Post by Barry Schwimmer, Managing Partner
In my early days as a private investor I learned and adhered to a foundational precept -“No liquidity for management before investors”. I have frequently repeated the following mantra to private company management teams when tasked with the age old problem of their liquidity “You get out when we get out.”
Should later stage vc funding rounds be used to provide liquidity for company Founders and management/angel investors?
But they say, “You have lots of investments and this is our only one. We are working for low salaries, trying to build long term value. Plus ultimately you as the controlling shareholder get to set our exit. How can we achieve liquidity for ourselves and our families?”
Standard response: “Our interests are aligned. You get out when we get out.”
I recently read VC Fred Wilson’s 12/29/14 blog post titled “Some Thoughts on Founder Liquidity” in which he reconsiders the possibility that the traditional prohibition against using later stage funding rounds to provide liquidity to management and earlier investors should be updated and supported by later stage VC’s.
In short he posits:
I have evolved my point of view on this issue a lot over the years and I now believe that providing some founder liquidity, at the appropriate time, will incent the founders to have a longer term focus and that will result in exits at much larger valuations because, contrary to popular belief, founders drive the timing of exit way more than VCs do.
@FredWilson’s blog really made me contemplate whether the traditional model should be reconsidered.
Certainly founders/investors ultimately want the same thing-build a great company and achieve the highest valuation on exit. Investment holding periods have grown and new types of investors have emerged. Can later stage investors-with different risk tolerances be comfortable that investing in an early stage company for the sole purpose of cashing out others is an appropriate use of funds?
Maybe there’s a model for accommodating early founder, employee and investor liquidity desires while allowing new types of later stage investors to participate in a company’s growth opportunities
- Candidates for early liquidity investment should be self-sustaining (profitable) with proven operating models.
- Selling Founder and employee shareholders should keep a significant portion of their stake in the company post transaction. My rough guidelines as a new investor would allow still active Founders to sell 10-25% of their total stakes, early employees 20-40% and early angels/VC’s as much as they like.
- New investors should be organized for this kind of situation and understand that they may not get a “quick flip”. Paradoxically their investment may serve to lengthen the time to sale/IPO.
- This later stage investment is risky and subject to misalignment of interests. See 1 and 3 above. Diligence regarding motivation and valuation bubbles is critical. An interesting dynamic would arise if the takeout financing is done by the same VC’s using different “later stage” funds to monetize their prior fund investments. Clearly this should be avoided.
- Given today’s longer holding periods, larger late stage rounds and broader investor (diversified fund) participations, such financings are creeping closer to public secondaries.
- Perhaps these interim takeouts will allow for longer gestation periods before a company is sold and ultimately produce higher total returns? I appreciate and support the logic but would still approach with caution and restraint.
While I have not seen empirical investment results for these situations, clearly larger institutional investors (eg Tiger Global) appear to be increasingly comfortable with these situations. It will be interesting to monitor how the current crop of late stage takeouts mature-particularly when the IPO window inevitably closes.