FASB INTERPRETATION NO. 46 MAY REQUIRE VC FUNDS TO
CONSOLIDATE “VARIABLE INTEREST ENTITIES”

TO: All Members
FROM: National Venture Capital Association
DATE: April 28, 2003
SUBJECT: Potential Significant Impact of New Rules on “Variable Interest Entities”

In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46, Consolidation of Variable Interest Entities (“VIEs”), as guidance on what entities are subject to financial statement consolidation according to the Interpretation’s provisions. This Interpretation explains how to identify variable interest entities, how to quantify and attribute variable interests in an entity and how to determine who must consolidate the VIEs’ assets, liabilities and results of activities. In essence, companies that have the controlling financial interest of another entity through interests other than voting equity are required to consolidate the controlled entity, even though historically, voting equity interests have been the principal indicator of financial control.

The Interpretation’s scope is broad, affecting almost any reporting entity that has an ownership, contractual or other financial interest in another entity, including investment partnerships, venture capital funds and private equity funds. Accounting experts are saying that Interpretation 46 may affect the way VC funds account for their investments in portfolio companies. For example, in evaluating the equity base of an entity, common and preferred stock may be included. However, rights of the preferred shareholders could cause some stock to be treated as outside of shareholders’ equity, and could, therefore, affect VIE status. In particular, as discussed in our Member Alert, dated February xx, 2003 preferred stock with “mandatory” redemption provisions, will be reclassified as liability under a new FASB Statement 150, Account for Certain Financial Instruments with Characteristics of Liability and Equity, which should be issued shortly. In addition, preferred stock that is redeemable upon “deemed liquidation” (such as a change in control) pursuant to the SEC’s Accounting Series Release No. 268 will likely not be considered an equity investment. These reclassifications could cause the balance sheets of portfolio companies to show little or no equity, creating the risk that the portfolio company would subject to VIE accounting treatment.

Interpretation 46 has a very rapid implementation schedule. As a result, NVCA members should promptly review Interpretation 46 to assess whether any financial interest its funds hold in portfolio companies may be deemed to be a variable interest. If so, the member will need to assess whether the fund is the “primary beneficiary” or whether the entity has effectively dispersed risks among other parties.

Interpretation 46 focuses on the amount of equity investment in an entity and the rights and obligations of the equity investors. Entities are subject to the Interpretation if the total equity at risk is not sufficient to permit an entity to finance its activities, or the equity investors do not have the controlling financial interest or decision making ability in the entity. Instead, holders of contractual or pecuniary interests -- variable interests -- such as loans, leases, service contracts, guarantees, call options, etc, absorb the risks and rewards of the entity’s assets and operations. If variable interests predominate over voting interests, the entity is a VIE, and the holder of the majority of the variable interests, or primary beneficiary, must consolidate the controlled entity. Assets, liabilities and non-controlling interests will be recorded at fair value on the statements of the primary beneficiary. Other variable interest holders do not have to consolidate, but must disclose information about the VIE and the nature of the relationship between the variable interest holder and the VIE.

Interpretation 46 has no bright line test of sufficient equity, although equity of less than 10 percent of assets is presumed insufficient. The analysis of sufficient equity and variable interests may prove cumbersome, as it entails estimations of expected losses and the probabilities of achieving these estimates. Likewise, once an entity is deemed to be a VIE, the analysis of who is the primary beneficiary may be complicated. This Interpretation will require companies to have a systematic plan and a controlled process for evaluating all financial interests in other entities, and for gathering adequate information from those entities.

The consolidation requirements apply immediately to all VIEs created after January 31, 2003. Rules for VIEs created earlier than January 31, 2003 are different for public and private companies. Public companies must apply the consolidation requirements as of the beginning of fiscal or interim periods beginning after June 15, 2003 (July 1, 2003 for calendar year-end entities). Nonpublic companies must apply them as of the end of fiscal periods beginning after June 15, 2003. Disclosure requirements take effect for all financial statements issued after January 31, 2003 (including December 31, 2002 financial statements) regardless of when the VIE was created.

If you have any questions or comments or would like additional information, please contact Jennifer Dowling, at NVCA (703 524 2549) or, NVCA’s outside regulatory counsel, Brian Borders, at 202 263 3374.