Waterfalls: What Are They Good For?

Why the SEC is missing the forest for the trees

This morning – PEHUB ran a commentary that the SEC is warning GP’s to pay close attention to waterfall calculations, as they’re worried that imperfect calculation tables or assumptions are impacting the carrying value of as this would imply that fund managers are marking their portfolio to the distribution amounts in a waterfall to their investors.

For those of you who haven’t taken accounting in a while- here’s a quick refresher on GAAP principles.

1. The historical cost principle states that assets shall be recorded at the cash amount (or its equivalent) at the asset was acquired.
2. Fair value (or mark-to-market) accounting states that the fair value of an asset or liability shall be based on the current market price of the asset.

It should hold true that in the absence of one, the other should prevail – in that in absence of a liquid market, then the value of that asset shall be equal to the amount paid for it.

However, according the SEC, fund managers are taking a far more artistic view of the underlying value of their companies. Fund managers are looking at their holding through the lens of their preferred share provisions, such as liquidation preference, participation rights, or cumulative dividends. Under a waterfall analysis, a GP estimates what they would receive in the event of a liquidation at an assumed price (typically based on public comps and the current/projected financial performance of the business), while taking into account all of the preferred provisions of shareholders ahead and behind them in the cap structure.

While GP’s are correct to acknowledge the potentially large impact these rights can have on the their realizations, it is foolhardy and misguided to value the portfolio on this basis.

1. Going Concern: While there is no discrete definition under GAAP, generally a company can be viewed as a going-concern when it can operate without the threat of liquidation in the next 12 months. Given that many startups are financed under the assumptionthat they will be profitable once they reach scale, its safe to say that most companies funded at the early-stage do not qualify as a “going concern”. It is very difficult to maximize the value of a sale process when you do not have the time to execute it in an orderly fashion.
2. Assumed Market: While many private companies operate at a size and scale much larger than their public counterparts (think Unicorns), using a public company as a proxy for a private company’s potential value is tricky with early stage businesses for two reasons: lack of decent comps and high trading multiples. The private equity firm that marks a retail chain investment at 2x forward revenues, and points to its largest public competitor as a proxy is a relatively safe assumption, but an early stage HR tech company marked at 10x forward revenues pointing to Workday is aggressive.
3. Protective Provision: There are lots of reasons for and why these terms are included – (just read one of Fred Wilson’smany posts on the subject) but for the most part, a preferred share is issued as a protection for investors, not as a tool to engineer greater returns. An investor should look at their preferred share to protect them, or build an implied small rate of return in the event of an early sale of the business – something that would be viewed as a failed outcome for both the entrepreneur and the investor. An investor that marks their portfolio companies to the waterfall valuation of this sub-optimal outcome clearly assumes the company will never have an exit through a Qualified IPO. Note: typically you see preferred shares convert to common shares in the event of a Qualified IPO (defined in the term sheet).

The SEC shouldn’t be concerned that analysts at venture capital firms are building poor waterfall models that do not capture the “leakage” seen in many early sales of startups, they should be concerned with the set of assumptions being made by GPs. Early stage private investments are incredibly risky investments into companies that have not established that they are a going concern or that there is public (or other private) demand for their securities. Investors marking these investments at anything greater than the share price they paid, (or at a price greater than a recently priced round by another investor) deserve scrutiny for these marks, and should serve as a red flag to any LP looking at someone’s track record or fund performance.

After all – if I invested $5 million into a a Series A preferred security that has a 2x liquidation preference at a $15 million pre-money valuation, should I mark the value of my investment up to $10 million the day after I invest because that’s what I would receive in a liquidation?

The SEC shouldn’t be concerned that analysts at venture capital firms are building poor waterfall models that do not capture the “leakage” seen in many early sales of startups, they should be concerned with the set of assumptions being made by GPs. Early stage private investments are incredibly risky investments into companies that have not established that they are a going concern or that there is public (or other private) demand for their securities. Investors marking these investments at anything greater than the share price they paid, (or at a price greater than a recently priced round by another investor) deserve scrutiny for these marks, and should serve as a red flag to any LP looking at someone’s track record or fund performance.