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10.1.

15: Partnership Private Placement Memorandum


General partners, investors and occasionally counsel may overlook from time to time the fact that limited
partnership interests are generally deemed to be securities e.g., Long, Partnership, Limited Partnership,
and Joint Venture Interests as Securities, 37 Mo. L. Rev. 581 (1972). within the 33 Act definition and,
thus, to be handled with caution in light of the registration and antifraud provisions of the securities laws.
It is, therefore, curious, that PIV sponsors, hypercritical of ambiguities in the business plans presented to
them by hopeful issuers, are often quite reticent in outlining in a private placement memorandum what it
is they plan to do with the money they are soliciting from investors.
Moreover, the focus of the investment strategy is usually outlined in generalities. There may be a tilt to the
program-biomedical and health sciences, leveraged buyouts, turnarounds-but, in the interests of
flexibility, escape language in the document gives the managers the opportunity to take advantage of a
broad range of opportunities.
The generality of the partnership selling document reflects some history. When the first investment
partnerships were organized, it was generally conceded that the managers enjoyed unique expertise. The
investors, as experienced in business and finance as they might be, had little to contribute to the process
since venture capital was perceived as an esoteric art, a mystery shared by only a few initiates. That
balance of intellectual power and experience has shifted somewhat over the years as the controllers of the
sources of capital have become initiated. Nonetheless, opportunities crop up at unexpected points of the
compass and the fashion is not to require a concentrated focus by the investing partners.
Some PIV private placement memoranda include both an elaborate risk factors section and a
memorandum outlining the tax considerations and risks, a section reminiscent of the extensive language
found in tax shelter syndication partnerships. Others omit both these sections entirely. Thus, the model
drafted by Larry Sonsini, as reproduced in one of the best of the source books, is very much a plain
vanilla version.
[2]
Sonsini is one of the most experienced and successful lawyers in investment capital and
his views are entitled to great weight. In his form, the risk factors section is quite bland, and the tax
consequences section is no more than a brief overview of how partnerships are taxed from a federal
standpoint. Counsel wishing to go further than Sonsini would, presumably, introduce mention of special
risks-for example, that the carried interest in profits may induce the general partner to take greater risks
than would otherwise be the case if its capital were at stake. The tax consequences section could
mention such problems as allocations being recharacterized by the Service because of the lack of
substantial economic effect, what factors are required to constitute the entity as a partnership under
7701 of the Code, the risk of being considered as publicly traded partnership and so forth. There have
not been, as far as the author is aware, any successful actions for rescission against the organizers of a
PIV based on the paucity of information in the private placement memorandum. Moreover, the more
extensive the disclosures in the memorandum, the greater the likelihood that potential investors will
perceive the fund as a new boy on the block". However, returns from investment partnerships are, as of
this writing, flatter than in prior periods and it may be that lawsuits by disappointed investors are on the
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immediate horizon.
Track Record
In a typical private placement memo, the sponsors indicate their track record, meaning the returns they,
or each, have or has achieved with prior investment portfolios entrusted to their supervision. These
presentations differ widely, ranging form the most blatant fudging (presenting only the winners, not netted
against the losers) to such questionable practices as displaying returns without netting management fees
and the managers carried interest. More importantly, since some of the prior portfolio remains
unharvested, valuation must be made of illiquid positions.
[3]

In an attempt to facilitate apples to apples comparisons in this area, a draft proposal to track the
performance of investment capital partnerships was presented in 1989 by an ad hoc committee
[4]
at a
prestigious forum.
[5]
The committee was formed with the stated purpose of designing a methodology to
standardize portfolio company valuations and interim performance measurements so that such
information would be consistently reported throughout the industry.
[6]
The committee recently updated
and modified a number of the guidelines, in large part to incorporate comments from the industry.
The proposal first sets forth the general (and presumably noncontroversial) rule that unregistered
securities are normally to be valued at cost unless something significant has happened since their
acquisition-that is, a different price in a later round of financing (defined as an arms-length transaction by
a sophisticated and unrelated new investor) or a significant change in the news (good or bad) at the
operating level. The recommendations then proceed to set up certain bright-line guides.
[7]
For example,
for companies that do not need subsequent rounds of financing-self-financing and companies with
significant progress-the committee recommends that, once 18 months has elapsed from the last financing,
"carrying" value can be moved based on applying price/earnings ratios from comparable publicly traded
companies discounted 30% for illiquidity.
The proposal suggests discounting the price by 25% for a financing led by a strategic ally because strategic
investors-corporate partners-often pay higher prices than professionally managed investment pools.
[8]

Some would agree, on the other hand, that the corporate partner often adds value by committing
marketing and distribution resources.
[9]
This rule could require the price to be knocked back to a number
under the first-round price.
For publicly traded securities, the proposal includes a 30% hair-cut for restricted securities at the
beginning of the initial two-year holding period under Rule 144, with the discount declining proportionately
as the restrictive period lapses. There is no discount for publicly traded securities that may be freely traded
(and they should be valued at the closing or bid price) unless the holder holds a "substantial number of
shares in relation to the usual quarterly trading volume, in which case the discount should be 10%.
The proposal also suggests that (as indicated above) fees, including the general partners carried
interest, should be deducted in calculating the return in the investment portfolio to the limited partners
and calculation of internal rates of return should be based cash on cash.
[10]

The SEC has occasionally spoken to the issue of valuation, as has the Small Business Administration. Thus
in a 1969 Release dealing with restricted securities held in the portfolio of registered investment
companies,
[11]
the Commission required fiduciaries in charge of the valuation function to treat each case
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on its own merits and to avoid standard formulas, such as the commonly quoted 15% discount, or haircut,
for securities not publicly salable. Whatever the situation in publicly traded funds owning restricted
securities, the Commissions suggestions are utopian in the context of a investment partnership-the time
and money are not available to do much more than approximate values on the basis of informal rules of
thumb. The valuation standards appearing in Appendix III to the Small Business Administrations
Regulations implementing the Participating Securities program are more down to earth, not dissimilar to
the ad hoc committees, on which they are, presumably, based.
[12]

Whatever the authority, the same basic principles should, and generally do, apply. Thus, the first principle
is, of course, cost. In keeping with the fundamentals of cost accounting, assets are carried at cost until
something happens to compel a change in that judgment. The first such change is usually a subsequent-
round financing at a price higher or lower than the initial round.
[13]
If the subsequent financing is at a
lower price, it would be unusual for the Valuation Committee not to adjust the carrying value downward.
The higher price requires a somewhat more sophisticated analysis. If there are no new investors in the
subsequent round-to put the simplest case, if the investor partnership is the only outside investor in the
first and second round-then an increase in the price paid per share should not be, of and by itself,
conclusive. When new investors are brought into the syndicate (and assuming that price is not fixed by
corporate partners who are willing to pay extra for access to technology), the custom is to mark values to
the price at which the last trade was executed. This can create an anomaly on occasion, arising out of the
fact that, when a company goes public, the investors ability to sell is usually restricted by either the
underwriters holdback (to allow the market to stabilize without the selling pressure of secondary offerings)
or the handcuffs of a Blue Sky administrator.
[14]
Going public, accordingly, may require the investor
partnership actually to write down its investment. If, for example, the last-round price was $5 a share,
stock is issued to the public at $6 but the investor partnerships shares are tied up for a year or more,
rules of thumb might require a haircut of as much as, say, 30% to account for the illiquidity of the position
the investor partnership holds, albeit in a public security. Prices in rounds led by so-called strategic
investors can be deceiving given the strategic investor may overpay in exchange for access to technology.
[15]

Another anomaly resulting from the propensity to use the price of private financings as a benchmark
(absent any superior alternative) can occur in the rare instance where a start-up is so successful it never
requires a second, third, or fourth round of financing. If the guidelines cited above (revalue after 18
months) are not followed, such a company may be carried at its initial cost indefinitely while an inferior
company, requiring additional rounds, finds its valuation boosted by the prices obtained in the subsequent
rounds.
[16]

Nonetheless, it is common to use private-round prices as an appropriate and, barring unusual
circumstances, conclusive indicia of valuation and to employ a formula for haircuts when the investor
partnership holds an illiquid position in a public security. If the sale is restrained only by Rule 144, the
haircut normally hovers around 15%. If the security cannot be traded for a year or more, the haircut is as
high as 33.33%; intermediate lock-ups occasion haircuts in between those points.
[17]

[2]
Sonsini, Private Placement Memorandum, reproduced in 1 Halloran at 2-1.

[3]
Some practitioners require that track records be assembled in such a way as to pass muster under the
SEC Rule imposed upon registered investment advisers. Investment Advisers Act, Rule 206(4)1. The gist of
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the Rule is that an adviser who refers to its track record must print the entire record, warts and all.
[4]
In a private letter to the author dated January 1990, Bart Holaday of Brinson Partners, the chairman of
the committee, described the membership of the committee [hereinafter Mr. Holaday]:
Tom Judge, who is responsible for alternative investments for AT&T and a long-time venture capital limited
partner; Stan Golder, managing General Partner of Golder, Thoma and Cressey, a former President of the
NVCA, and long-time venture capitalist; Tim Barron, Chief Investment Officer for the State of Virginia, a
large public fund, who has made a commitment to venture capital, Mike Lavin, Senior Partner with Peat
Marwick, in Chicago who is in charge of their commercial practice and has had a long-term involvement in
venture capital funds, venture-backed companies, and was in charge of Peat Marwicks venture program.
[5]
Venture Economics Venture Forum 89 (Oct. 5, 1989). See the discussion and an excerpt of the
proposals in Standard Valuation Proposal Draws Fire, Venture Cap. J. 12 (Oct. 1989).
[6]
See Transcript of Plenary Session: A Proposal for a Standard Valuation Methodology, Venture
Economics Venture Forum 89 (Oct. 5, 1989).
[7]
Bright-line guides are susceptible of quantification in numbers. Just because, however, a rule uses a
number does not mean it is inflexible-as, for example, when it is stated as a model or guide. As stated by
Mr. Holaday:
We are not intent on setting out rules but rather setting out guidelines that would be followed in most
cases. Certainly, as weve stressed, we want to leave the ultimate authority with the general partners to
make their best valuation decisions, since they are closer to the companies. If they choose to deviate from
the guidelines, then they would simply do so in a footnote.
[8]
See 12.5.

[9]
To quote Mr. Holadays comments on this issue:

Concerning the guidelines on strategic investors/corporate partners, there is also broad disagreement
about what the appropriate discount should be. As those of us who have done direct investments know,
sometimes a corporate partner may strike a fairly demanding price; in other cases they may choose a
price substantially higher than a venture investor would choose. The key thing we want to do with the
guideline is simply get a recognition that when a corporate partner enters a financing, there should be
consideration given to the appropriate valuation. In most cases, a company should not be written up as
high as the price of that financing would indicate.
[10]
Industry critics-and there are many-object not so much to the substance of the guidelines as to the
very existence of the project. Oversimplified, the case for the opposition is that pension fund advisers are
attempting to hold investment managers to the same quarter-to-quarter performance sprint that rules the
world of investment managers generally. The loyal opposition argues that quarterly performance is the last
tune a investment manager should be dancing to. However, as Stanley Golder remarked, if the industry
does not self-regulate in this area, someone else will take up the regulatory burden. See Standard
Valuation Proposal Draws Fire, Venture Cap. J. 12, 13 (Oct. 1989).
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[11]
Inv. Co. Act Rel. No. 40-5847 [Accounting Services Release Transfer Binder] Fed. Sec. L. Rep. (CCH)
72, 135 (Oct. 21, 1969).
[12]
App. III to 13 C.F.R. pt. 107, Valuation Guidelines for SBICs III.C.1 [hereinafter SBA Appendix].

[13]
Valuation should be adjusted to a subsequent significant equity financing that includes a meaningful
portion of the financing by a sophisticated, unrelated new investor. A subsequent significant equity
financing that includes substantially the same group of investors as the prior financing should generally not
be the basis for an adjustment in valuation. A financing at a lower price by a sophisticated new investor
should cause a reduction in value of prior securities. SBA Appendix.
[14]
See 14.9.

[15]
If substantially all of a significant equity financing is invested by an investor whose objectives are in
large part strategic, or if the financing is led by such an investor, it is generally presumed that no more
than 50% of the increase in investment price compared to the prior significant equity financing is
attributable to an increased valuation of the company. SBA Appendix III.C.5
[16]
Where a company has been self-financing and has had positive cash flow from operations for at least
the past two fiscal years, Asset Value may be increased based on a very conservative financial measure
regarding P/E ratios or cash flow multiples, or other appropriate financial measures of similar publicly-
traded companies, discounted for illiquidity. SBA Appendix 11I.C.6.
[17]
The valuation of public securities that are restricted should be discounted appropriately until the
securities may be freely traded. Such discounts typically range from 10% to 40%, but the discounts can be
more or less, depending upon the resale restrictions under securities laws or contractual agreements. SBA
Appendix III.D.2.
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