VC valuations fail to mirror tough times

The financial tsunami that has swept over the tech industry in the last 18 months has left a very visible trail of destruction: hundreds of companies have shut down, tens of thousands of people have been laid off and companies have been crushed by plunging credit ratings and stock prices.

But one area where the damage has been less obviously on display is in the valuations that venture capital companies bestow on their funds, many of which are loaded with troubled start-ups.

Typically, VCs do not adjust the value of a company or an investment fund unless a company in the portfolio has sold shares to the public, has acquired additional funding or has shut down. While outright failures have been fairly plentiful, initial public offerings and funding rounds have been fairly rare.

Because of this relative stagnation, many venture companies have not significantly adjusted the value of their funds in several months--which could be masking the underlying deterioration in the funds. And that can leave investors, particularly corporate investors, thinking they have a stake in a much healthier portfolio that they actually do.

"The competing pressure to look good outweighs the desire to get the bad news behind them," said Anthony Romanello, manager of analytics with research company Venture Economics. "Generally, they're sitting on inflated valuations today...and eventually they will come down. It's just a question of how long will they take."

Without outside pressure, there is little motivation for venture capitalists to update the figures. But there is plenty of incentive--such as marketing a new fund--for wanting current investments to look as strong as possible, said Gary Lutin, an investment banker with Lutin & Co. and former co-sponsor of the Committee for Corporate Governance and Shareholder Rights forum.

"In the extreme case, a fund may not recognize a lot of their significant disappointments. And, in the extreme case, the reported valuation number can almost be all fantasy," Lutin said.

Concern over accurate valuations comes as many corporate investors have been writing off extraordinary amounts of money, largely for direct investments in public and private companies that have gone bad. During the second quarter, Microsoft announced a $2.6 billion loss on its investments, Comverse Technology warned it would take up to a $15 million charge, E*Trade said it expected to write off $6.8 million and Wells Fargo took a staggering $1.1 billion write-off.

Having somewhat cleaned up the books on these direct investments, the focus is now shifting to the valuations of these venture funds, which have attracted investors ranging from pension funds and endowments to large tech companies. IBM, for example, has $300 million invested in venture companies worldwide, and NEC USA has roughly $200 million invested.

Up until now, it was not unusual for corporate investors to accept the venture companies' valuations with little question and feed that information into their overall investment portfolio performance--which in turn is reported to their respective shareholders each quarter.

"It all comes down to, essentially, committing a certain amount of trust in the funds' management. There's always an element of risk in that," Novell spokesman Bruce Lowry said.

Now some companies are starting to take a closer look at the numbers they get from VCs, even though investors generally acknowledge that they have good, long-standing relationships with VCs and trust their judgment in valuing the funds.

NEC takes "appropriate measures on a case-by-case basis" when it receives valuation information from VCs, before feeding them into their own financial results, said Masaru Sakamoto, director of corporate strategy and business development for NEC USA.

Novell, which had a $100 million write-off after Internet consultancy MarchFirst filed for bankruptcy in April, has not taken any write-offs related to the $60 million invested in 20 different venture funds, according to Lowry.

Diamondhead Ventures, which conducts seed and early stage investments, said it has a reputation for a conservative portfolio in part because it readjusts the value of companies in between events such as an IPO or bankruptcy.

"We mark them up if there is another financing round, acquisition or IPO," said Managing Director and General Partner David Lane, whose corporate investors include Oracle and Sun Microsystems. "And, on the negative side, we mark them down if there is a negative event or their business significantly deteriorates--even without outside events or financings."

But VCs that do not adjust their figures can pass along a valuation inflation problem, with corporate investors feeding erroneous investment information to their shareholders.

"VCs that mark companies to fair valuations (in between financial events) are being complimented for their approach," said Blake Modersitzki, vice president of Novell Ventures and Strategic Alliances, an investment arm of Novell.

"For those who don't, I don't know whom they are trying to kid," Modersitzki said. "It's to everyone's benefit to mark them to where the market gyrations are today."

The consequences of an inflated investment could be serious for the corporate investor, according to Melinda Litherland, an audit partner in the technology practice at accounting giant Deloitte & Touche.

"Most companies carry their investments at cost, so the most they can lose is cash that they spent," Litherland said. "Where companies get hurt is if they took a mark-up in valuations alongside the VCs during the markets' (boom). They may now be facing the need to not only write off their cost, but more."