California is home to some of the biggest venture capital firms and many of the young companies they invest in. So it is not surprising that the state has been a major battleground in efforts to strike a balance between the venture industry’s need for confidentiality and the public’s right to know about investments made by public agencies.
A recent ruling by a California state court offers one option â€" allowing venture capital firms and public agencies to control the amount of information they disclose. But is it the best solution? Probably not.
First, a little background. The venture capital business is actually a fairly confidential one. A venture capital fund typically raises money by privately offering limited partnership interests. The fund then invests in young companies that are privately offering preferred stock.
Until a company goes public in an initial public offering, both the fund and the company have many reasons to maintain confidentiality. Young companies are fragile. Their most valuable assets may be intangible, like business plans and technical insights. Struggling to attract customers, business partners and additional employees, they can be destroyed by premature publicity or even rumor.
Venture funds have their own reasons to crave confidentiality. It is notoriously difficult, for example, to establish the value of private company stock in their portfolios. Different venture funds that have invested in the same private company may attribute wildly different values to their holdings. Publication of those valuations could wreak havoc on young companies.
Because it can take a portfolio company five to seven years or more to generate liquid returns for a venture capital fund, it often takes a decade to determine whether a particular fund is a “success.†Indeed, most venture funds spend years officially “under water†because they must recognize operating expenses and early losses, while gains from successful investments come much later. Prematurely publishing information about the investment performance of a specific venture fund can damage the reputation of its parent venture capital firm, making it more difficult for the firm to conduct business.
Perhaps more insidiously, publication of venture fund performance can motivate fund managers to seek positive returns as quickly as possible by selecting investments with a shorter path to liquidity. This could sacrifice the longer-term, higher potential investments that represent what venture capital is all about.
If both portfolio companies and their venture capital backers are motivated by similar desires for confidentiality, what’s the rub? It’s this. A large portion of the money invested in venture capital funds comes from public agencies, and these agencies are governed by myriad laws intended to protect the public’s right to know.
In 2003, a university employees’ union successfully sued the Regents of the University of California for access to an array of statistics on the university’s venture capital and other private fund investments.
Reaction by the venture industry was swift. Many of the most prominent and successful venture capital firms announced that they would no longer accept capital from California public agencies. This, argued the University of California, the California Public Employees’ Retirement System and other public agencies, was a blow to public employees, retirees, students and others who have benefited from strong returns on venture investments.
In response, the California Legislature amended the law governing public disclosure â€" the California Public Records Act. Broadly speaking, the amendment divided information into two buckets. Information relating to specific portfolio companies was exempted from public disclosure, while information relating to specific funds was not.
In practical terms, this meant that a public agency must annually disclose the name of each venture fund in which it invests, the amount invested, the fees paid to fund managers and the fund’s overall investment performance.
The amendment was a major step forward. It protected young portfolio companies and there has been little debate about public agencies’ disclosure of nonperformance information on their venture capital investments â€" like the names of the funds, amounts invested and fees paid.
Nevertheless, almost no one in the venture industry is happy about the law’s requirement that each fund’s performance data be disclosed each year. Indeed, the websites of California public agencies that disclose this data are replete with warnings that the information is unreliable and misleading.
A public agency can disclose only information to which it has access. To minimize disclosure of fund performance data, a number of venture firms and public agencies have entered into contractual arrangements that limit the amount of data the agencies receive about fund performance. These arrangements were a major issue in a recent lawsuit brought by the Reuters news agency against the Regents of the University of California.
Reuters argued that the Public Records Act prohibits public agencies from agreeing to forgo performance data that (if received) must be publicly disclosed. In December, the California Court of Appeal sided with the Regents, holding that the Public Records Act imposes no obligation on public agencies to acquire data they believe they can do without.
But does the court’s ruling mean we have now reached a stable balance? Probably not.
For starters, the current situation is genuinely perverse. Public agencies, seeking to invest in the best venture capital funds, are forfeiting the right to receive data that will help them understand and manage their investments. It’s easy to see how the next lawsuit may assert that public agencies breached their fiduciary duties by making investment decisions based on inadequate information.
The simplest solution would be to eliminate mandatory public disclosure of fund performance data. Yet it is difficult to reconcile this with the public’s need to hold government officials accountable for the performance of public agency investment programs.
A more attractive middle ground would allow public agencies to combine the performance data of multiple private investments and disclose only the aggregated result. This would allow the public to hold agency officials accountable for overall performance, while protecting individual venture capital funds from premature and misleading disclosure of their investment data. Given the inherent contradictions of the current situation, this seems an experiment worth conducting.
Jonathan Axelrad is a partner in the Silicon Valley office of the law firm Goodwin Procter, and co-head of its venture capital fund formation practice.
