Where is Goldilocks when you need her? On the one hand you have high frequency and algorithmic trading dominating the world of listed companies with market shares often exceeding 50% of all volumes traded and with increasing instances of unstable trading and extreme volatility in liquidity as these machines enter and exit the market creating a complex, unstable chaotic system where long term investors who aren’t careful can literally be run over in both directions like Wile E. Coyote on an Arizona desert highway… On the other hand, in the world of private investments – in particular in the broad category known as venture capital – liquidity remains elusive with (too) many practitioners having a disfunctional and often irrational set of beliefs as to how and when liquidity is acceptable and when it is not, with the end result making naturally illiquid investments even more so. And yet, wouldn’t it be nice (for investors and companies) to have a long term capital market where liquidity was “just right?”
So what would just right liquidity look like? Can you have your cake (all the typically enormous strategic advantages that accrue to a private company) and eat it too (the advantages of being listed, afforded by having a periodic mark-to-market and the ability to use your equity as a real currency)? I think you (mostly) can and am very encouraged to see this sweet spot slowly emerging and gaining traction outside of a handful of what previously would have been considered exceptions to the rule. In my opinion, the answer (as I have mentioned before) lies in further developing secondary markets in private company equity.
The two most successful companies I have had the privilege of investing in – Markit and Betfair – despite being multi-billion dollar companies and market leaders, are still today private companies and have provided liquidity to investors, management and employee shareholders (in different ways) which has gone a long way to allowing them to remain private and reap the associated benefits. The flexibility of Facebook’s management to run their company for the long term optimal outcome has I suspect been a direct function of the liquidity that secondary investments (from DST) and a relatively active secondary market in Facebook shares on platforms like Second Market and SharesPost have provided to early investors and employees. And it’s not just about cashing out – at least half the value of these secondary markets comes from providing a credible mark-to-market and the reasonable expectation that – if needed – an investor could access liquidity. Perhaps paradoxically, with these two factors in hand, more often than not, investors will actually have a higher propensity to hold on too their investment, not lower.
Another benefit of secondary markets would be to improve the health of the overall venture investment ecosystem which while evolving in fits and starts, most recently with the rise and rise of “super-angels” and “seed funds” still mostly remains in the eyes of this industry outsider, static and prone to herding around the notion that one-size-fits-all in terms of capital structure and financing paradigms is somehow optimal and should not be questioned. In particular, I fail to understand why the received wisdom of the venture capital community seems firmly stuck on the concept of “nobody exits until everybody exits”. It’s a dumb concept and worse, quite frankly is at odds with the interests of the various investors and stakeholders in a private company, including later stage investors (aka mainstream venture capital funds.) I believe much of the angst surrounding seed stage investing and (traditional) venture capital investing, arises as a result of a dysfunctional transition mechanism. (ie There isn’t really one.)
What I would like to see – and quite frankly have never heard a good counter-argument against – is a more dynamic and flexible financing chain, one that pragmatically combines both primary and secondary elements. Practically speaking, what would this mean? At its simplest, it would mean that at any given funding round, the possibility of existing investors exiting part or all of their holding is considered objectively and without undue emotion. Having participated in many such transitions in companies going from “seed” funding to “series A”, or “series A” to “series B”, etc. the relationship between existing shareholders and the new shareholders is far to often one of conflict – to the extent that this is often seen as just the normal way of things – when there is no reason that this ever need be the case. Venture capital firms often talk of “needing” to invest a minimum amount of capital and/or “needing” to own a certain minimum stake in the companies they invest in. While I think the case is sometimes overstated, if you understand the dynamics of their business model, their attitude is easily understandable and basically rational. And yet, I have never yet seen a venture capital fund offer to buy-out the early stage investors in whole or in part when more often than not this would be an ideal outcome for everyone:
- the company: not needing to raise more new capital than strictly necessary
- the early stage investors: (whether professional angels or seed funds or friends and family) allowing them to reduce risk, recycle capital and retain focus on the market segment (early stage) they know best and which corresponds to their capital base
- the venture capital funds: allowing them to simplify the capital structure, deploy more capital and ease negotiations
If this became the norm, I think it would drive a massive downstream benefit which would be to create a more dynamic, focused and intelligent early stage investment paradigm as investors in this ecosystem niche could really focus on funding two types of companies:
- companies that have a plausible case to become successful but modestly sized businesses worth $10-40 million; and
- companies that have a plausible case to become “VC fundable” where the goal is to exit in a series A or series B at $10-40 million
This would considerably improve both the availability but also the quality of early-stage capital as the risk / return dynamics would become much less random and the impact and velocity of the best investors in this space would increase considerably, providing more, cheaper and easier access to capital to entrepreneurs while at the same time providing a fantastic “farm-system” of talent and corporate development to later stage VC’s, perhaps even allowing (the best amongst) them to deploy their hundreds of millions or billions of capital efficiently as their ecological niche becomes better defined. I am absolutely convinced that this paradigm would create a much healthier, more vibrant capital market for innovation and disruption, improving returns for everyone in the ecosystem.
What I am not saying is that buying out seed investors would be appropriate in every situation. Nor that all seed investors would always be happy to sell all or even part of any individual investment. Nor that later stage investors should always look to buy out early stage investors. What I am saying is that this discussion should always be a part of the financing tool-kit, this option should always be on the table, and dismissed only when and where it is objectively inappropriate. Let’s get rid of the dogma and let markets work. Liquidity: not too much, not too little, let’s get it right!