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.

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

Note: Register now,  Company pass code – 710004, Course code – 11738


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.

Participants include:

• 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.
  

Space is limited. Register today. <http://university.learnlivetech.com/gtt>

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.

• Go to http://university.learnlivetech.com/gtt and choose “New Student Registration” to create your account, then enter company pass code 710004.
• If you have attended a Grant Thornton Webcast within the past year, simply log in to your account.
  

Locate the Webcast in the catalog and sign up for A Wake-up Call for America, course number 11738.

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.