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What's a Company Worth? Depends Which GP You Ask
By Colin Blaydon and Michael Horvath

Venture Capital Journal
Copyright (c) 2002 Thomson Financial, Inc. All Rights Reserved.

It's a scenario that by now, most any limited partner is familiar with: You receive three different valuations of the same portfolio company from three different venture funds. Who's right? Each general partnership might have legitimate reasons for its figure. But because there are no real industry standards for reporting valuations, and because there's so little transparency in most GPs' valuation methodologies, limiteds are unsure of where they stand. Confusion doesn't make for happy limited partners.

Assessing and reporting portfolio valuations has recently emerged as the most fundamental structural issue facing the venture capital industry today. In a cheerier time, when portfolio companies raised new rounds at higher valuations with relatively clean term sheets, valuation was a straightforward matter. But in a dreary funding environment with infrequent rounds often done at lower valuations with non-price preference terms, things have gotten complicated.

Often the parties' interests in measuring valuations are not aligned. If GPs, for example, can take distributions when the portfolio valuation exceeds the contributed capital from LPs, then they have an incentive to report higher valuations. But limited partners need cold hard assessments to know where they stand in their investment program for decisions such as portfolio allocation and risk management.

The absence of consistent ground rules for valuation is taking its toll on LP/GP relations. Until recently, GPs' most consuming relationships have been with company managements. The LP relationship had been a relatively minor sideshow. Now, GPs are spending almost as much time managing their LP relationships as their portfolio companies, with valuation reporting being one of the thorniest issues.

How Do Valuations Happen?

Absent agreed upon standards on valuations, how do VCs value their companies? Each general partnership comes up with its own approach, and numerous factors might inform the exercise. The cost of the initial investment is the natural starting point. It reflects the value of the position taken in the company at the time the VC first invested. From that point, further financing events where the company is re-valued provide updates to the value of the VC's investment. It gets messy when those financing events don't happen, or when they're loaded down with non-pricing twists like ratchets and preferences.

For example, suppose a VC initially invested and reported to LPs a $1 million investment in a company with a post-money valuation of $2 million. If the company later did a down round of $500K at a pre-money valuation of $1 million with the same VC, the VC now holds 2/3 of the company ($500k new money, plus $500k representing the remaining worth of its original $1 million in the down round, on a $1.5 million post-money valuation). The valuation of the total $1.5 million investment could be reported as $1 million. However, suppose as part of the down round the VC was given a 4X liquidation preference (on the $500K) and that the VC reasonably expects to sell the company before the next reporting period for $2 million. Then the expected valuation of the VC's stake in company is arguably $2 million. As for other VCs in the earlier round who did not invest and get the preference in the new round, they might now see their investment as worthless.

Are LPs happy with these views of things? They might be if they could see the methodology and evaluate the way the VCs' expectations were set. However, VC reporting often lacks transparency. Furthermore, LPs might view VCs' expectations as optimistic and might prefer the establishment of a reserve liability on the books for the VC's entire portfolio.

Another factor that might influence valuation is a substantial downward revision of the company's outlook. But absent a financing event, it's difficult to determine what events should and should not trigger such a write down. Plus, there's rarely coordination among multiple investors in a company on how much to mark down valuations in this scenario. VCs have a strong incentive not to report a mark down without a funding event under a "see-no-evil" mentality. If you're the one candid VC who accurately reflects a downturn in company prospects, that write down will hurt the reported results of your fund compared with your competitors, when all investors in the company should be sharing the misery.

Finally, there's the market portfolio or "mark-to-market" method. The VCs first identify a set of comparable public companies whose valuations are established by daily trading of their shares, and then they discount some average valuation from this set to reflect the added risk inherent in the privately held and often smaller, younger portfolio company. The good thing about this approach is that it picks up changes in company valuation stemming from undiversifiable industry risk factors. The problem with the method in a down economy is that valuations change often and for reasons that may be specific to companies in the comparison portfolio set. The VC's portfolio company may be in better shape than the public companies in the comparison set. And as with other valuation approaches, VCs construct their market portfolio for the same private company differently, which means conflicting conclusions reported to LPs.

Going Forward

In sum, the lack of consistent ground rules for valuation makes it difficult for both limited partners and general partners to do their jobs. In the short term, both parties need to become more aware of the circumstance under which the other is laboring. Rather than assume that VCs are untruthfully reporting valuations because of untoward incentives, LPs should consider that VCs may really be in a fog about the value of some of their portfolio companies in today's climate. And VCs should acknowledge that LPs have legitimate concerns about consistency and transparency in valuation methodology.

Longer term, the industry needs to consider whether consistency and transparency are goals worth pursuing. We at the Tuck Center for Private Equity and Entrepreneurship at the Tuck School of Business are conducting a survey that we have recently sent to general partners to learn what they consider to be the major industry issues surrounding valuations and to solicit their opinions about possible approaches. (We urge anyone interested in contributing who has not yet been contacted to email us at pecenter@dartmouth.edu.) We expect to report the results of that survey in a future article in the Venture Capital Journal.

Colin Blaydon and Michael Horvath are professors at the Tuck School of Business at Dartmouth. They are also directors of Tuck's Center for Private Equity and Entrepreneurship. They can be reached at pecenter@dartmouth.edu.

This article originally appeared in the May 2002 issue of the Venture Capital Journal.

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    Copyright 2002 The Trustees of Dartmouth College. All rights reserved.