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Transcript of Venture Capital Review Fair Value
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7/31/2019 Venture Capital Review Fair Value
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VENTURE CAPITAL REVIEIssue 27 2
produced by the NatioNal VeNture capital associatioN aNd erNst & youNg llp
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National Venture Capital Association (NVCA)As the voice of the U.S. venture capital community, the National Venture Capital Association
(NVCA) empowers its members and the entrepreneurs they fund by advocating for policies
that encourage innovation and reward long-term investment. As the venture communitys
preeminent trade association, NVCA serves as the definitive resource for venture capital dataand unites its 400 plus members through a full range of professional services. Learn more at
www.nvca.org.
National Venture Capital Association1655 Fort Myer Drive Phone: 703.524.2549
Suite 850 Fax: 703.524.3940
Arlington, VA 22209 Web site: www.nvca.org
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By stvn Nbb, CFA, Dirctor, and David L. Larn, CPA, Managing Dirctor, of Dff & Phlp LLC
Primarily because of historical bias, during the past
decade and especially during the past several years,
venture capitalists have repeatedly been heard toay: Fair val rporting for th Vntr Capital (VC)
indtry i maningl; LP dont nd it; GP dont
want it; regulators dont understand it. However, a
more critical examination of a wide range of reporting
and governance issues demonstrates that fair value
is not only required by most LPs, but provides key
bnfit to both LP and GP.
Part of the stigma associated with fair value is a lack
of understanding of what fair value means for the VC
indtry. som incorrctly bliv that FAsB intittd
fair val rl for th VC indtry in 2006 with thianc of th mch-malignd sFAs 157. Yt sFAs
157 (now AsC Topic 820) do not rqir any at
or any liability to be measured at fair value. Fair value,
for the investment industry, has its origins with the
1940 Invtmnt Company Act. Frthr, invtmnt
company accounting,1
which originated with the AICPA
Audit and Accounting Guide for Investment Companies
in th 1960/70 rqir invtmnt to b rportd
at fair value.
Wh i Fr V?Most discussions about fair value still begin witha description of what fair value represents. With
liquid securities, fair value is a concept that is much
easier to understand since the definition becomes
somewhat formulaic: market price times number of
1 US investment company accounting requirements are now promulgated byFASB Accounting Standards Codification (ASC) Topic 946.
Fair Value, Who Cares?and Why They Should!
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shares owned, or a value that has direct benchmark
indications from other market transactions. However,
when considering illiquid investments, fair value
represents a more qualitative and ambiguous
concept. Even in such instances, fair value is still
strictly defined. Accounting guidance establishes the
definition of fair value as the price that would be
received to sell an asset or paid to transfer a liability
in an orderly transaction between market participants
at the measurement date.2
The guidance adds that
to the greatest extent possible, valuations should be
based upon observable market data from reliable
sources. For VC investments, there is often limited or
no rliabl markt data. each invtmnt i niq (no
comparabl compani or tranaction) and involv
sensitive details that many times would be harmful to
the investor if disclosed. As a result, VC investors must
use supportable unobservable inputs, often using a
managers own assumptions, about how a market
participant would transact.
Historically, VC fund managers have reluctantly
embraced fair value concepts, using cost or the value
of the last round of financing as their best estimate of
fair value in between financing events. The use of cost
to estimate fair value was driven by three key factors:
1. A hitorical convntion that idntifid conrvatim
as a positive attribute;
2. Draft 1989 NVCA gidlin (which wr nvr
ratifid or adoptd), which ncoragd th of
cost; and
3. An invtor (LP) ba mad p of individal rathr
than entities that had less strict fair value reporting
requirements.
Furthermore, because the development of an
emerging business or technology requires financings
more frequently, investors attempt to manage their
exposures to certain risks by funding development
at discrete points in time. Multiple financing events
potentially generate an opportunity to assess implied
val in Lat Rond of Financing (LRF) tranaction.
However, caution should be applied when considering
LRF as indications of fair value since implying value
for existing investments using LRF requires material
assumptions that may or may not be appropriate.
Bca of thi, th ability to LRF a an indicator
2 FASB ASC Topic 820-10-35-1
of value does not mitigate the need for alternative
methods and procedures for estimating a robust
fair value.
Why Fr V?Bca many VC fnd managr hav partially
convinced themselves that fair value is not
estimable, is not cost-effective to estimate or is not
needed by their investors, it is important to dispel
such myths and once and for all acknowledge that
while imperfect, estimating fair value is not only
possible, but necessary for most investors and
helpful to most managers.
Our experience with our VC clientele is that while a
current period valuation of a VC investment requires
significant judgment, the focus on a valuation
framework that considers the analysis of all meaningful
factors and inputs beyond LRF, and the effort to
document these considerations, does indeed help the
fund in its strategic planning and in communication
with its investors. It also provides a meaningful method
for monitoring its investments and satisfying the funds
governance requirements. Additionally, we find that
most of our clients are already doing what is
necessary in some form to satisfy these goals, but
the lack of a formalized process or documented
methodology has not allowed them to take full credit
for the work performed.
One other important consideration that should not
be ignored is the fact that investment companies are
not required to consolidate underlying investments
because they report fair values. However, if a fund
did not report its investments at fair value, arguably,
from an accounting point of view, underlying control
investments would be required to be consolidated,
making internal and external reporting significantly
more complex and less meaningful.
evn of Fr V
If there are real difficulties in estimating the value of anemerging company, how then do venture capitalists
determine the valuation at which they will invest at
various points in time? Many valuation practitioners
and auditors like to refer to market studies that have
been conducted over the past couple of decades
as support for indications of value. These studies
demonstrate the step-up in value between major
rond of financing typically coniting of 25% to
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100%+ incra in val a compani progr
through the stages of development. However, this is
only true for investments at specific points of time thatsuccessfully secure financing and is only meaningful
on an aggregate level, not necessarily applicable to
a single investment.
In working with our VC clients, we have observed
numerous examples of a portfolio company being
able to meet significant milestones only to have forced
recapitalizations or down-round financing available to
it. The question then becomes, why does this happen?
The illiquid nature of the VC market sustains pricing
inefficiencies. Ultimately, the supply and demand of
VC capital and the bargaining power of entrepreneursand ownership syndicates does change, and at times
will not be correlated with the performance of the
underlying company. This environment clearly muddies
the waters for determining values. However, what this
truly means is that when estimating the fair value of an
investment, considerations beyond LRF or company
performance are meaningful.
The assessment of what could be termed non-
performance risk is the risk that a portfolio company
with negative cash flow will be unable to raise
additional capital when needed. This factor is materialfor VC investments that are capital intensive in one
form or another, and are expected to generate
negative cash flow over the development period of
two to five years. In situations where capital becomes
unavailable, the company is typically sold, possibly at a
loss, recapitalized at a valuation significantly lower than
the post-money valuation implied by the progress of
the firm or is shut down.
Ultimately valuations should consider the inputs used
to derive value, the intangible assets of the business.
These intangibles include intellectual property andknow-how, long-term growth potential, management
team talent, financial strength of existing investors,
perception of VC market interest, progress toward
milestones and competitive landscape. For early-
stage, venture capital-backed companies that require
additional capital, these intangibles may impact
positively or negatively their ability to raise capital in
the current venture capital environment. The resulting
non-performance risk for companies that need to raise
money to reach cash flow breakeven or a successful
exit continues to be substantial, and may outweigh
many or all other valuation considerations.
While changes in value are certainly not linear, it
should be clear that value does not magically increase
or decrease on the day a new financing event takes
place. Since VC investors are instrumentally involved
with their portfolio companies, they likely are aware of
how a company is progressing toward its milestones,
and they typically have timely knowledge of trends in
the VC capital market that lead to an understanding
of the willingness and ability of the market to fund the
next stage of development for a company. Therefore,
while significant judgment is required, it should be
evident that an estimate of value can be derived at
times other than on the day of a financing event.
Why invor (lp) n Fr VOn of th mot trobling fatr of th GP/LP
interactions is the seeming inability of both sides to
fully understand the needs of the other. This failure to
One other important consideration that should not be
ignored is the fact that investment companies are not
required to consolidate underlying investments because
they report fair values. However, if a fund did not report itsinvestments at fair value, arguably, from an accounting point
of view, underlying control investments would be required to
be consolidated, making internal and external reporting
significantly more complex and less meaningful.
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communicate has given rise to more specific Limited
Partner Agreements, requests for side letters, ad hoc
data requests and LP initiatives such as the ILPA
Privat eqity Principl. Any intittional LP (LP
that prodc GAAP-bad financial tatmnt and
invest on behalf of others fund of funds, pensionfnd, ndowmnt, tc.) ha nd for timly, priodic,
robtly timatd nt at val (NAV) pportd
by a rigorous measurement of the fair value of
underlying investments. LPs dont always articulate
the reasons they need fair value reporting. LP needs
include, but are not limited to, the following:
Fair val i th bai invtor (LP) to rport
priodic (qartrly/yarly) prformanc to thir
investors, beneficiaries, boards, etc.
Fair val i th bt bai for LP to mak
apples to apples asset allocation decisions.
Fair val i an important data point in making
intrim invtmnt (managr lction) dciion
on a comparable basis.
Fair val i oftn ncary a a bai to
make incentive compensation decisions at the
investor level.
Limitd partnr nd conitnt, tranparnt
information to exercise their fiduciary duty.
fair value provides such information on a
comparable basis for monitoring interim
performance. An arbitrary reporting basis such
as cost does not allow comparability. Mot invtor ar rqird by rlvant GAAP to
report their investments on a fair value basis.
Not all LPs articulate their needs as described above.
som may vn tll GP that thy prfr cot.
In many cases, this failure to communicate occurs
because deal team members of LPs speak with
dal tam mmbr at th GP and may not flly
articulate all of the needs of the investor.
Additionally, reporting fair value for financial
instruments is required to be consistent with otherfinancial reporting requirements. In particular, the
recognition of the fair value of contractual rights for
future cash flows typically resulting from earn-outs or
contingent considerations at fair value is required.3
3 Established by FASB Statement 141 (revised 2007), Business Combinations(FASB Accounting Standards Codification (ASC or Codification) 805,Business Combinations.
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Bad on th ncrtainty mbddd in many arly-
stage companies, it is not suppressing that many
M&A transactions increasingly include earn-outs
or some form of future consideration. Since other
rporting ntiti (byr) mt rport th contractal
payments at fair value, it is logical that the seller should
also recognize this contractual asset at fair valueas well. LPs must have fair value-based NAV and,
therefore, managers need to include the fair value of
all investments, including contractual payments, in
their calculation of NAV. Determining the acquisition-
dat fair val of contractal right (contingnt
conidration) may ntail th timation of th
likelihood and timing of achieving relevant milestones
and/or th dvlopmnt of xpctd or cnario-
based projections relevant to sales- or profitability-
based payments. The good news is that these types
of assumptions and inputs are the same details that
are considered by the manager in making the decision
to ll it invtmnt in th firt plac (and only nd
to b adjtd for byr/ngotiation conidration).
Essentially, the reporting of fair value for contractual
rights becomes an extension of the processes already
performed by fund managers.
lm prnr Von NAs noted above, limited partner investors have a
number of reasons for needing and using fair value
derived NAV. LPs must value their interest in an
underlying fund at regular intervals to support theirfinancial reporting process. The recent accounting
gidanc (Asu 2009-12) otlin whn and how an
LP may estimate the fair value of an interest in a fund
ing th rportd fnd NAV. Bad on th gidanc,
reliance on a reported NAV is only appropriate to the
extent that the investor has evidence that the reported
NAV is appropriately derived using proper fair value
principles as part of a robust process. In order to do
this, the most frequent ways to assess the robustness
of reported NAV are:
1. To condct thorogh pr-invtmnt d diligncand to leverage this diligence in ongoing monitoring
procedures;
2. To assess the funds fair value estimation processes
and control environment, and to monitor any
periodic changes; and
3. To rviw th fnd polici and procdr for
estimating fair value, including considering factors
such as the use of independent third-party valuation
experts to augment and validate the investee funds
procedures for estimating fair value.
Ultimately, the investor is required to assess,
ndrtand and concld that th GP ha dlivrd
a NAV derived from a rigorous estimate of the fair valueof underlying investments.
Why Fr V Mnngf?Whthr it i from th GP prpctiv, or an
LPs requirement, fair value is ultimately the
contemporaneous measurement basis that allows
the VC industry to deliver on its obligation to be
fair, ethical and to effectively communicate critical
information needed by multiple interested parties.
Arbitrary valuations, such as cost, or inaccurate
valuations can undermine effective asset allocationfor investors, resulting in the inability of an investor
to properly manage its investment strategy or
possibly increasing the risk of fulfilling its fiduciary duty
to its beneficiaries.
Industry best practices centered around robust fair
val dtrmination provid GP with ffctiv
strategic tools for making appropriate comparisons
and for monitoring interim performance of their
investments, in addition to satisfying fiduciary
obligation. Bca fair val rqir a ytmatic
approach for estimating value and supporting
assumptions, appropriate procedures that generate fair
value will provide additional focused information
to monitor portfolios regularly.
An incomplete development of policies, procedures
and processes that measure fair value may expose
fund managers to significant reputational and legal
risks and, ultimately may adversely affect their
marketing and fund-raising efforts. In the current
market environment, fund managers must now be
aware that investors should, both in their initial due
diligence process and in periodic reviews, discount
managers that have not adopted appropriate valuation
practices that generate robust indications of fair value.
Additionally, auditors and regulators will scrutinize
funds that dont have well-defined and documented
valuation process and governance policies.
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Wh Vc o do?The determination of fair value, for VC investments,
requires a significant level of informed judgment,
rather than a rigid application of a mechanical process.
Therefore, fair value requires thoughtful involvement
from all stakeholders, including fund managers,institutional investors, auditors, valuation experts
and regulators.
The valuation process should not be a make work
xrci. Bt practic dictat that th information
needed to make, monitor and improve investments
is the same information used to value investments
on an intrim bai. Gnrally, thr i no nd for
a fund manager to develop extensive policies, but
leveraging or enhancing existing processes to develop
and use a comprehensive and integrated valuation
framework that is clear, consistent and pragmatic willprovide effective documentation and communicate
the funds efforts in monitoring its investments and
reporting fair value robustly. This typically means that
the valuation process is an extension of the funds,
already developed, diligence, monitoring and strategic
decision-making processes.
A well-developed and documented valuation
process can provide the basis for demonstrating to
investors that the fund manager is compliant with
fair value measurement principles. The specific
components of a thorough process should includea governance structure, well-documented valuation
policy and clearly defined roles and responsibilities,
including independent personnel who are extremely
knowledgeable about valuation methodologies. The
elements of the valuation policy should cover specific
approaches and valuation methodologies appropriate
for various types of investments at various stages of
development, and should include details regarding
typical assumptions and sources of data that would
be part of each valuation methodology. Additionally
the policy should address the internal documentationprocdr to pport valation (modl and
tmplat) and a dlination of circmtanc that
permit a manager to rely upon specific or different
models. The valuation policy and supporting
documentation should be periodically reviewed and
updated. Having established valuation policies and
procedures will allow a manager to communicate
and discuss its approach to fair value and satisfy an
investors need to understand the processes and
controls related to deriving value.
It should be emphasized that fair value does not
represent what a fund manager ultimately expects
to receive for exiting an investment, but the amount
that would be received in an orderly transaction asof the valuation date. This concept troubles some VC
managers because they would not, and likely could
not, sell the investment at an interim date. The orderly
transaction price determination is hypothetical and
requires the exercise of informed judgment. This
means that fair value does not have to assume that
the underlying business or investment is saleable, the
investor or shareholders intend to sell in the near future
or the likely transaction would have to be a forced sale
or liquidation. In assessing fair value, fund managers
should be able to answer the following questions in
a consistent manner to explain how the investment isbeing valued.
1. How corrlatd i th invtmnt to pblic markt
data? What objective data may indicate whether
value is moving in a logical direction? This should be
from a perspective that adjusts for outliers that may
significantly impact reported trends.
2. What other recent transactions has the fund been
involvd with (or know th dtail of) that pport
the current fair value of an investment? Are there
similar deals that provide an indication of the fair
value of the subject investment? This may include
transactions of the subject company securities,
comparable company transactions, or sector and
industry transactions involving companies in similar
stages of development.
3. Ar thr any potntial i with obtaining th
nxt rond of financing for an invtmnt (compard
to original xpctation)? What th likly impact of
l/mor dmand to fnd th portfolio company?
4. Do th fair val indication rprnt a pric [a
of the valuation date] that you would be willing toinvt in th am portfolio company (with th am
xiting trm)? Wold mor invtmnt for a highr
or lower percentage interest be appropriate? Does
it make sense to invest less money for the same
percentage interest because the company has
atifid om dvlopmnt hrdl (milton)
and has less need for capital at the current stage?
Will the company need more capital than originally
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expected because the burn rate is higher, more
uncertainty developed in the market or negative
results require more development effort?
5. I it poibl to ll an intrt in an xiting portfolio
company at the same price as you could have
sold it previously? This question may help limit thehypothetical nature of a fair value transaction since
it contemplates the comparison of a hypothetical
transaction in the past to a current hypothetical
transaction.
6. What ha changd with th portfolio company in
relation to the companys position at entry, during
the LRF and with the expectations of the business
over the holding period? Its more important to
understand why things have changed than to simply
recognize that things are different. An understanding
of why changes have occurred should be helpful in
assessing the potential impact the changes will have
on the success of the business, which is the key
to assessing the progress of value during the
holding period of an investment.
7. Have the current market and economic conditions
affected the underlying opportunities, risks orprobability of success of the portfolio company?
Considering these questions and documenting the
answers will be a good start at a well-thought-out and
documented process for estimating the fair value of
VC investments. Again, since these considerations
are the same considerations that are used in making,
monitoring and exiting an investment, they flow
dirctly into th priodic (ally qartrly) valation
assessment. For example, a simplified way to consider
valuing VC investments is using the following decision
tr (for illtrativ prpo only):
. if no, h v of mo rn ron of fnnng my h
m of fr v.
No
5. Has there been any significant change in the results of the
investee company compared to budget, plan, etc? Has there been
any significant change in the market for the investee company or
its products or potential products? Has there been any significant
change in the global economy or the economic environment in
which the investee company operates?
. if h hng ov, hr n non h v h
nr. drmn fr v ng ojv from h
omny, nvmn rofon n ohr nvor
. if h hng ngv, hr n non h v h
r. drmn h v r o ror
on ojv mr n mngr xrn.
No
Yes
4. Does the investee company have positive sustainable
performance (for example, positive recurring EBITDA)?
Fr v my rmn ebitda m ron
mrk m for h omny.
No
Yes
Yes3. Is there a comparable company from which fair value can
be derived?
uz omr omny von hnq o rmn
fr v.
. if hr no g rron (r o h hr, no o
h hor), fr v rmn h mrk r m
h nmr of hr own. No on ow vn f h
nmr of hr own rg rv o h vrg y
rng vom.
No
No
Policy Statement:
All investments are recorded at fair value.
All relevant information is taken into account to make the fair value determination.
1. Barring contradictory information, the cost (excluding transaction
costs) of an investment is deemed the exit price on the date of
investment and is therefore used as its initial fair value.
2. Are shares publicly traded in an active market? 2a. Is there a legal restriction?
. Fr V mr h mrk r m h nmr of
hr h o on. sor for h on
gnry mo-.
Thereafter
Yes
Yes
Valuation Decision Tree
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By tilizing th implifid illtrativ dciion tr, many
arly-tag vntr invtmnt wold fall into tp 5.
Therefore, for some period of time after investment,
aming non of th chang otlind in tp 5
have occurred, fair value is often measured by using
the value of the last round of financing. However,
as knowledge is gained about the progress on ameaningful milestone, or it is clear that more or less
fnding will b ndd (brn rat) to gt to th nxt
tag (probability of cc), or that fnding i or i
not likly to occr at typical trm (prformanc rik),
fair value has diverged from the last round of financing,
and fund managers have a duty to acknowledge and
report that fact in the normal reporting process to the
funds investors.
cononsinc th ianc of th PeIGG gidlin in 2003,
th rla of th IPeV Gidlin in 2005, FAsB
ianc of statmnt 157 in 2006, th financial crii
of 2008 and bqnt rviion and application
of the preceding, fair value measurement has been
a topic of concern in the VC industry for almost a
decade. Rather than being vilified, fair value should
b mbracd a th bt (albit imprfct) bai for
measuring investments at interim periods, resulting
in the fulfillment of a multitude of needs for both
investors and managers.
About the Authors
David L. Larsenis a Member of FASBs Valuation Resource Group, a Board Member of the International Private Equity
and Venture Capital Valuations Board (IPEV), led the team that drafted the US PEIGG Valuation Guidelines, and is a Memberof the AICPA Net Asset Value (NAV) Task Force. Mr. Larsen serves a wide variety of alternative asset investors and managers
in resolving valuation and governance-related issues.
Steven Nebbserves as the project lead for numerous Alternative Asset managers and investors, including large global
private equity, venture capital, and Business Development Companies. He provides advisory support to many limited
partnerships and corporate pension plans regarding fund management, financial reporting requirements and general
valuation of investments, and has significant experience in performing valuations of intellectual property, private equity,
illiquid debt, and complex derivatives for a variety of purposes, including fairness opinions and transaction advisory,
financial reporting, tax, litigation, and strategic planning.
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7/31/2019 Venture Capital Review Fair Value
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ernt & Yong i a global ladr in aranc, tax, tranaction and adviory rvic. Worldwid, or141,000 popl ar nitd by or hard val and an nwavring commitmnt to qality. W maka difference by helping our people, our clients and our wider communities achieve their potential.
ernt & Yong rfr to th global organization of mmbr firm of ernt & Yong Global Limitd, achof which i a parat lgal ntity. ernt & Yong Global Limitd, a uK company limitd by garant,does not provide services to clients. For more information about our organization, please visit www.ey.com
Abot ernt & Yong stratgic Growth Markt Ntworkernt & Yong worldwid stratgic Growth Markt Ntwork i ddicatd to rving th changing ndof rapid-growth compani. For mor than 30 yar, wv hlpd many of th world mot dynamic and
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Cooley represents hundreds of clients in a wide range of industries from offices in nine major commercial
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As a leading global independent provider of financial advisory and investment banking services,
Duff & Phelps delivers trusted advice to our clients principally in the areas of valuation, transactions, financial
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Th Tch Grop at Lowntin sandlr i a nationally rcognizd thoght ladr in th dvlopmnt oftchnology-bad and vntr-backd bin acro indtri. Th Tch Grop, which ha conldclint on mor than 300 vntr and angl financing in th pat two yar, rprnt th contryleading venture funds and works with technology entrepreneurs and businesses at every level from the
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NYPPeX i on of th world lading vntr condary intrmdiari. W provid indpndnt adviory,xction and procing rvic for por tfolio divtitr and block tranaction (ingl companytranaction gratr than $10 million).
Gnral partnr and limitd partnr bnfit from or track rcord with nmro larg, mid-iz andmall vntr firm inc 1998, foc on achiving prior pric xction and tranaction pd, andacc to maiv liqidity worldwid providd throgh tablihd rlationhip with qalifid prcharholding privat qity at in xc of $2.3 trillion (a of Dcmbr 31, 2010). Mmbr FINRA and sIPC.
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Prokar (www.proskauer.com) i a lading intrnational law firm with ovr 700 lawyr that provid arange of legal services to clients worldwide. Our lawyers are established leaders in the venture capital and
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management buyouts and leveraged recapitalizations, risk management and compensation and estate
planning for partners.
Hadqartrd in Nw York inc 1875, th firm ha offic in Boca Raton, Boton, Chicago, Hong Kong,London, Los Angeles, New Orleans, Newark, Paris, So Paulo and Washington, D.C.
2011 ernt & Yong LLP and th National Vntr Capital Aociation. sCORe no. Be0138
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