VC Governance FAQ: (2) Especially now, when transparency is so important, why is limited financial information available from a private company?
This is the second in our series of ten frequently asked questions from investors in venture capital partnerships.
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.