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.

There is plenty of ink flowing with speculation on the future of the venture capital industry.  Phil Wickham, CEO of the Kauffman Fellows Program, has a constructive perspective on this topic, which he expressed in his CEO recap in the Kauffman Fellows Program eBulletin that was published on June 2.

Below, I’ve quoted his key observations from the newsletter, with which I agree:

“… I [have] found two camps regarding venture capital: the majority believes venture is the answer to all our needs (mostly entrepreneurs) and the minority seems to think that the entire industry couldn’t fall of the edge of a cliff fast enough (mostly policy and academia). I have to say that the whole thing alarmed me, since we so strongly believe that the answer is nuanced and solidly in the middle of these two extremes. The CVE’s [Center for Venture Education] DNA is that of an “entrepreneur-first” organization, growing out of the culture and values of Mr. K [Ewing Marion Kauffman] and his Marion Labs team that put together and operated the Kauffman Foundation.

Since our full independence from the [Ewing Marion Kauffman]Foundation in 2001, our focus has been to anticipate as much as possible the evolution of the entrepreneur’s needs and opportunities, since we are management’s primary service provider. As a result, we have included the unique expertise of tech transfer funds, angel groups, corporate venture funds, international government seed funds and even foundation investors in the Kauffman Fellows Program as we strive to build a curriculum with maximum value for our customers.

… We’ve concluded a few simple things. First, that entrepreneurial capital is about enabling scale, and the value we deliver as an industry is much the same at any stage or in any environment. Second, that the CVE’s intellectual capital built up over the past 15 years is broadly applicable across all forms of entrepreneurial capital. Third, within that body of knowledge, our evolving expertise in leadership and managing the human dynamic has far more long-term impact than anything else we do. Finally, we are starting to discover that there is a much broader opportunity to spread this leadership know-how to all of the players in the eco-system: university researchers, entrepreneurs, LPs, government policy experts and service providers. We think that if – across the globe – each positional player can come to understand their own and each other’s roles and put their collaborative talents and energies behind the entrepreneur’s imagination, the world will be a better place for our children to inherit.”

I usually try to keep my blog posts short. Today I have failed in this endeavor but urge you to please read through to the end of this important post. The current issue of Foreign Affairs Magazine features an excerpt from Leslie Gelb's new book, Power Rules: How Common Sense Can Rescue American Foreign Policy.  This essay is exceptionally good, and, in my view, Gelb's thesis should be applied to all forms of statecraft and to promote the resolution of both newly emerging and long stagnating public policy debates.

Gelb accurately diagnoses the "weakening fundamentals of the United States.  First among them is that the country's economy, infrastructure, public schools, and political system have been allowed to deteriorate.  The result has been diminished economic strength, a less vital democracy, and a mediocrity of spirit."

Several paragraphs in this powerful essay deserve highlighting:

"The bases of the United States' international power are the country's economic competitiveness and its political cohesion, and there should be little doubt at this point that both are in decline.  Many acknowledge and lament faltering parts here and there, but they avoid a frontal stare at the deteriorating whole.  It is too depressing to do so, too much for most people to bear. … The United States is now the biggest debtor nation in history, and no nation with a massive debt has ever remained a great power.  Its heavy industry has largely disappeared, having moved to foreign competitors, which has cut deeply into its ability to be independent in times of peril.  Its public-school students trail their peers in other industrialized countries in math and science. They cannot compete in the global economy.  Generations of adult Americans, shockingly, read at a grade-school level and know almost no history, not to mention no geography.  They are simply not being educated to become the guardians of a democracy.

These signals of decline have not inspired politicians to put the national good above partisan interests or problem solving above scoring points.  Republicans act like rabid attack dogs in and out of power and treat facts like trash.  Democrats seem to lack the decisiveness, clarity of vision, and toughness necessary to govern.  This tableau of domestic political stalemate begs for new leadership.  The nation that not so long ago outproduced the rest of the world in arms and consumer goods, the nation lionized and envied for its innovation, can-do spirit, and capacity to accomplish economic miracles, has become overwhelmed by the tasks it once performed competently and with relative ease."

This is the most succinct and gut-wrenching summary of our national predicament that I have read.  Gelb puts his finger directly on the jugular vein of America's innovation ecosystem and diagnoses the multiple layers of dysfunction that have launched our country into such a deep crisis.  I share his fear of a new global reality developing along the following lines:

"The real danger in this universe of primitivism and plenty is not new wars or explosions among major states, or a world war, or even a nuclear war.  It is the specter of nations drowning in a flood of terrorism, tribal and religious hatred, lawlessness, poverty, disease, environmental calamities, and governmental incompetence.  Many nations are going under because they are simply unable to cope, and they will drag others down with them."

 

Gelb closes this essay with an impassioned plea for action, and most important, he retains a strong sense of hope and pride in our country:

"Every great nation or empire ultimately rots from within.  One can already see the United States, that precious guarantor of liberty and security, beginning to decline in its leadership, institutions, and physical and human infrastructure, heading on the path to becoming just another great power, a nation barely worth fearing or following.  It is time to send up flares signaling that the United States is losing its way and its power, that it is in trouble. But it is even more important to reaffirm the belief that the United States is worth fighting for both across the oceans and at home.  There should be no doubt that the United States, alone among nations, can provide the leadership to solve the problems that will otherwise engulf the world.  And for all the country's faults, there should be no doubt that it remains the last best chance to create equal opportunity, hope, and freedom.  But to restore all that is good and special about the United States, to rescue its power to solve problems, will require something that has not happened in a long time: that pragmatists, realists, and moderates unite and fight for their country."

I've been sending out flares to other realistic moderate pragmatists on this and other topics that demand a "common sense" approach for years.  Through groups such as the Council on Foreign Relations, the Aspen Institute's Socrates Society, the Working Group on Director Accountability and Board Effectiveness, and, most recently, the Security Innovation Network, I have joined and helped forge communities of interest bound together by empowered individuals who are thoughtful and constructive agents of change.  As Gelb points out, we have a lot of wood to cut, but I remain energized and, most importantly, hopeful that we can make a difference because we have to.  Given where America stands today, fomenting pragmatic and realistic change is not an option, it is a requirement.

  

 

 

The Q1 2009 venture capital investment statistics
are in, and they are down, BIG.  While
nobody expected a strong showing given the environment, the magnitude of the across-the-board declines should give everyone pause.

(Note: Source for graphic at right, Judy Estrin, Closing the Innovation Gap)

In the speech that I gave at the DHS CATCH conference in Washington,D.C. on March 4th and on the panel that I
moderated at Stanford on March 18^th at ITSEF III, I pointed out that one developing impact of the global financial crisis that was not yet evident in the financial statistics would be accelerated declines in
new capital formation from venture-backed companies because capital normally dedicated to long-term risk has been severely drained from our equity markets—both public and private.

The following data comes from The MoneyTree(TM) Report by PricewaterhouseCoopers and the
National Venture Capital Association based on data from Thomson Reuters:

"Quarterly investment activity was down 47 percent
in dollars and 37 percent in deals from the fourth quarter of 2008 when $5.7
billion was invested in 866 deals. The quarter, which saw double digit declines in every
major industry sector, marks the lowest venture investment level since 1997.

Seed and Early stage investing fell 45 percent in terms of
dollars and 40 percent in terms of deals in the first quarter of 2009
with $852 million invested into 204 deals, compared to the fourth quarter when
venture capitalists invested $1.6 billion into 338 deals. Seed/Early stage
deals accounted for 37 percent of total deal volume in the first quarter, down
from 39 percent in the prior quarter.

First-Time
Financings

The dollar value of first-time deals (companies receiving
venture capital for the first time) declined by 48 percent to $596 million
going into 132 first rounds, compared to the fourth quarter of 2008
when $1.1 billion went into 246 first-time deals. First-time financings accounted for 20
percent of all dollars and 24 percent of all deals in the first quarter
compared to 20 percent of all dollars and 28 percent of all deals in the fourth
quarter of 2008.

The Clean Tech sector, which … comprises alternative energy,
pollution and recycling, power supplies and conservation, saw a substantial
drop in investment levels with $154 million going into 33 deals in
the first quarter. This represented an 84 percent decline in the dollar
level in the Clean Tech sector from the fourth quarter of 2008 when
$971 million went into 67 deals. This quarter marks the lowest investment level
for the Clean Tech sector since 2005.

The Life Sciences sector (Biotechnology and Medical Devices combined)
experienced a 40 percent decline in terms of dollars and a 31 percent drop in
deals with $989 million going
into 133 rounds."

New capital formation, particularly first time
financings, plants the seeds for the next generation of successful companies
that are going to be creating new jobs and a sustainable cycle of economic
growth.  New Technology,
particularly Cleantech and Life Sciences investments, are critical focal points
for the Obama administration.

With California unemployment now over 11%, it is
hard to see a reversal in this trend developing in Q2.

James Freeman's Wall Street Journal Editorial of April 8th eloquently captures the critical differences between the positive risks associated with venture capital investing in new technologies and the negative systemic risks associated with the use of debt to magnify otherwise small and non-productive returns from other investing strategies. 

Policymakers need to understand that taking risk is inescapable and desirable in investing.  As long as you know what type of risk you are taking, the fact that an investment is risky does not, in and of itself, make it unwarranted.  Our country is in today's financial crisis due to the massive misrepresentation of the actual underlying risks in financial derivative products by the underwriters of those products and a massive failure of oversight by our regulatory agencies.   This has nothing to do with venture capital– our entire industry is a rounding error in the financial markets. 

In its zeal to show a renewed commitment to oversight, the Treasury Department is currently on a path which may lead to further disastrous unintended consequences from broad brush stroke regulation.  Haven't we already seen enough collective damage from regulations such as Sarbanes Oxley?  The NASDAQ is a ghost town– as of March 9, the market capitalization of 22% of all NASDAQ listed equities were below their balance sheet cash.

Freeman rightly points out:

"…venture investors have been trying to solve the mystery of how they
could possibly threaten the financial system. Their work involves very
little banking. Venture firms raise equity from wealthy investors to
buy ownership stakes in small companies. The VCs and the companies in
which they invest use little or no debt."

Of far greater concern, Freeman raises fundamental issues associated with America's economic and national security in his article, noting that unnecessary regulation will have the unintended effect of choking risk taking in technology investing:

"Attempts to limit risk pose a systemic threat to American technology.
Venture capitalists, mainly veterans of the tech industry, are deeply
involved in the companies they back, often helping to recruit each of
the key employees at a start-up. This hands-on feature of venture
investing means that innovative companies and their backers tend to
cluster in areas like Silicon Valley. If the VCs move offshore, that's
probably where the next generation of companies will be born."

The Obama administration and many Senators and Congressmen are betting our country's future on a renewed, sustainable economic growth cycle anchored by new business formation led by the next generation of American entrepreneurs.   Venture capital is already proven to be  the most efficient capital formation growth engine in the world, and venture capitalists are key players in the innovation ecosystem.  Let's not regulate our venture industry to death in the name of oversight. 

The first 100 days of the Obama administration
are widely expected to usher in a new era of U.S. capital markets regulation designed to restore the
public’s trust in the decimated institutions that provide much of the liquidity
infrastructure for the global capitalist system.  It is imperative that improved financial oversight be
achieved swiftly through the enactment of effective regulation so that the
markets can re-equilibrate and resume their normal function.  Without these necessary changes, global
economic growth will continue to falter.

At the same time, we must recognize that
regulations enacted in haste can have severe, negative unintended
consequences.  The current moribund
state of the American IPO market is a real-time case study in such unintended
regulatory consequences.  Of equal
import is the fact that the IPO drought is structural, not cyclical, and this
has far reaching implications for the future of innovation in America. 

On November 19^th, Grant Thornton
released a white paper, “Why Are IPO’s in the ICU?” written by David Weild,
former Vice Chairman of the NASDAQ, and Edward Kim, former head of NASDAQ
product development, both now principals at Capital Markets Advisory Partners. 

To download the white paper click Download Why are IPOs in the ICU_11_19 :  

The paper was presented to the NYSE and
National Venture Capital Association’s Blue Ribbon Regional Task Force, which
has been convened to make specific recommendations to the Obama administration
in January regarding changes that must occur if America is to restore the small cap IPO
as a compelling and differentiated positive feature of our capital markets.

The paper is concise and makes a cogent case as to how we got here.  If you want to understand why the IPO
market has died and why the middle market for public emerging growth companies
has effectively ceased functioning, you must read this paper.

 I agree with the paper’s overall thesis and with
a number of its important assertions, including:   

* While conventional wisdom may
say the U.S. IPO market is going through a cyclical downturn, exacerbated by
the recent credit crisis, many are beginning to share a view of a new and much
darker reality: The market for underwritten IPOs, given its current structure,
is closed to most (80 percent) of the companies that need it. 

* The lack of an IPO market has
caused venture capitalists to avoid financing some of the more
far-reaching and risky ideas that have no obvious Fortune 500 buyer. Gone are the days when most venture
capitalists would so willingly pioneer new industries and technologies (e.g.,
semiconductors, computers and biotechnology) that have no obvious outlet other
than the IPO market.

* Regulators may have unwittingly
done a real disservice to mom and pop investors by enabling traders to hijack
the markets for speculation. This phenomenon can be seen by the large Wall
Street firms who have witnessed their top 10 (by revenue) institutional
investors — which only a decade ago were “long- only”
mutual funds such as Fidelity and Alliance — be displaced by hyper-trading
long-short hedge funds.

* The U.S. will lose its
competitive advantage in developing, incubating and applying new technologies.
Technologists are already returning to foreign jurisdictions like China and
India where government has devised an increasing array of economic and capital markets
incentives to compete.

The lack of IPO’s in the U.S. has broad, negative
implications for continued risk taking by U.S. venture capitalists. If we have
no public market liquidity for emerging growth companies, there will be no next
generation of American technology giants. The demise of the technology IPO has also
contributed to the structural breakdown in the broader cycle of research and
development that underlies the American innovation crisis heralded by Silicon
Valley thought leaders such as Judy Estrin.

 

If you have constructive recommendations for reforms that
you believe should be enacted to support a renewed IPO market, please contact me
at pascal@levp.com, and I will forward
your suggestions to the NVCA.

Vivek Wadhwa, currently a Wertheim Fellow at the Harvard Law School and a successful tech entrepreneur, wrote a constructive article in Business Week, "Startups: The Upside of a Downturn", providing advice and encouraging entrepreneurs not to wait to start a business during a recession– on the contrary, he identifies a recessionary environment as supportive of well-crafted new business opportunities.  For a link to the full article, click here.  

I used to be in the moving business. Eighteen years ago, after working for seven years in the risk arbitrage business, one of the many ‘moving’ businesses of Wall Street, I left New York to come to San Francisco in order to get into the ’storage’ business. America’s strong economic foundations are rooted in multi-year business building and long-term risk taking. We are now bearing witness to the sour fruits of moving securities around like meaningless scraps of paper for short-term profit and the securitization of risk into a daisy chain of the unknown and the unmanageable.

Over the past 20 years, the average holding period for stocks has declined from 2+years to just 3 months as of earlier this year. A root cause of the relentless volatility in the equity, commodity, and debt indexes is the steady erosion of long term thinking in investing, not only in this country, but all over the world. How many public company CEOs have lamented the wholly inconsistent demands of managing quarterly earnings expectations for fickle institutional investors while maintaining a consistent long term operating strategy to maximize shareholder value?

It’s time for a global re-boot of the investor mindset so that people can start investing responsibly– there are many reasons why Warren Buffett is such a successful investor, and long-term thinking is one of them.

I can thank Brett Haire, my boss at First Boston during the 1980’s, for inspiring me to leave Wall Street and risk arbitrage behind. I remember once asking Brett for permission to accumulate a long-term, unhedged position in the spin-out of a company that we were researching for investment. Brett looked at me, incredulous, and said, “Pascal, we’re in the moving business here, not in the storage business.” At that moment I realized that I did not want to be in the moving business and initiated the career path that led me to become a venture capitalist.

America needs to get back in the storage business at many levels and actively promote the entrepreneurial spirit that built this country one brick at a time at the same time that we re-build our securities markets. Let’s learn from our mistakes.