreement and certificate of limited partnership and all amendments thereto, together with executed copies of any written powers of attorney pursuant to which the partnership agreement and any certificate and all amendments thereto have been executed;

(5) True and full information regarding the amount of cash and a description and statement of the agreed value of any other property or services contributed by each partner and which each partner has agreed to contribute in the future and the date on which each became a partner; and

(6) Other information regarding the affairs of the limited partnership as is just and reasonable.

The current state of the art for Agreements of Limited Partnership in venture capital allows the GP to override the information rights LPs have pursuant to the Delaware Revised Uniform Limited Partnership Act (the “Act”) as permitted pursuant to the Act and allows the GP to “adjust” identifying information given to the LPs in order to protect the identity of the Fund’s portfolio companies, which often is an issue in the case of Freedom of Information Act (FOIA) LPs.  In addition, the partnership agreement allows the GP to restrict / withhold information from LPs if “the General Partner reasonably determines [such LP] cannot or will not adequately protect against the [improper] disclosure of confidential information, the disclosure of such information to a non-Partner likely would have a material adverse effect upon the Partnership, a Partner, or a Portfolio Company.”  Other elements of the well drafted agreement do provide the LP’s with disclosure rights to their advisors, equity holders, etc. and provide remedies and protections to the GP with respect to GP withholding rights and improper LP information disclosure.

First of all, we must say it is a compelling read with some disturbing trends and conclusions that vividly show that the US has experienced serious decline of leadership in the IPO market, and overseas markets have seen rapid growth in IPO listings, especially in Asia, where listings have more than exceeded their strong GDP performance. …

Doubtless, there is a crisis in the US IPO markets, and this issue is getting compounded each year. If action were not taken now, the US could lose the lead it has held for decades in global capital markets. The situation is dire indeed, and all regulators and lawmakers should react to save the US from certain followership.
This report is a must-read for all players in the capital market space, and we trust you will find the results equally astounding.

Clearly, this is a wake up call for America, and the title does full justice to the seriousness of this problem.

For anyone interested in listening to the archived webcast form November 9th, CLICK HERE

Join Grant Thornton for a free Webcast on A Wake-Up Call for America, the greatly anticipated study demonstrating how market structure changes over the past 10 years have had a profound negative effect on the number of publicly listed companies in the United States – ultimately inhibiting economic recovery, worsening the job market and undermining U.S. competitiveness.

Date: Monday, November 9, 2009

Time: 12:30-2:00 EST

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The Webcast will feature a lively discussion among the study’s contributors and other industry-leading capital markets executives, and will include an in-depth look at the steep decline in U.S. listings, the macroeconomic implications, and recommendations for attainable solutions. A Q&A session will conclude the event, and all participants will receive a copy of the study.

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• David Weild – Former vice-chairman and executive vice president of the NASDAQ Stock Market, and current Senior Advisor at Grant Thornton LLP and founder of Capital Markets Advisory Partners.
• Edward Kim - Former head of product development at the NASDAQ Stock Market, and current Senior Advisor at Grant Thornton LLP and Managing Director of Capital Markets Advisory Partners.
• Pascal Levensohn – Founder and Managing Partner of Levensohn Venture Partners, and Director of the National Venture Capital Association (NVCA), where he is chairman of the education committee.
• Barry Silbert – Founder and CEO of SecondMarket, the largest marketplace for illiquid securities.  SecondMarket was named the top start-up in the entire Northeast by AlwaysOn Media and one of the Top Fifty Startups You Should Know by Businessweek.
  

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Follow the steps below to register. You will receive an email confirmation with instructions for attending the Webcast. If you need assistance with registering, please call 206.812.4700.

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On Monday, August 10, Barron’s ran a story “Does the IPO Market Shun Smaller Companies?”, written by Mark Veverka, asserting that “venture capitalists want to widen the playing field for the underwriters.” The story includes quotes from former National Venture Capital Association (NVCA) chairman Dixon Doll of DCM and investment banker Paul Deninger, who is the vice-chairman of Jefferies & Co. It accurately points out that, when it comes to IPOs, many venture capitalists have mistakenly defaulted to choosing the large investment banks (such as Goldman Sachs, Morgan Stanley, and Credit Suisse) as lead underwriters for their portfolio companies.  This practice has created “a near oligopolistic hold on tech IPOs” by these large investment banks.  Such market power allows bankers to shapes the profile of those companies worthy of going public to favor the natural demand from their largest clients: short-term trading focused hedge funds and large institutional investors that demand highly liquid public securities.

The collateral effect of this market reality is that the vast majority of emerging VC-backed companies are effectively barred from going public.  To be clear, there are plenty of strong venture-backed companies today that should be public but that do not meet the valuation or liquidity criteria of the three large remaining investment banks (more on this below).  Unfortunately, outside of the IPO-syndicate-bias and the much-maligned Sarbanes Oxley, the article does not address far more serious systemic regulatory consequences that further exacerbate the problem– such as the combined impact of decimalization and the Spitzer decree (taking trading commissions down from $0.125 per share to $0.01 or $0.02 per share and requiring that equity research be paid for by commissions ) which have effectively gutted both the after-market trading and research support that emerging company IPO’s need.

While the article notes that “the objective is to get back to late-80s, mid-90s practices, allowing more start-ups access to capital so they can remain indepenedne tand create more opportunities for venture capitalists to cash out”, the emphasis on who is cashing out is misplaced.  More accurately stated, the institutional investors who fund the venture capital partnerships need more opportunities to cash out– and these institutions are largely public pension plans, college endowments, and other true long-term investing financial institutions.  Why do they need to cash out?  Because they are also the main players who have historically reinvested in the next generation of innovation.

Sadly, the article completely ignores the implications of this systemic liquidity crisis.  If we look at the historic record, the most important point overlooked by this story is that smaller companies need to go public because they are the engines of growth that drive the U.S. economy– both in terms of job creation and GDP growth.  The IPO chasm that exists today is the result of the death of the sub $50 million IPO.  For a clear example, see the following list of 17 companies that went public and raised $50 million or less between 1971 and 1996:

These companies only raised $367 million in the public markets and they account for 470, 000 U.S. jobs today. Adjusted for inflation andmeasured in 2009 dollars, the $367mm in total dollars raised by this group equals$670mm, and only 2 of these 17 companies’ IPOs (EMC $80mm; and Oracle $70mm) exceed $55mm in 2009 dollars.  While today these companies are household names, when they went publicthey were largely unknown. How many companies are unable to go public today  because they aren’t big enough to merit the attention of the large investment banks who cater to short-term traders?  How many future engines of U.S. GDP growth and job creation will be still-born and be forced in to a merger?  Should they be starved of liquidity because they need to cash out investors, build working capital, but it is unavailable to them because they need less than $50 million?

Deninger points out in the article that “In recent years, VC firms have become too dependent on mergers and acquisitions as the exit strategy of choice. . .. In fact, most tech-start-ups are ‘built for acquisition’, as opposed to being built to become the next publicly held Microsoft or Oracle.” An addendum to his quote should be that merger synergy is code for firing people.  Mergers trigger job losses; IPO’s create jobs.

In my view, it is wholly inconsistent with the Obama administration’s economic growth objectives for the current systemic liquidity crisis in our equity capital markets to be strangling our emerging technology growth companies while they are still in their venture capital cribs.  We need to raise awareness of this severe problem because it threatens an entire generation of American innovation.  Venture capitalists only make money if their investors make money, and many of their investors are the stewards of America’s pension plans.  VC’s need to build companies that are cash flow positive as private companies, not only so that they can improve their negotiating leverage in the event of an acquisition but, more importantly, so that they can wait to go public until the regulatory constraints that have killed the sub $50 million IPO are lifted.

In closing, the article incorrectly asserts that “ironically, the tech IPO market is re-awakeining just as the NVCA prepares to roll out its initiative.“  The few IPOs so far this year are drops of water in the desert, and those that are in the queue, while they represent outstanding companies, do not represent a sufficient number of companies to make a material difference for the institutional investors and the many entrepreneurs who have the most at stake.  Let’s not misinterpret false positives at the expense of the future of the American economy.

I liked the Friday, August 7 Wall Street Journal editorial, Washington vs. Silicon Valley, but it does not go far enough.  In Silicon Valley, Boston, Austin, and other innovation centers across the country, entrepreneurs and their backers (who are not limited to venture capitalists) are all keenly aware that Washington’s addiction to enacting hasty, one-size-fits–all financial regulation will continue to have far-reaching unintended negative consequences for the U.S. economy:

“… Sarbanes-Oxley compliance costs, Eliot-Spitzer’s stock analyst settlement and the economic downturn have created an historic drought in venture-backed companies going public.  . . .  It boggles the mind that Washington would enact new policies sure to prolong this (IPO) drought and strike at the heart of American innovation.” (from the WSJ editorial)

The U.S. IPO drought testifies to a systemic liquidity crisis for emerging growth companies that is putting at risk an entire generation of innovative American companies.  IPO’s are essential to job growth in America and to maintaining a balanced innovation ecosystem for two important reasons.  First, the National Venture Capital Association has published data revealing that over 90% of the jobs created by venture-backed companies occur AFTER they go public—and this relationship holds over the past 40 years.  Second, emerging growth companies lose negotiating leverage in acquisitions when they have no other viable liquidity alternatives.  Between 2001 and 2008 mergers and acquisitions (M&A) accounted for 87% of venture-backed company exits, up from an average of 44% in between 1992 and 2000.

Large corporations are generally not known for being innovative and even less for creating new jobs after acquiring other companies (merger “synergy” is code for firing people). In the current liquidity starved environment, some acquirers are able to drive draconian acquisition terms, including features such as two-year contingent calls on up to 100% the cash proceeds to selling investors.

Venture capital partnerships are typically ten-year partnerships with historically proven expectations that significant liquidity will be delivered from successful partnerships to investors by year 6. The median age of a venture-backed company at the time of its IPO has increased from 4.5 years in 1998 to 9.6 years as of year-end 2008.  The median company age at the time of an M&A exit has increased from 3 years to 6.5 years over the same time frame.

What makes this combination untenable is that the IPO drought, combined with lengthy “tails” on lower-value merger payouts, pushes liquidity out much closer to the end of life of the partnerships themselves, making it impossible for investors to re-cycle their prior risk capital to fund the next generation of innovative companies based on previously valid asset allocation models.  The massive institutional investor losses incurred from investments in asset classes unrelated to venture capital due to the global financial crisis have only fanned the wildfire fire burning in the American innovation forest.

We must solve the IPO problem, and a review of historic IPO data pre-technology bubble suggests that we need to achieve an average of 130 IPO’s per year to restore equilibrium to the venture-backed company liquidity cycle.   While Sarbanes Oxley compliance costs and the stock analyst settlement are part of the problem, the root causes include the decimalization of stock trading commissions and the death of the sub $50 million IPO.

Investors take risk in order to reap rewards.  Washington needs to recognize, first and foremost, that entrepreneurs, venture capitalists, institutional investors, market markers, and underwriters all seek to be rewarded for committing risk capital (which includes sweat equity) to making these highly risky ventures successful.  If the upside is taken away by regulations that make the risk/reward equation unattractive, risk capital and entrepreneurs will leave the U.S.  That exodus has already begun, and it is evident in many statistics that testify to America’s slipping global competitiveness since 1999.

Sadly, risk aversion is the order of the day in Washington at a time when we need risk takers to lead America to a new cycle of sustainable economic growth through new job creation.  It’s past time for our policymakers to unwind the unintended consequences of a decade of ill-conceived securities regulations that have already weakened our innovation ecosystem.  Let’s start by advocating policies that will bring risk-taking entrepreneurs and technology innovators back to the table before the American cupboard is bare.

The accounting firm KPMG recently issued a public policy alert with respect to new international tax regulations that were introduced in May for Congressional consideration.  According to the report:

Under existing U.S. tax rules, companies may defer paying taxes at rates as high as 35 percent on most types of foreign profits so long as that money remains invested overseas. The administration proposals are intended to reduce incentives to invest overseas so that companies would be more likely to invest in the United States.  The potential consequences ofthese proposals include a significant increase in the financial accounting and cash effective tax rates of affected companies, accompanied by a corresponding reduction in net income and earnings per share.

The three proposals impact the deferral of U.S. deductions allocated to foreign-source income, reform foreign tax credit (FTC) rules through pooling, and modify the “check-the-box” rules, requiring certain foreign entities that were previously ignored for tax purposes to be classified as corporations.

Based on my discussions with KPMG tax partners, the practical impact of these proposed rules is negative in two important ways: First, companies will still be required to deduct expenses from foreign operations for book purposes but will not be able to deduct the majority of them for tax purposes, regardless of whether the income is repatriated or not.  This effectively raises corporate taxes and will reduce corporate earnings and free cashflow for re-investment.
Second, and this is the part that should be of greatest concern to legislators and American business people, I do not believe that this legislation, if enacted, will achieve the intended objective (per KPMG) of reducing incentives to invest overseas.  On the contrary, it will encourage corporations to both accelerate and permanently  increase their investments overseas by divesting themselves of their foreign subsidiaries, selling them to foreign-domiciled intermediary corporations, and paying those corporations a margin for servicing the U.S. corporation’s continuing needs.  In effect, the unintended consequence will be to permanently keep these assets offshore and make U.S. companies pay more to intermediaries for the same service, because it will still cost them less than paying the higher tax burden imposed by the Congress.

The abundance of risk capital during America’s technology bubble in 1999 and 2000 effectively financed the launch of the technology innovation ecosystems that now thrive in China, India, Singapore and other emerging (and increasingly robust) economies.  Are we now going to change our international tax structure to further entrench the dependence of American companies on these emerging giants?  The pursuit of short-term tax revenues as the expense of sound long-term industrial planning is yet another example of tunnel vision among Washington policymakers.

If you are involved with companies that do international business, please do the research, understand the implications, and contact your legislators in Congress and urge them to vote against this ill-conceived regulation.  We must stop damaging America’s global competitiveness.

CLICK HERE to see the original White house document.