Fidelity just wrote down the value of their Snapchat investment by 25%. You can read about it here.
It reminded me of when I learned the accounting rules on how these investments have to be valued. In terms of process, if you imagined a bunch of Fidelity analysts creating spreadsheets to come to some agreement on a quarterly fair value number, you’re right — but there’s a pretty complicated history here.
The Fair Value Trend
First, some background on the popularity of fair value measurement in financial accounting and its and steady rise over the last few decades. This article offers a great explanation on why:
One explanation for the rise of fair value accounting is that finance theory — in particular, the idea that financial markets are efficient and their prevailing prices are reliable measures of value — permeated academic accounting research in the 1980s and 1990s, thus changing opinions on the relative merits of historical cost and fair value.
Why is this relevant to Snapchat? Because the accounting rules around how assets are supposed to be “marked to market” are motivated by this idea. And that’s what brings us to TOPIC 820 (FKA FAS 157), proposed by the Financial Accounting Standards Board in 2006.
FAS 157 (AKA TOPIC 820)
FAS 157 was the big rule change that injected a heavy dose of “mark-to-market” into our early stage world.
FAS 157 became effective for fiscal years beginning November 15, 2007 and thereafter. According to the Summary: This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements.
…defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
When you compared this to the old methodology, the latter seemed very intuitive and straight forward. In Brad Feld’s rant/post on FAS 157, he reminisces about the good old days:
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%).
But no longer. In a nutshell, FAS 157 created a lot of pain. The whole exercise of arriving at a fair value on illiquid (Level 3) assets is much harder than getting an asset price for a publicly traded stock. Here’s Fred Wilson writing about it in 2009: The Valuation Blues (aka How FAS157 Is Tortuous). To start, their process involves creating spreadsheets, finding a handful of private and public comparables, calculating revenue and EBITDA multiples, quantifying traction, and getting a baseline comp. And that’s for each portfolio company!
So in summary, fair value measurement in venture capital is complicated voodoo. Topic 820 provides the guidelines that Fidelity uses to value their to portfolio. In the last quarter, their data and analysis required them to write-down the valuation of their Snapchat shares. If you read Fred Wilson’s post, you can see there are scenarios where the methodology produces non-intuitive results because of the reliance on market comparables. It’s something to keep an open mind about while you’re reading all these headlines about the sky falling at Snapchat.
As an aside, I wonder if GPs were expecting mutual funds to be so aggressive with their fair value accounting. I’m curious to see how this write-down affects the other VC funds holding Snapchat equity. Will they incorporate this signal from Fidelity and mark down their shares too? The answer to that question provides good insight into how a broad unicorn devaluation could unwind faster than we expected.
This was originally posted on John’s Medium.