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Milestone Matters
Spring 2009
“Once in every ten years, there is a period of excessive general speculation culminating in a severe panic or depression when the man who is
borrowing money is at great disadvantage and he who has ready cash stands like a tower, four-square to the ill winds that blow.” John Loeb (19021996) CEO, Loeb, Rhoades & Co., Fortune Magazine, 1970
Editor’s Corner
Dear Friends, Investors and Associates,
At Milestone we are just completing the audit process with respect to the
three venture funds under our management. It has been the most time consuming, complex and problematic exercise that I have ever experienced in the business. This is a classic example of the Law of Unintended Consequences at work
and reflects the general concern of those that regulate the financial community
that we move toward greater transparency and accountability in light of the
many failures in this respect over the last few years. Sadly, in the case of the
venture community, I believe the new rigorous auditing approach will guarantee that a huge amount of General Partner time will be spent on these issues and
administrative and accounting costs will explode but no clearer picture will
emerge with respect to venture funds’ balance sheets.
Part of the difficulty lies in the faulty thinking which led us to mark-tomarket FASB (Financial Accounting Standards Board) rules and additional
problems which arise when trying to address the assets of venture funds. As
some of you may know, the financial assets of the world have been divided by
the regulatory powers that be into Level One, Level Two and Level Three.
A primer on “SFAS 157” excerpted from the notes of an investment partnership follows:
“SFAS 157 clarifies that fair value is an estimate of the exit price, representing the amount that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants (i.e. the exit price
at the measurement date). The three-level hierarchy is as follows:
Level 1: Unadjusted quoted prices, where an active market exists for identical assets or liabilities.
Level 2: Inputs other quoted market prices that are observable, either
directly or indirectly, and reasonably available.
Level 3: Unobservable inputs. Unobservable inputs reflect the assumptions that the General Partner develops based on available information about
what the market participants would use in valuing the asset or liability.”
The vast majority of venture assets fall within Level 3 and therefore, ipso
facto, they are exceedingly difficult to value. Heretofore, the highly rational
treatment of these assets that has evolved over the years is basically to carry
investments at cost when funds are invested in a company, to adjust them downward when companies consistently fail to meet operating plans and to also
adjust them up or down, as the case may be, to reflect independent third party
financings which frequently occur during the holding period. Finally, when the
positions are ultimately sold, a final value is established beyond debate. This
valuation approach is generally supplemented by the comments of the General
Partner who can lend perspective to the progress or problems in the portfolio.
Such General Partner commentary is of particular importance for start-up and
early stage investments because, per se, there is very little in the way of thirdparty reference points and historical financial data and therefore valuation
assessment and forecasting is that much more treacherous.
Prior to the introduction of FASB 157, the accounting profession implicitly recognized the validity of this modus operandi or, arguably, the futility of a
more quantitative approach, in that, they routinely and specifically excluded
from their financial opinions with respect to venture funds’ audited financials,
an opinion on the valuation of the portfolio positions. This methodology
worked well for years but now is being “fixed”. The new thinking within the
accounting profession is that this approach is inadequate and a number of other
tests are being imposed in a futile effort to paint a clearer picture for
investors. For example, one is encouraged to seek publicly listed
companies as reference points for valuation. This exercise is, on its
face, ludicrous when dealing with very young and small enterprises.
Regarding the broader financial markets, similar opinions have
emerged from other quarters including from Stephen A. Schwarzman,
the co-founder and CEO of Blackstone, the large private equity firm.
In the March 30th issue of the Wall Street Journal, and on other occasions, he has held forth on the current financial crisis and concedes
there are multiple causes. Among them, he cites the mark-to-market
accounting rules. This ruling by FASB has a benign if not benevolent
ring to it but in some circumstances, has had a pernicious impact. As
Schwarzman points out, under the ruling, if a bank makes a loan in,
let’s say, the amount of $1 million to a very healthy borrower and that
loan is being serviced and the borrower is operating comfortably
Cont’d on Page 2
Chutzpah Award
Milberg’s New Hire
Plaintiffs lawyers seem to operate on a different ethical plane than
mere mortals, in case you hadn't noticed. Consider the latest news from
the notorious Milberg law firm.
The class-action giant only last year settled a federal indictment over
charges it had run a 30-year kickback scheme. The firm paved the way
for this nonprosecution agreement by repudiating three partners -Melvyn Weiss, David Bershad and Steven Schulman. Milberg claimed
it had been in the dark as to their "illegal activities," and all three men
later pleaded guilty to felonies.
Only later did we learn and report that Milberg the law firm had
agreed to pay indicted partner Melvyn Weiss a slice of the firm's future
lawsuit winnings, and was also picking up his legal fees. The supposedly remorseful firm made sure its founding felon would receive this
cash even if he went to prison -- which he did. The Justice Department
later admitted it had inexplicably sanctioned this sweetheart deal.
Meantime, as a felon, Melvyn Weiss had to obtain court approval for
any fees for legal services he provided. In July of 2008, New York
Supreme Court Judge Herman Cahn was asked to pronounce judgment
on the Milberg payoff. A month later he agreed to let Melvyn Weiss
have his booty, even as the judge acknowledged that law firms are generally barred from sharing legal fees with nonlawyers, and that Melvyn
Weiss had forfeited his right to practice law.
And now for the latest news: In December, Judge Cahn retired from
the bench. Last week, the renamed Milberg LLP announced it had
hired a "distinguished" new attorney: Herman Cahn. In its press
release, the firm listed his most notable cases, though omitting any on
which he'd ruled on its behalf.
To recap: A class-action firm's name partners are nailed in a 30-year
fraud. Class-action firm rewards lead perpetrator with share of future
earnings. State judge sanctions the earnings deal. Class-action firm
hires state judge. We'll let our readers decide what they think of this
"fact pattern," as a plaintiffs lawyer might put it.
Source: Wall Street Journal, February 25, 2009
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Cont’d from page 1
within the imposed covenants, there is, under
the new rules, one threshold test with respect to
the “value” of that loan, i.e. can it be sold immediately to a third party for “par” ($1 million)? If
the answer is “no”, then the loan must be written down on the bank’s balance sheet to reflect
this illiquidity. For purposes of this example,
we will say the loan is written down to a “value”
of $700,000. In this case the $300,000 “written
off” is written down on the bank’s balance
sheet, passes through the bank’s income statement as a “loss” and reduces the bank’s equity
by $300,000. Now, since the equity of the bank,
based on certain regulatory financial ratios,
governs how much the bank can loan, the exercise described here, reduces the bank’s ability
and incentive to make additional loans. On a
system-wide basis the effect of this application
of mark-to-market accounting is hugely exacerbating the financial system’s illiquidity at a time
when a critical objective is to enhance liquidity.
I would argue that, in this, and I fear, in
many other instances, the Bank’s operations
have been impaired while a clearer understanding of the Bank’s financial position has not been
achieved. It is true that the economist Robert
Shiller and other distinguished knowledgeable
figures, although not contesting the validity of
Schwarzman’s argument, have maintained that
we cannot afford to soften these rules because
”trust” in the system, which is crucial, would be
undermined. I think this is irrational and wrong
headed. In any event, since this discussion took
place, a move is afoot, under congressional
pressure, to have FASB soften the mark-to-market rules.
Now, I find it awkward, to praise Congress
but, I think, in this instance, they are to be commended. However mixed their motives may be,
as they seek to curry favor with the banking
lobby, they are right on the merits. Of course, it
took less than 24 hours before various pundits
arose to denounce this “caving in” to the “financial interests”. The underlying tone of these
pieces is that the financial community is full of
knaves and even the best of bankers will use
chicanery to put the best face on things. My
experience suggests that the ethically challenged are evident in all walks of life but perhaps disproportionately so in the financial
community where the stakes are so high. But
I think the missed lesson here is that ill-conceived and sloppily applied accounting rules
will not thwart the miscreants or illuminate
financial statements for investors.
Returning to the venture community for a
moment, it appears that in light of the pervasive decline in the price of listed assets, that
one way to avoid the wasteful and time consuming back and forth with auditors, is to
accept a sharp discount on all portfolio assets
(like the bank example above) presumably
reflecting illiquidity within the context of an
inefficient market. Sadly, the tactic would fall
short in achieving the primary goal of financial statements of which we may have lost
sight – conveying to investors the most accurate possible picture of the progress of investment funds and the underlying value of portfolios.
After this debate is settled, it will remain
the case that investors must pick their financial
partners with great care, read their reports with
equal care and a dose of skepticism and ask
questions of the stewards of their money. The
reason that Warren Buffet’s financial reports
are justifiably renowned is not because he rigorously applies the requisite accounting rules
(which I am certain he does) but because his
comments on his investments are concise,
clear and commonsensical. In that spirit, we
look forward to communicating with our
investors further throughout 2009 and
beyond.
With best wishes for a pleasant summer,
Edwin A. Goodman
General Partner
MVP Portfolio News
In late April 2009, MVP III invested $1.35 million in Collections Marketing Center, Inc. ("CMC").
Milestone led the $2.0 million first institutional round
with participation from the Delaware Economic
Development Authority and existing individual
investors.
Delaware-based CMC provides a multi-channel
collection platform - web, e-mail, text messaging,
voice - that enables creditors to reach and engage
debtors more effectively, thereby increasing payments and decreasing delinquencies and charge offs.
The CMC platform is the only fully-integrated platform in its market, and it is deployed as an outsourced
service that integrates with a creditor's existing collections infrastructure. CMC generates revenue through
a subscription model based on the number of accounts
managed by its platform. Currently, CMC is managing close to 7 million accounts across its customer
base, which includes Discover Card, PNC Bank, US
Bank, and CitiBank.
Morgan Rodd will serve on the board of directors.
In March 2009, MVP II invested $141,000 in a
follow-on financing in GenomeQuest. MVP II participated with Cross Atlantic Partners, Societe Generale Asset Management and Mosaix Ventures in this
$1.5 million bridge financing round.
The company intends to raise an additional $1.5
million of equity capital from a new investor in the
course of the next quarter.
GenomeQuest is a leading provider of sequence
data management software and services to the biopharmaceutical industry. The company counts 17 of
the top 20 pharmaceutical companies and the top 5
agriculture/biotechnology firms among its customers.
In April 2009, MVP III and MVP III NY invested a total of $265,000 in SmartAnalyst, Inc. Milestone participated alongside Edison Venture Fund
and individual investors in the $1.2 million followon financing round.
SmartAnalyst provides custom research and
outsourced analytical services to the life sciences
industry.
investing in early stage technology-enhanced service companies
in the new york metropolitan area
Milestone Venture Partners
551 Madison Avenue - 7th Floor
New York, NY 10022
V: (212) 223-7400 f: (212) 223-0315
www.milestonevp.com