Brad Feld RSS Feed: FAS 157 - Another Annoying Accounting Provision

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My RSS Feed, Brad Feld, is a Thinker and Has Just Posted the Following:

I feel like bitching about FAS 157 today.  I was at the annual meeting for one of our LPs yesterday and there was a long discussion about the impact of FAS 157 on both the buyout and the venture capital business.  Once again everyone was in violent agreement that this was yet another accounting rule - promulgated by the accounting industry - to generate more fees for the accounting industry while burdening companies, especially entrepreneurial ones, with additional regulations that have no real impact on reality.

If you aren't familiar with FAS 157, it's officially known as the "fair value measurement" rule and unofficially known by some as the "mark to market" provision.  Before you ask, "wait - isn't mark to market the thing that got Enron in trouble and started this whole wave of SOX regulatory stuff", I'll simply answer "yes" and let you ponder that.

Like our dear friend 409A, FAS 157 has come out of the latest efforts by accountants to create more transparency in financial reporting.  Like 409A, I'm sure these are well intentioned ideas although my cynical side envisions an accountant in a sub-basement of a building NY with green eyeshades and a little green desk lamp sitting around dreaming up ways to torture entrepreneurs while accomplishing his accounting bosses goal of generating more work (and fees) for themselves.  Oops - sorry - back to the main story.

Since the beginning of the VC business, valuation methodologies were generally consistent and straightforward.  They were usually some variation of:

1. Value your investments at your cost.
2. If a financing happens at an increased valuation and is led by a new investor, write your investment up to the new price per share.
3. If a financing happens at a decreased valuation regardless of whether or not there is a new investor, write your investment down to the new price per share.
4. If bad things are happening, you can take a discretionary write down based on your best judgement.
5. If good things are happening, you should not take a discretionary write up.  Only write things up in case #2.
6. If the company is public, use the publicly traded price but discount it due to illiquidity (usually 25%).

Pretty straightforward.  Very conservative.  This almost always understates the value of a VC portfolio, which presumably is a good thing since it's illiquid and the only fund performance information that should ultimately matter to a VC (and their LPs) should be the one linked to cash flows (draw downs from their LPs and distributions to their LPs.)

FAS 157 blows this up completely.  Under FAS 157, VC's now have to mark all of their portfolio company values to market (er - "fair value measurement") qualify for GAAP (which is a requirement for every VC firm - our investors require we have audited GAAP financial statements.)

It gets worse.  Our LPs (who typically invest in multiple VC funds - in some case many multiples) also have to adopt FAS 157.  So they also have to mark their portfolios to market.  It used to be the case that they could simply rely on the VC valuations.  To comply with FAS 157, they theoretically have to look at all of the underlying assets in the VC portfolios and make an independent judgement on the values of those underlying assets.

Some VCs (and LPs) are just starting to implement FAS 157.  Ironically, some accounting firms wanted 2007 as the start year; others seems to want 2008 as the start year.  Many VC firms are viewing this as an annual exercise even though they report to their LPs quarterly.  Some VC firms (like us) have already built it into our quarterly reporting cycle (our accountants told us we needed to comply in 2007).  Yeah - it's all over the map. 

But that's not the real problem.  I'll get to the real problem(s) in my next post on our new friend, FAS 157.






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