May 14, 2003 SOMETHING VENTURED: Looking Anew At Fund Performance By Mark Boslet PALO ALTO, Calif. - (Dow Jones) - By one count, venture capitalists gave birth to 5,534 startups during the 1998 to 2000 go-go years of Internet investing. About 3,297 remain three years later. Of these young companies, 1,600 to 2,000 could easily lose money for their investors, venture capitalists say, and lead a generation of troubled boom-era funds to erase more assets from their books. The question that will face many general partners is how much of a markdown to take. No single, widely approved set of financial rules exists to guide them. And the rules that are available fail to address the nuances of today's complex refinancing rounds. Venture capitalists instead often rely on subjective measures to value portfolio companies, using estimates of future markets or hopes for a technology under development. Because the firms are private, there are no financial markets to establish a price. To fill the gap, several groups of investors are offering new guidelines they claim will promote consistency. If adopted, a new set of guidelines could have a significant impact on an industry that fiercely guards its independence and freewheeling spirit. It also might stir up new competitive posturing now that public pension funds have begun openly reporting private-equity performance results. The effort to find a standard way to value companies appears to have significant support from limited partners. Limited partners are clamoring "to have the truth told to them," says Michael Horvath, an associate professor at Dartmouth's Tuck School of Business. "The downturn has been the driver." However, imposing a common yardstick will be no easy task. Practices in the industry vary widely. Venture capitalists say the markdowns they took last year lopped anywhere from 50% to 100% off the value of startups that didn't meet financial targets or other expectations. Others have yet to cut that deep. The result is an environment where the same company can have substantially different values from one venture fund to the next. "There will always be one or two companies (in a portfolio) where there is a judgment," says Jos Henkens, a general partner at Advanced Technology Ventures. Take Santera Systems Inc., where a share of preferred stock was worth about 10 times more on the books at Austin Ventures than at Sequoia Capital. Austin declined to discuss its decision. Another example is Zhone Technologies Inc., where the difference in value among VCs was more than 50%. A Zhone spokesman said he wasn't aware of the differing valuations. With the industry caught in a downturn, limited partners may find themselves with the power to force a new set of guidelines on venture capitalists as they come hat in hand for new money over the next couple years. Some argue that self-regulation is a far wiser alternative than waiting for the Securities and Exchange Commission to impose government rules. The goal is to "get some uniformity in the portfolios," says Mario Giannini, chief executive of Hamilton Lane Advisors. "I think that the consistency issue is what you hear more and more." However, convincing VCs to subordinate personal judgment to standard appraisal rules will meet resistance. In a clubby business, where relationships between limited and general partners are only built up after years of working together, "standards are a fool's errand," says Mark Saul, a general partner at Foundation Capital. The process of "reducing everything to one number provides little nominative value." Widespread Skepticism On Standards The skepticism about a standard is obvious in a survey of 288 U.S. venture firms the Tuck School conducted last spring. About a third of the funds use an aging set of guidelines proposed to the National Venture Capital Association in 1989 but never adopted. Less than 10% use guidelines from the British Venture Capital Association and a slightly larger percentage rely on standards from the European Venture Capital Association. The rest do not adhere to a standard. The survey found almost 50% of the firms said they would like to see a standard. "It would be good to have a set of rules that work better," says Nancy Schoendorf, a general partner at Mohr Davidow Ventures. "It would only benefit us." However, the study also foresaw significant challenges to creating guidelines with enough detail to make them effective and enough flexibility to convince recalcitrant firms to sign on. Current guidelines offer several key principles for calculating the value of a company. In general, company values are not increased unless a new round of funding takes place with new investors. Valuations are trimmed when a company's performance or potential deteriorates. Different values for a company can sometimes be justified. One VC might intend to support the company with more money while another doesn't. That VC might carry the startup at a higher value while the other might write it off. However, current rules don't guide VCs through write-downs, long-term market changes, or now popular Draconian liquidation preferences that favor one fund over another when a company goes out of business and liquidates. Every deal has nuances that don't easily fit into an all-in-one standard, VCs say. "I'm very suspicious whether there is a better method," says Steve Domenik, general partner at Sevin Rosen Funds. Besides, a new standard might be unnecessary. The issue of down rounds - new financing for a company that reduces its value - will resolve itself in 18 months or so when the companies that can't sustain themselves either raise more money, and reset their valuations, or go under. "I don't think it is as big an issue as people make it out to be," Advanced Technology's Henkens says. "This phenomenon will go away." Organizations, such as the Association of Investment Management and Research, which posted a draft standard in September for comment, say important principles need to be stressed. The AIMR document stands for full disclosure and fair representation, says Alecia Licata, a vice president. And yet it is largely a framework that leaves an additional layer of detail to the future or to other organizations to provide, she says. Guidelines also are available from the BVCA, emphasizing an adherence to GAAP practices, and the EVCA, which has offered little detail on down rounds. The Private Equity Industry Guidelines Group, a dark-horse group promising the necessary detail the others lack, could have its rules available by the end of the year. "We're not trying to be revolutionary," says member W. Stephen Holmes, an administrative partner at InterWest Partners. "Nobody's trying to create a magic formula for valuing a company." Nevertheless, Holmes says the guidelines will deal with down rounds, liquidation preferences and explicitly call on general partners to lower valuations when long-term changes take place in customer markets. Despite whatever controversy arises, some powerful limited partners seem steeled to push ahead. The California Public Employees' Retirement System - the nation's largest pension fund - is urging private-equity organizations to work toward agreement on a standard. Calpers' goal: guidelines for financial reporting and company valuation in 12 months. (Mark Boslet covers West Coast technology companies for Dow Jones Newswires.)