Editor’s note: The AllRounds Private Capital Management System is a platform of integrated applications that automate private capital data flows from the front end to the buy/sell securities transaction to the valuation, portfolio analytics, regulatory compliance and fund accounting. It is the only system that keeps the accounting and transactions in sync for financial integrity. In this interview, AllRounds’ CEO and founder Jamie Cohan explains the challenges that investors, startups/entrepreneurs and lawyers encounter with the financial integrity of investments and how the AllRounds system helps them make better decisions that reduce risks and increase opportunities.
SandHill.com: What drove you to develop this system? What was the need that was not met in the market at that time?
Jamie Cohan: When investors buy stock in the private securities market, they buy preferred stock that is negotiated with the company. That stock has layers of rights and terms that affect who gets paid what and how they get paid in the event the company exits the market. As the securities get more complex economic terms with different prices and preference payments, the calculations that go into managing a capitalization table and analyzing risk-adjusted returns or doing the partnership are very complex and are prone to errors.
In some cases, the value that an investor thinks he is buying may actually be off by as much as 60-70 percent.
Typically the information that’s captured in the buying and selling of securities, which is kept in spreadsheets or in silos of disparate applications, does not transfer over to the information in the accounting for those transactions. There is a manual link between the two, and that also leads to errors. And the process is very interdependent, very circular and multi-dimensional. Spreadsheets are inherently two dimensional and not set up to handle a complex multi-dimensional problem.
The dislocation in the market that results because participants cannot analyze their at-risk investments and gain access to liquidity except in the case of low probability IPO/Acquisitions is what drove me to create the Private Capital Management System in 2008. By providing liquidity, analytics and efficiency, the private capital markets will evolve to a more predictable, more accessible market. Moreover, the connection between the capitalization analytics and the fund accounting ensures financial integrity so investors can invest based on accurate information.
This dislocation is prevalent throughout the private capital markets, which include the real estate market, oil and gas partnerships as well as private equity and venture capital. As private capital markets evolve providing more liquidity, portfolio analysis that we take for granted in the public markets, the private markets will be more predictable and will have more efficient capital flows.
SandHill.com: Wow. Calculation errors in the range of 60-70 percent less value is drastic. Are investors and entrepreneurs generally aware of this issue?
Jamie Cohan: Entrepreneurs often operate on the theory that “if you build it they will come.” Well, they may come, but the entrepreneur may not end up with what he expected when he built it. Many private companies, for instance, have raised several hundred million dollars over several financings.
If the per share value of the financings is not increasing at a non-linear rate, early investors such as founders/employees with common stock and early stage investors (Series A, B) face significant dilution due to liquidation preferences, participation rights and anti-dilution. Entrepreneurs and early-stage investors need to realize that with each new financing there is another person ahead of them in the payout. Most of the time entrepreneurs focus on getting the highest price. But the highest valuation can actually be the death knell for a company if the value is too high too early.
Investors are focused on the deal and will pay whatever to get in. That strategy works only in the event that the company leaves the stratosphere successfully and everything gets converted to common stock in an IPO. There is a lot of middle ground of exits where paying any price or taking any term might not result in what the investor is looking for.
If you ask an entrepreneur what a participation right is, or how broad-based anti-dilution operates, usually only the people that have been through it would know and would understand the implications. Everybody struggles with the complexities of private capital securities, on the investor side and the company/issuer side as well as auditors, valuation service providers, lawyers and accountants.
SandHill.com: Can you give me some examples of the kinds of miscalculations and accounting errors that occur?
Jamie Cohan: It’s easy to over-allocate on an option pool. It’s easy to lose track of when employees exercise their options or sell securities to another buyer. And the accounting is only as good as the analysis; so if the analysis is off, the accounting is off. As discussed earlier, there are no fewer than six economic terms that affect returns on investment. If one piece of information is incorrect, the analysis is off. That assumes that you built the payout analysis correctly. The calculations are further complicated by cascading strike prices of options, warrants, convertible debt that results in conditional fully diluted shares and anti-dilution calculations.
In a partnership, all of the income, expenses and unrealized and realized gains have to be prorated among all the investors based on their capital contributions. But if their capital contributions are incorrectly accounted for, then all the journal entries related to those have to be recalculated. For instance in a fund with 500 investors, if one of the capital contribution percentages is off because someone didn’t account for a small portion of someone’s contribution into that fund, it affects all the journal entries. A typical fund that is 10 years old with 500 investors would need to fix over 200,000 journal entries and most likely restate partnership reports sent to limited partners.
SandHill.com: How does the AllRounds system differ from others in the market?
Jamie Cohan: Competitors’ products are point solutions. AllRounds is the only solution that integrates capitalization analytics with the partnership accounting platform as well as portfolio analytics and deal flow. In addition the system provides liquidity by enabling online syndication of primary securities and partnership interests while combining it with a secondary trading platform. The system is built for transparency and ease of use.
As a hypothetical example, let’s say Fund A invests in Company B and buys in a $2/share. Then there’s a new round done at Company B and Fund A’s share based on this new round of financing goes to $2.50. That information must be entered into the accounting system as an unrealized gain. If the accounting and the transaction system aren’t tied together, one must enter that gain manually. Also the fact that the new round is at $2.50/share does not imply the existing shareholders shares are worth $2.50/share.
Manual entries are prone to error, and miscalculations have tax implications. They also hinder an investor’s ability to assess risks due to future investment dilution and liquidity constraints.
AllRounds not only eliminates the errors but also provides real-time visibility. Participants can see purchases and sales made on the system and see how the new share prices impute value to existing and future securities.
SandHill.com: I understand why this system would definitely help investors and entrepreneurs reduce their risks. But your company also claims the system’s benefits include increasing opportunities. Please explain how your system does that.
Jamie Cohan: It provides scenario analysis based on economic terms and the order in which investors eventually will be paid in an exit. One scenario might be an exit in a year or two. Another might be to plan for more rounds of financing. The system allows investors and entrepreneurs to quickly go through all the complexities and figure out the ultimate strategy for the company (based on the company objectives) and for the investor (based on the investor’s internal rate of returns that he needs to get on behalf of his limited partners).
Also, as more and more investors come onto the system, it provides the ability for investors and companies to network. For instance an entrepreneur could network to look for a certain type of investor (someone who invests in healthcare companies in Europe, for example, or someone who invests in seed-stage startups).
SandHill.com: Your platform of applications is offered on demand, but it seems that this system would be used on an ongoing basis rather than on demand.
Jamie Cohan: It depends. Different end users will use the system at different times. Lawyers, for instance, might use it every day if they are responsible for their clients’ capitalization tables. Or they might use it on demand when a client has a financing going on and needs to advise the client on economic terms that will yield the optimal result. Or they might use the system when a client’s employees exercise options or a client company repurchases options.
The point of use for an investor looking at thousands of business plans might be in deciding which company to invest in. And the investor can use the system to analyze the optimal term sheet structure for the financing. Or she may want to look at her overall portfolio and see how this potential investment stacks up as part of the overall investment strategy. Also that investor may want to buy securities in the primary market or sell in the secondary market.
A startup company ready to do a financing may want to use the system to evaluate different financing opportunities or to manage all the potential investors in that round of financing. Or the investor may want to allow secondary trading of the stock.
SandHill.com: The transparency provided by the system also helps with regulatory aspects, right?
Jamie Cohan: Yes. Think back to the 2007 financial crisis. A lot of the issues occurred because of incorrect perceived value of illiquid holdings. Company valuations actually serve a purpose. If the methodologies are followed, they help show investors or companies the real value of the private securities. That value is based on the lack of liquidity and the inherent risk of holding that security, and the rights and preferences of other investors holding onto other securities within that company.
Post financial crisis, both auditors and regulators are increasing their reporting requirements to include more sophisticated analysis to assess the true value of portfolio holdings. Ultimately it is the function of the auditors to ensure the financial reports best reflect economic reality. That reality is very much dependent on the complex economic terms particular to the private markets. Ultimately it is the regulators that are responsible for ensuring efficient markets and that investors have access to accurate information. Due to the complexity of the economics, the private capital markets have systemic market errors that impact the markets’ ability to assess risk and determine performance, which has led to the market dislocation that the regulatory body is beginning to address.
Jamie Cohan is the founder/CEO of AllRounds. Prior to AllRounds, Jamie was founder/CEO at Round1 Incorporated, where he pioneered the development of software aimed at private capital market participants, which provided deal-flow management, portfolio analytics, reporting and accounting and investor relations solutions for its clients. Earlier he co-founded Andromedia Incorporated (acquired by Macromedia in 1999), a supplier of reporting and analytics software, and helped pioneer the personalization market on the Internet. Contact Jamie at jcohan@allrounds.com.
Kathleen Goolsby is managing editor of SandHill.com.