Another Accounting Law Designed To Increase Transparency Does The Opposite
from the unintended-consequences dept
With all of the financial mess out there, it's likely that we'll soon see calls for new regulations to help "protect" against fraud. However, before we rush into doing so, it's worth looking at how damaging previous attempts to do the same thing have been. We've already covered the massive amount of damage done by Sarbanes-Oxley, which basically made it extremely difficult for a private company to go public and significantly increased costs for any public company -- all while doing next to nothing to actually cut down on fraud.And, now, FAS 157 has come into play -- a new rule impacting many venture capitalists, forcing them to figure out what the "fair market value" of their investments are, and provide that number to their investors. This has many different VCs complaining about what a stupid process this is. It raises similar questions as the legal change a few years ago that required companies to put stock option valuations on their books as well. The problem is that these things are impossible to accurately value. Not difficult, but impossible. You're asking people to value a totally illiquid asset as if it were liquid.
Even if the venture capitalists use a rigorous process, the result will be wrong. There's simply no way to accurately value something like a private startup until another transaction happens where the value is actually set. And, that's the way it should be for a private investment (it's also why not everyone is allowed to invest in such endeavors, because it is inherently more risky). But forcing companies to make up bogus (no matter how well meaning) valuations for companies has dangerous unintended consequences. No matter how bogus the numbers are, since they're there, people will use them as if they're real. And that will lead to more bad investing, rather than less. So, once again, we have a law designed to stop bad investing, which will most likely cause the opposite to occur.
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Filed Under: accounting, fas 157, regulations, sarbanes oxley, unintended consequences
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That info was clearly stated in the footnotes, so that it WAS reported back to the shareholders. The problem is including it in the actual statements, when the actual liabilities are unknown.
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Options
So it's not true it's "impossible" to value them, the prices are available and just as good as stock prices when the stock is liquid.
Of course if the stock is not liquid, there's no good stock price and no good option price so in this particular case (startups included) it's indeed impossible to have a good price for both stock and options.
One side note on this debate: while privacy-like protection might be commonly accepted for accounting information about private firms which make public only limited agregated data, since we're talking about more or less direct nationalization of some parts of the economy it would be good to remind the public and politicians that there's no good reason at all in the internet age with near zero publication cost not to have fully detailed accounting information on public entities, down to each purchase and each valuation of each asset.
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Fact is the regulations are there to attempt to stop the GREED. If the SEC was paying attention to any of this we would not be in this spot, but to summarily dismiss all regulations under the pretense you do not see the value is like publishing an article that says, "...I think seat belt laws are worthless because I have never had an accident..."
Bottom line what is needed are the governing agencies like the SEC and laws like FFIEC to be enforced - plain and simple.
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It's not that you "have" some valuation. It's that the market for your shares at the time (i.e., those who invest) set the valuation. But between those times, there is no market for your shares, and thus no valuation. The problem with the law is it requires a valuation at those times.
This has to be the most ridiculous article I have read.
Thanks for your support.
Fact is with out regulations, and yes I mean SOX too, plus the agencies that are there to ensure enforcement (e.g. the SEC) this global economic melt-down would be 100x worse.
Can you offer at least an iota of proof? So far, there has been no evidence that SOX did anything to stop fraud.
Fact is the regulations are there to attempt to stop the GREED.
Well, tragically, greed isn't a factor that can be stopped, nor is greed illegal. So, you are wrong.
Fraud is illegal, and SOX is SUPPOSED to stop fraud. But it does not.
If the SEC was paying attention to any of this we would not be in this spot
You do realize that that had nothing to do with SOX, right? The SEC's failure to pay attention had absolutely nothing to do with SOX.
but to summarily dismiss all regulations under the pretense you do not see the value is like publishing an article that says, "...I think seat belt laws are worthless because I have never had an accident..."
Not quite. But if you want to set up straw men after getting most of the basic facts wrong in your comment, boy, that sure adds to your credibility.
Bottom line what is needed are the governing agencies like the SEC and laws like FFIEC to be enforced - plain and simple.
Can you point to a single example where SOX was not enforced? There were other things overlooked, but SOX enforcement was pretty widespread. I haven't heard anything about SOX not being enforced.
And, I note, you seem to totally ignore the unintended consequences of SOX.
So you ignore all the downsides, pretend that there are upsides that don't exist, and you call my post ridiculous?
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more fraud likely
That said, I do not think this new rule will necessarily lead to more fraud litigation, though I do think there may be some rise in actual fraud as a result of it. Honest VCs and early round private equity investors will simply undervalue their portfolios -- to their own detriment in terms of formation of future funds -- while more aggressive or even dishonest ones will make up numbers, paper it over as best they can with documentation from valuation "experts" and opinion letters from accountants and attorneys, and it will be left to courts to try and sort the wheat from the chaff.
That said, I'm not sure how many of these lawsuits will get very far, because most of these cases will be dismissed at a very early stage. Investments in venture capital funds and private equity funds are not "securities," at least not if they are structured properly, and they have always been documented out the wazoo with caveats about the extremely high risks, assumptions and unknown/unpredictable factors that could affect fund performance. It's almost always a matter of private contract, and generally speaking neither the Securities Act or the Securities Exchange Act apply (or, if they are "securities," they are subject to exemptions such as SEC Rule 144A (the private placement rule) -- meaning that the securities are sold to relatively few wealthy, sophisticated and typically very private people and institutions who don't file lawsuits unless there truly are indications of a serious problem that can't be resolved quietly and privately.
The litigation that may arise from this new accounting rule will, with respect to these private funds investing in start-ups, will be very difficult to pursue without serious indications of real fraud. In both federal and state courts, although the pleading rules vary, you have to allege actual facts with a level of particularity not required in other kinds of litigation -- i.e., you need to provide sufficient details so that a court would find that a reasonable person would believe those facts to give rise to a strong inference of fraud. With respect to privately managed funds that invest in illiquid investments, this is a nearly impossible standard to meet except in extraordinary circumstances. That's why you rarely see litigation even when it involves actual securities issued by extremely large public corporations when the securities at issue were private placements (unregistered and highly restricted in terms of resale).
When the investments at issue are in brand new enterprises, with either no cash flow or at such an early stage that any cash flow is meaningless in terms of predicting value, I would be amazed if many cases will be filed, let alone survive a very early motion to dismiss.
Last -- as to firms that specialize in private company valuations, they've been around for a very, very long time, and there most definitely are accounting firms with people who do nothing but that, as well as small accounting firms and solo accountants who are competent to do it. Not typically for something like what we're talking about here, but frequently when there is a change of control transaction involving a private business, someone has to be retained to provide a valuation analysis, and often both counterparties retain their own people to do it. If you own a small business, and you want to acquire or merge with another small business, it's highly likely that neither you nor the owner of the other business has any real idea what your respective companies are worth. You each know how much you've been taking out as profits each year, and you each will have your accountants look over the books of the other company so that you both have some comfort that the numbers are all correct -- but how to you value the transaction? Do you use a cash-flow method? An annual distributable profits method? Do you measure it in some way by EBITDA? Some other way? What about comps -- how do you even access that information for similarly situated companies? Even if you can access comp data, do you look only in your local market, more regionally, nationally? Are there any public companies you can look at for any guidance? (Not very likely).
There are a number of different methodologies for valuing private companies, and it depends in part on what industry or industry sector you are in, in part on what the company's size is relative to various external factors, and in part on other variables and factors. I'm not sure there's ever been a time when there were not competent people whose job it was to come in and provide advice on all of that.
But it's pretty much an impossible job when the company is brand new, may not even have any meaningful cash flow, is still getting situated in the market and undertaking huge costs and obligations, and otherwise simply making all the available data on the balance sheet and, if there is one, the P&L, inherently unreliable as a predictor of current or future value.
So, were I a VC faced with this scenario, I'd probably take the safe road and simply book those investments at zero value, or if there is some way to place some value on it, I'd select the very lowest number on the range, and maybe even discount that by some percentage. I'd disclose it all in my private placement memos, my reports to investors, and all the ways I communicate with current and prospective investors. And I'd probably sleep well at night, knowing that I've been as honest as I can be in terms of "fair market" valuation of my portfolio companies.
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Bullshit
If you were to be a member of 5-partner VC firm, you are saying that your firm could NOT:
- pick the weakest companies that get cut-off (if you cannot value a company at all then you can’t value it against another company either)
- decide which partner is doing better and which partner is picking poorly (can’t value, means can’t value partner performance either)
- explain to a limited partner how well the fund is doing (”We can’t value our portfolio companies….” “WTF???” )
- make a decision if the next round should be an up or downround
- figure out if you got a great deal or if the founders got a great deal
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