Sean Park Portrait
Quote of The Day Title
The Web will own every bit.
- Kevin Kelly

On liquidity.

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!

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  • Great post. In particular, it is very hard for *anyone* looking at a disruptive startup to see more than 2-3 years in the future. So it's just too hard for a big fund to get confident about a mega outcome from a new business, or for a smaller investor to have any visibility of when they'll get their money back from an early investment (and how much dilution they'll experience along the way). If exit milestones allowed people to get money in and out every couple of years, then all investors could make confident 2-3 year decisions rather than (guesswork) 5-7 year decisions, and everyone would be better off.

  • The argument is solid and makes a lot of sense, especially the part about Round A and Round C having different agendas. In my three companies, I was always shooting for a 2.5 - 3x multiple on Round A post-money as Round B pre-money. Three out of three times, it happened... within 18 months of Round A closing. So, if there was a VC who cared only about more consistent returns on a Round A investment, they would do fine, though not get the big score from my second company's IPO.

    I think the issue I have is that this approach tends to stratify funds into "minor leagues" and "major leagues" not just because the investment thesis is different but also because smaller funds have difficulty coming up with the money to play in the big leagues (yeah, yeah, Venrock, smaller fund, blah blah, but it's still $350M). The desire to stay in the initial stages of a deal and exit is driven by financial circumstances of the fund and not necessarily the best outcome for the fund's LPs if (big if) the company is a big winner. The magical desire to "return the fund" is still very strong and secretly beckons venture investors.
    I just had a discussion on this with @epaley who made a compelling argument that the follow-on requirements have led to more VC losses than they choose to admit -- that often good money is thrown after bad because it's the "thing to do" as opposed to a prudent financial decision. I can't argue with statistics, and Eric made the point very well.
    But human nature tends to make VCs think they can pick ultimate winners. What the approach advocated here calls for is a realization that the status quo needs a serious, unnatural disruption -- that people should play in the league they chose to play in and not always strive to make the ultimate score. Very hard to do.

  • Kirill, thanks for the great comment. You basically hit on one of the things I find most frustrating and puzzling in the current venture paradigm - that is the dominance of the 'return the fund' algorithm in terms of portfolio construction and risk management. Again before anyone freaks out - I am not saying this is structurally the wrong or a bad approach but that it is only one amongst many potential approaches and should be chosen not by default but by deliberately, by design (because that is the optimal strategy for a given investor as a function of their capital - size and form - and skills. Or just because there is no other alternative given the market structure.

    A more open-minded and pragmatic approach to secondary liquidity in the venture lifecycle - a change in the market structure (and associated 'cultural' norms) would in my opinion, open up the door to a much more diverse set of viable investment strategies which would make for a healthier ecosystem overall. At the risk of sticking my neck out, I also firmly believe that it would raise aggregate investment returns to the asset class generally; it's my conviction that homogeneous ecosystems always underperform (sometimes catastrophically) heterogeneous ones over time.

    The current status quo - one-size-fits-all - market structure is ultimately self-defeating as it is only really optimal for a limited subset of investable companies. For all the others they are consigned to trying to adapt their business models, growth cycles and even their market opportunity to fit the constraints of the market norms for private growth capital more often than not to their detriment. Doesn't sound like a very good value proposition to me: "Venture Capital - we'll do any kind of financing you like, as long as it is black."

    If I were running a large venture capital fund, where my sweet spot was (big) Series A rounds and above, my default position would be:

    a) how much new capital does the company really need?
    b) how much capital at what price would I ideally want to commit at this point? (ancillary: what minimum stake, if any do I need? note this is a related but nonetheless different question and of secondary importance to amount of capital committed); and
    c) if these numbers are different (which I think they very often are), can I source the difference from previous investors at my price point?

    Indeed, all other things being equal, I should rather do as much secondary as possible so long as the company has sufficient cash to realize it's growth plans. ie There is no point diluting for dilutions sake. To the extent you don't need to, don't do it! A mountain of cash (beyond what is needed to give the company the optimal operational and strategic freedom it's business needs) sitting on a company's balance sheet is just poor management. A wonderful side effect of this approach would also be less complicated cap structures: take out the previous money, create a culture of periodic liquidity and many of the arcane - potentially toxic - bells and whistles of traditional later rounds would often become unnecessary.

    We live it this strange world where on the one hand you have hyper-liquid public markets driven by high-frequency statistical traders turning over multiples of the capitalization daily, and on the other end a private company market where liquidity is non-existent and totally predicated on the occurance of highly uncertain one-off events (trade sale or IPO.) The vast middle ground has somehow evolved into a no-mans land. I think it is time the market addressed this and embraced a spectrum of liquidity options; allowing each company or investor to adopt a path that was suited to their circumstances.

  • While I applaud the idea of second markets, at this time, I've found them to be somewhat faux. In many cases, especially Facebook, the private-side share prices have been outrageous, and there are funds which I feel are robbing investors by means of hype-analysis + transaction fees. It seems performing a private stock purchase on second markets costs around $5k and funds which are buying a single stock are excessing 5% + a 3% carry. A private company is just that, which means any kind of analysis is little more than speculation.

    As far as seed to staged investment discussions, I hope everyone agrees with you. I think there's a great opportunity in always satisfying investors, no matter what stage. However, I'm not sure a "farm-system" would happen so easily; I think talent within the context of startups has an expiration date -- just like the early investor. Most the time I think the talent is the entrepreneur and if you could pin down the entrepreneur to begin with, he or she probably wouldn't be in a startup to begin with.

  • Edzei8

    Bravo! Excellent post, thank you for putting such creative thought to this problem. Especially it is refreshing at a time when the Paul Krugman's of the world are calling for a "Third Depression"! Actually, I'd love to see you have a comeback to Krugman's gloom and doom < http://www.nytimes.com/2010/06... > in a separate post some day!

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