Reporting portfolio investment performance to limited partners has always been a sensitive issue for U.S. venture capital funds, even in good times. But challenging market conditions have made it an even more contentious issue. The lack of a universally accepted standard for financial reporting, as well as lack of agreement on what would constitute a set of best practices, heightens this sensitivity.
The closest thing to a standard is what has come to be known as the “NVCA Guidelines,” a set of proposals made at an annual meeting of the National Venture Capital Association in the early 1990s but never adopted by the association. The NVCA guidelines are listed on industry web sites and are followed by many venture capital firms, despite the fact they haven’t been officially endorsed by a recognized body. Other efforts to come up with policies and standards for venture capital financial reporting are currently under wide discussion, but, despite such initiatives, it is not clear where venture capital firms stand on many of the issues and what the industry wants to see developed, if anything. For this reason, the Foster Center for Private Equity at the Tuck School of Business sent a survey to more than 550 venture capital general partnerships. This article describes the study and some of its main findings.
(The full report can be found at http://mba.tuck.dartmouth.edu/pecenter/.)
The survey was sent to 561 venture capital general partnerships, 422 of which are members of the NVCA. The response rate was 51%, indicating that the topic we addressed is clearly of importance to the VCs surveyed. Of those who responded, 28% provided observations that went beyond just answers to the questions, and 25% agreed to confidentially share their own reporting policies.
Most respondents (54%) worked at firms founded in the 1990s. The largest number of responses (64%) came from firms that had recently raised funds under $250 million. Another 13% of those surveyed were partners at funds in excess of $750 million.
The questions we asked and the opinions we gathered in the survey responses can be grouped under three broad categories: Is a standard needed and is it important? What are the challenges to establishing a standard or set of agreed best practices? And, how should standards be developed.
Nearly half of the respondents said that they would like to see a common industry standard and nearly three-quarters saw such a standard as being of some importance (see chart, lower left). Smaller firms placed the highest level of importance on a standard, with 40% seeing it as “important” or “very important,” compared to less than 30% of medium and larger firms. About 25% said a standard was unimportant, a view held to the same degree regardless of firm size. But 15% of those respondents who said a standard was “insignificant” or “unimportant” still see some need to develop one.
Given the fact that about one-third of the venture capital firms surveyed, regardless of size, rely on the 1990 proposed NVCA guidelines, developing an industry standard seems like a potentially useful idea. More than half of the respondent firms are familiar with at least one of valuation guidelines put forth by the NVCA, European Venture Capital Association, British Venture Capital Association or some other group. Furthermore, our results indicate that awareness of valuation guidelines highly influences their use-61% of firms familiar with one of these guidelines make use of them in their valuation practices.
Even though there is strong agreement about the importance and need for standards, there is less agreement about what exactly should be done and the challenges to getting it accomplished. The biggest challenges are seen as the low likelihood of agreement within the industry and the difficulty of designing the specific components of a standard (see chart, below).
The design difficulty is perceived equally by firms of all sizes, with three-quarters concerned about the difficulty of designing the specific components of a standard. Larger firms are more concerned about the degree of importance, with 45% seeing this as a “very important” challenge compared with one-third of smaller and medium firms feeling as strongly. While firms of all sizes indicated substantial concerns about reaching industry agreement, larger firms expressed the greatest concern (82%) about this being an obstacle. However, what has been thought to be an equally sensitive issue, namely confidentiality of company valuations, is somewhat less of a concern, but 50% of all firms do rank this concern as “important” or “very important.”
Finally, most difficult obstacle to developing standards may be the small but significant portion of the industry expressing outright opposition to standards, with 22% opposed to any standard at all. Perhaps most sensitive is the fact that twice as large a portion of the large firms express such opposition as do small- and medium-size firms (32% vs. 16%). Some explanation for this sentiment can be seen in written comments submitted by respondents, where a sizeable number indicated that inefficiency and lack of transparency are good for the industry and a standard would either be restrictive or uselessly vague.
How To Do It
Overwhelmingly the industry believes that if a standard is to be developed it should be developed by an industry association. More than half of the respondents expressed this preference, compared to no more than 14 % for alternatives. Larger firms see more value in broadening the participation to include LPs, with 18% of those firms saying that the standard should be developed by LPs. Just 12% of small- and medium-sized firms share that opinion.
Perhaps most encouraging to the possibility of developing standards is the expression by nearly one-half of the responding firms (48%) that they would like to be part of the process of developing industry standards, with the largest firms expressing the most interest (55%).
There is a strong body of opinion in the venture capital industry that an industry standard or a broadly accepted guideline on valuation practices is both important and needed, largely because of perceived LP concerns about consistency and transparency. But such agreement may not be strong because, when it comes to details of a standard, many see difficult issues, and a substantial minority is opposed to any standard at all. Most encouraging to the possible development of a standard is that half of respondents expressed interest in participating in that development.
Colin Blaydon and Michael Horvath are professors at the Tuck School of Business at Dartmouth. They are also directors of the university’s Foster Center for Private Equity. They can be reached at firstname.lastname@example.org.