It is the time of year when VC firms do year end valuations for their portfolio company holdings. While not as bad as water boarding, this exercise always makes my stomach turn. Luckily, I am not in charge of the internal finance function at our fund.
Most of my stomach turning results from the fact that this exercise is purely about unrealized return values of purely non-liquid assets (unless of course there is an active secondary market for the stock – this applies to a few handfuls of VC backed companies). FAS 157 and other accounting rules require such a valuations be done, but what is the real value of doing them? Yes, large institutional investors use the unrealized values and need them for reporting purposes. I get that and understand it. But unrealized values are sometimes rather illusory in that they are based on what are called “Level 3” inputs that by definition are often not exact and even non-quantitative.
Some VC firms use the art of Level 3 inputs to mark up their valuations, which has a tendency to make limited partners happy. I think this practice is not prudent.
My easy solution for VC firms would be to mark up or down the valuation of investments based only on new independently led outside rounds of financing. An inside round could only result in a mark down (if the new inside round was a down round), but not any mark ups (if the new inside round was an up round). This rule would keep the process simple and very conservative, which I think is sound.
It is easy to tell your LPs that the valuations are conservative…..