Toward Transparency –

Talk to a venture capitalist about communicating with limited partners, and the big buzz word that you will hear is “transparency.” After the Internet Bubble popped in March 2000, VCs learned the hard way that their investors didn’t like the way they had been treated. Institutions and funds-of-funds expected not only more information, but more openness.

Venture capitalists loudly proclaimed that they would change their ways, but these days, “transparency” is a difficult word to define. While VCs claim they want to be more open with their limited partners, the recent spate of Freedom of Information Act (FOIA) lawsuits involving public institutions such as CALPERS and the Universities of Texas and Michigan has exposed closely held information about fund management fees, carried interests, IRRs, the amount of capital contributed and even the full text of partnership agreements.

And for all of the talk of transparency, the venture capital market is hot once again. LPs who ask too many questions may feel like they could be excluded from a top-tier fund.

What does it mean for a VC firm to be transparent? In many cases, not much.

For many years, venture capital firms have communicated with LPs through quarterly reports and yearly offsites. Today, VCs seem to be making more of an effort to visit their investors. Allegis Capital meets with its strategic investor base twice a year, and new funds, like Shasta Ventures, are planning to hold at least one face-to-face meeting with their LPs every year. Kelly DePonte, a partner at placement agency Probitas Partners, views these visits as essential. He points out that fund managers from some institutions don’t have the budgets to attend yearly off-sites, and the makeup of these investment staffs can change significantly over time.

Ira Ehrenpreis, a general partner at Technology Partners, suggests that VCs need to view their communication with LPs as ongoing, not transactional. “If you just come to me when you need something, I will be much less likely to think highly of our relationship than if you keep up a constant dialogue with me,” he says.

Still, limited partners don’t necessarily want more contact; they want more honesty. Paul Kedrosky, who teaches entrepreneurship at the University of California, San Diego, takes issue with the way VCs report their numbers. Although he recognizes how difficult it is for VCs to accurately value their investments, he would like to see more frequent revaluations of portfolio companies-both downward and upward.

“Of all of the major asset classes, the most backward in reporting and dealing with investors is the venture capital industry,” he says. “Nobody re-prices based on competitors’ deals, public company transactions or sectors falling out of favor. Everybody’s doing the math in their heads, but nobody’s telling the LPs.” One of the most infamous examples is Google, which was reportedly carried by its investors at a valuation of $300 million before it ultimately went public last year at a valuation of roughly $24 billion.

Predictably, VCs see a flip side. Even though quarterly reports are supposed to be confidential, information about companies has a nasty way of leaking out. The consequences for young companies can be devastating. If a potential acquirer finds out that a venture firm has marked down its investment in a company, the acquirer will downgrade its bid accordingly. Mike Kwatinetz of Azure Capital says that his firm was involved in a transaction recently in which the bidder knew the value at which investors were carrying the investment. Craig Dauchy, an attorney at Cooley Godward, adds that a portfolio company’s competitors could also show this information to potential customers to raise doubts about its viability.

Closing the Books

Because of factors like the questionable confidentiality of quarterly reports in general and the requirements of FOIA in particular, Eric Wright, an attorney at Wilson Sonsini Goodrich & Rosati, believes that “partnership documents are moving away from transparency.” Apparently it’s not enough that standard language in agreements grants venture firms the right to suspend information rights to investors that disclose facts about a fund. Now, some VCs are also reserving the right to post only the aggregate value of their entire portfolios for periods as long as 18 months. The purpose of this provision is to protect the privacy of a portfolio company that may be struggling to regain its footing, but to an LP the picture can’t be very clear.

More Face Time

In light of the issues involved in disclosing information through quarterly reports, some VCs are holding more frequent face-to-face meetings with LPs. Even then you need to be careful. Wright says that any information an investment manager writes down from such discussions is discoverable-including notes from a discussion with a VC written ex post facto. Dauchy observes that informal handouts to public LPs at annual meetings are also “FOIAble.”

Are all of these fears about disclosure just plain paranoid? Not according to Josh Lerner, the Jacob H. Schiff Professor of Investment Banking at Harvard Business School. “There is a real danger of strategic information about portfolio companies reaching the public eye, and limiting the information about specific companies that is distributed in writing is highly reasonable,” he notes. “One of the powerful weapons that VCs have is their ability to shield information about operating companies from the public eye, which gives them time to refine their business model in relative seclusion.”

Ira Ehrenpreis, a general partner at Technology Partners, argues that FOIA is a red herring. “We care more about the LP relationship than the effect of FOIA,” he says. “You can have an open discussion with FOIA investors or a shallow discussion with non-FOIA investors. It all comes down to whether you view your investors as partners.” Kwatinetz echoes this sentiment and notes that FOIA investors are taking measures to prevent the distribution of sensitive company information. “LPs don’t want to damage these companies either,” he says.

Dauchy says he know of at least eight funds that have held in-camera meetings with public LPs that agreed in advance not to take notes. He also says more firms are holding quarterly calls with LPs in which they give oral updates in lieu of more detailed quarterly reports.

In addition, VCs are increasingly turning to their advisory boards for help in establishing private company valuations. One fund-of-funds manager who asked to remain anonymous believes that as many as one-quarter of the firms he sees have adopted this approach.

As for more frequent revaluations, some habits are hard to break. The Private Equity Industry Guidelines Group (PEIGG), a private group of industry professionals, has established valuation guidelines for VC firms that conform with Generally Accepted Accounting Principles (GAAP) and “fair value accounting.” These guidelines (and specifically Paragraph 30) spell out specific instances in which a VC firm should mark up an investment. While the Institutional Limited Partners Association (ILPA) has formally endorsed PEIGG’s work, the response from the National Venture Capital Association has been more muted: It “suggests” that its members review PEIGG’s guidelines “when evaluating current valuation procedures or developing new approaches.”

Because the impact of public market transactions or other events is hard to measure, VCs are sticking to their old valuation practices-marking down investments or carrying them at cost. Stephen Holmes, a PEIGG member and CFO of InterWest Partners, says he does not know of a firm that does not claim to be GAAP-compliant, but adds, “If a firm is just marking down an investment or carrying it at cost, it may not be good enough for GAAP, because GAAP requires fair value.”

Holmes’ concerns make a lot of sense. But let’s be honest. When most firms talk about “transparency,” they are spinning. One prominent LP who asked not to be named put it this way: “We tend to find an inverse correlation between the amount of communication and the ultimate performance of a fund.”

Money Talks

This LP argues that, “the best form of GP communications are large and frequent distributions of cash. Most other forms of communication are superfluous. The best communicators are the ones with the most frequent distributions, and I think you can imagine who they are. The most important information for me is: How many shares do I own?’ and What is the stock price?'” In particular, this LP would like to see more guidance around the timing of distributions.

Venture firms need to respond to their investors’ demands for openness. But, please, enough talk about “transparency.” VCs will earn the respect of their investors through their actions, not their words. Nothing could be more transparent.

Alex Gove is a Vice President at WaldenVC, a venture capital firm that focuses on investments in digital media companies. Additional focus areas include software as a service and information services. Additional information may be found at www.waldenvc.com. Alex mat be reached at alex@waldenvc.com.