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Hi, I’m Brad Feld, a managing director at the Foundry Group who lives in Boulder, Colorado. I invest in software and Internet companies around the US, run marathons and read a lot.

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FAS 157 – Another Annoying Accounting Provision

Comments (14)

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.

  • Dean Leffingwell

    Good post Brad.
    Question, wrt to your comment “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.”

    Have you ever seen a case where an up round did NOT include a new investor?

    If not, why not, and if so, how do you value that asset?

    Dean Leffingwell

    • http://www.feld.com Brad Feld

      Yup – i have seen plenty and participated in some. Under the old methodology you wuld carry the old rounds at their previous value and the new round at cost. Under FAS 157 you have to mark everything up to the new price per share.

  • Luca

    HA! You touched a sore spot…

    A public company I work with has a convert outstanding which is very illiquid. Because of a depressed stock price and the state of debt market, the occasional small trade takes place at around 70. Since the bond trades deep under par, FAS 157 forces this company to create a significant intangible asset, to be written down over the years until the convert is due. Net results: (1) the company's balance sheet will be misleading with that asset that has no real value, and (2) net income (for those who care) will be depressed by the writedowns.

    Weren't accounting rules supposed to give a clear and fair view of a company's financial situation???

  • David Ulevitch

    It's policies like this that drive inaccurate and over-inflated valuations which ultimately force small growing businesses into unfortunate positions as they raise capital down the road. Ultimately it's the economy that suffers as a consequence.

  • Kyle S

    What is the purpose of this rule? As best I understand (IANAA), to the extent that your portfolio investments grow in value, gains aren't taxable until you actually take money off the table, which would lead me to believe there are no tax implications. I can understand why it makes sense to value derivative contracts this way, as they can have substantial impact on cash and earnings yet don't show up on a balance sheet; but venture investments are totally dissimilar from derivatives.

    While funds like yours are likely to be above-board, to play by the rules, and to be as conservative as possible, IMHO it's just a matter of time before an LP sues a less-than-stellar VC for valuing their portfolio companies too aggressively (and thus creating misleading expectations about returns, causing investment in a new fund that wouldn't have otherwise happened, etc etc).

    • http://www.feld.com Brad Feld

      Correct – there is no tax impact.  And your interpretation is correct – there is no real reason to have to do any of this.  But more in the next post.

  • http://mindaverse.com/ Devin

    Well hmm, it's not like this was a surprise. New accounting communications such as this come out years in advance to start the discussions like these.

    Not to sound snide but you might want to put IFRS on your radar if you haven't already.

    • http://www.feld.com Brad Feld

      Oh – we’ve known about this since 2006.  That doesn’t make in any less palatable. 

      • http://mindaverse.com/ Devin

        Right, I agree. The beauty of a self-regulating industry. To your point, it means more fees for “us”. That hurt to type.

  • Chris Mercer

    I'll wait for the next post before commenting further.

  • http://dfwfinancialexec.blogspot.com/2006/01/opening-post.html David McCully

    Interesting post; however, your FASB criticisms are misdirected in this case. Don't feel bad… most of the media make the same mistake.

    FAS 157 doesn't do or cause anything… it's simply a disclosure standard that categorizes and defines three levels of measurements of fair value. It doesn't require the use of fair value accounting at all. In fact, it doesn't even tell you how to calculate fair value for anything.

    The real financial accounting standards that are causing you heartburn are ones like FAS 133, FAS 141 and others that prescribe fair value accounting.

  • http://www.jasonmendelson.com Jason Mendelson

    David, I don't think this is correct and it's not a media issue. As someone who is in charge of our VC being FAS 157 compliant, I can tell you for certain that FAS 157 has several material effects:

    1. Uncertainty- as you correctly point out FAS 157 (and the accounting firms themselves) doesn't tell you HOW to calculate fair value. What the accountants WILL tell you is that they expect to see changes in the portfolio values each quarter, as “it's unlikely there is no change.” In essence, you are forced to prove a negative to your auditors in that you must justify the absence of changing each company's valuation. For example, the auditors will tell you that in order to comply with FAS 157 you must make discretionary write ups (and write downs) based on one quarter's revenue of a startup company that has just started shipping product. Bottom line, I have no idea how the market values a single quarter of revenue and how that would change the the acquisition price of a company. But my auditors may not let me leave the value as is because “something has changed.”

    2. Volatility – Much because of #1, above and also due to the fact that under FAS 157 valuations are changed outside of funding events, valuations change much more often and the volatility of the portfolio asset valuations have dramatically increased. I'd have no issue with this if I thought they were more accurate than the “old days,” but it definitely feels strange to me that a much more discretionary and arbitrary valuation methodology is also adding to volatility.

    3. Reliance – “Simply a disclosure standard” is not correct. LPs / investors are relying on these numbers as the correct valuation of the assets. Our VC track records and fund raising presentations are showing these numbers. People rely on these numbers, get paid bonuses per these numbers and their potential inaccuracies and / or volatility can have material liability issues.

    I could go on for a while – I won't. :) But as the guy sitting in the audit committee meetings with the auditors, I've seen this up close and personal and besides the frustrations and costs associated with FAS 157, there are real, material effects.

  • http://intensedebate.com/people/bfeld bfeld

    Yup – i have seen plenty and participated in some. Under the old methodology you wuld carry the old rounds at their previous value and the new round at cost. Under FAS 157 you have to mark everything up to the new price per share.

  • http://intensedebate.com/people/david_ulevi3244 david_ulevi3244

    It's policies like this that drive inaccurate and over-inflated valuations which ultimately force small growing businesses into unfortunate positions as they raise capital down the road. Ultimately it's the economy that suffers as a consequence.

  • http://intensedebate.com/people/bfeld bfeld

    Correct – there is no tax impact.  And your interpretation is correct – there is no real reason to have to do any of this.  But more in the next post.

  • http://intensedebate.com/people/luca8090 luca8090

    HA! You touched a sore spot…

    A public company I work with has a convert outstanding which is very illiquid. Because of a depressed stock price and the state of debt market, the occasional small trade takes place at around 70. Since the bond trades deep under par, FAS 157 forces this company to create a significant intangible asset, to be written down over the years until the convert is due. Net results: (1) the company's balance sheet will be misleading with that asset that has no real value, and (2) net income (for those who care) will be depressed by the writedowns.

    Weren't accounting rules supposed to give a clear and fair view of a company's financial situation???

  • David McCully

    Interesting post; however, your FASB criticisms are misdirected in this case. Don't feel bad… most of the media make the same mistake.

    FAS 157 doesn't do or cause anything… it's simply a disclosure standard that categorizes and defines three levels of measurements of fair value. It doesn't require the use of fair value accounting at all. In fact, it doesn't even tell you how to calculate fair value for anything.

    The real financial accounting standards that are causing you heartburn are ones like FAS 133, FAS 141 and others that prescribe fair value accounting.

  • http://intensedebate.com/people/jason4307 jason4307

    David, I don't think this is correct and it's not a media issue. As someone who is in charge of our VC being FAS 157 compliant, I can tell you for certain that FAS 157 has several material effects:

    1. Uncertainty- as you correctly point out FAS 157 (and the accounting firms themselves) doesn't tell you HOW to calculate fair value. What the accountants WILL tell you is that they expect to see changes in the portfolio values each quarter, as "it's unlikely there is no change." In essence, you are forced to prove a negative to your auditors in that you must justify the absence of changing each company's valuation. For example, the auditors will tell you that in order to comply with FAS 157 you must make discretionary write ups (and write downs) based on one quarter's revenue of a startup company that has just started shipping product. Bottom line, I have no idea how the market values a single quarter of revenue and how that would change the the acquisition price of a company. But my auditors may not let me leave the value as is because "something has changed."

    2. Volatility – Much because of #1, above and also due to the fact that under FAS 157 valuations are changed outside of funding events, valuations change much more often and the volatility of the portfolio asset valuations have dramatically increased. I'd have no issue with this if I thought they were more accurate than the "old days," but it definitely feels strange to me that a much more discretionary and arbitrary valuation methodology is also adding to volatility.

    3. Reliance – "Simply a disclosure standard" is not correct. LPs / investors are relying on these numbers as the correct valuation of the assets. Our VC track records and fund raising presentations are showing these numbers. People rely on these numbers, get paid bonuses per these numbers and their potential inaccuracies and / or volatility can have material liability issues.

    I could go on for a while – I won't. :) But as the guy sitting in the audit committee meetings with the auditors, I've seen this up close and personal and besides the frustrations and costs associated with FAS 157, there are real, material effects.

  • http://intensedebate.com/people/bfeld bfeld

    Oh – we’ve known about this since 2006.  That doesn’t make in any less palatable. 

  • Chris Mercer

    I'll wait for the next post before commenting further.

  • http://intensedebate.com/people/devinreams devinreams

    Right, I agree. The beauty of a self-regulating industry. To your point, it means more fees for "us". That hurt to type.

  • http://intensedebate.com/people/kyle_s10731 kyle_s10731

    What is the purpose of this rule? As best I understand (IANAA), to the extent that your portfolio investments grow in value, gains aren't taxable until you actually take money off the table, which would lead me to believe there are no tax implications. I can understand why it makes sense to value derivative contracts this way, as they can have substantial impact on cash and earnings yet don't show up on a balance sheet; but venture investments are totally dissimilar from derivatives.

    While funds like yours are likely to be above-board, to play by the rules, and to be as conservative as possible, IMHO it's just a matter of time before an LP sues a less-than-stellar VC for valuing their portfolio companies too aggressively (and thus creating misleading expectations about returns, causing investment in a new fund that wouldn't have otherwise happened, etc etc).

  • http://intensedebate.com/people/devinreams devinreams

    Well hmm, it's not like this was a surprise. New accounting communications such as this come out years in advance to start the discussions like these.

    Not to sound snide but you might want to put IFRS on your radar if you haven't already.

  • Dean Leffingwell

    Good post Brad.
    Question, wrt to your comment "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."

    Have you ever seen a case where an up round did NOT include a new investor?

    If not, why not, and if so, how do you value that asset?

    Dean Leffingwell

  • http://www.accountingnation.com Auditing

    I am waiting for your next post.

    • http://intensedebate.com/people/bfeld Brad Feld

      Yeah – I guess I never got around to it.  It’s probably time now that a year has passed and everyone has had to go through one full FAS 157 cycle (and boy did that work out well.)

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