Venture Fund Distributions - Cash versus Stock
The way a venture capital fund works is the investors (called LPs) invest their money in the fund over a five to seven year period, on an as needed basis, to fund the investments the fund makes and the management fees the managers are paid. As the investments become liquid, the proceeds are distributed back to the LPs. Typically these distributions happen in years five through ten, and in the ideal world the fund is totally wrapped up by year ten. A good venture fund will return at least 2.5 to 3x the invested capital. While that doesn’t seem like such a great return, when you factor in that the money comes in slowly over a 5-7 year period and is paid out over years 5-10, the rates of return on a good fund can be very attractive, at least 25% per annum and often much higher. There are a whole bunch of issues related to venture fund performance that I have glossed over here and don’t intend to address in this post.
The thing I want to talk about is the distributions, the return of capital to the investors. It is very typical in venture funds for the investors to get distributions of both cash and stock. The stock is almost always marketable stock that can be sold in the open market immediately upon distribution. I used to think that distributions of stock was a good idea. We did a lot of it at Flatiron Partners and Euclid Partners, the two firms I was with before starting Union Square Ventures.
The theory behind stock distributions is that it allows the investors in the funds (the LPs) to decide whether they want to hold the stock and capture additional appreciation or sell the stock and get cash. It gives the investor an additional option and options are worth something. For those investors who are tax paying entities (many LPs are pension funds and such), it also allows the LP to defer paying the tax on the stock distribution until the stock is sold.
The stock distribution also provides value to the managers of the venture fund and the underlying portfolio company. Imagine that a fund holds a $100mm position in a company worth $500mm. It’s going to be very hard to sell a block of stock that large without impacting the market. But if the fund managers distribute the stock to their investors and a significant number of the investors hold the stock, then the impact on the stock is minimized. It doesn’t hurt that many venture funds provide that the value of the stock distribution is calculated based on the stock price before the distribution is made (before the market is impacted).
There are two ways that venture funds get public stock. The first is when one of their companies goes public. In that case, the venture fund is often a significant shareholder. The example I gave earlier of a $100mm position in a $500mm market cap company is very typical of this situation. The second way is when one of the portfolio companies is sold to a public company in a stock transaction. In this case, the fund’s position is often a much smaller percentage of the total market cap of the public company.
While it is more convenient and often times more attractive to the fund managers to distribute stock, I think the practice of distributing stock will decline and I think it has already started to happen. First of all, LPs don’t actually like getting distributed stock. They think "I invested cash, I want cash back". They also have had numerous problems over the years getting stock distributed to them that declines in value, sometimes significantly, before they can sell it. And yet, on the books of the fund, they are getting credited with being distributed something worth a lot more than they could realize.
At the same time, investment banks are starting to realize that getting venture funds (and private equity funds) out of their significant positions in public companies is good for the companies and good business for them. And the public market investors are sophisticated enough to realize that it’s also good for them to have a managed sale of a significant position.
So we are seeing a material rise in "secondary" sales of stock both in IPOs and also in the secondary offerings that often follow an IPO within six months of the original offering. These secondary sales are managed sales, done through a registered offering of stock, of large positions in public companies.
We are also seeing secondaries being done more frequently to manage the sale of positions that are obtained through the a stock acquisition of a venture backed company.
This allows the venture fund to distribute cash to their investors instead of stock. The LPs like it better. And I think it may turn out that a move to distribute cash will improve returns in the industry. LPs, certainly the sophisticated ones, calculate their own "cash on cash" returns on their venture fund investments. While a fund might take credit for distributing a $100mm position, if the LPs only got $80mm, that’s what they will ultimately show in their return numbers. If via a managed sale of the $100mm position, the fund gets $90mm and distributes that cash, the LPs are better off and their returns will increase.
There has been a theme running through the debate about venture returns over the past five years that states that venture returns have been poor because of a lack of a vibrant IPO market. I don’t buy that. I think that a venture fund can deliver terrific returns to its investors without ever having an IPO in the fund. Merger and sale transactions can provide very good returns to venture investors. In fact, Broadview Associates used to show a chart that something like 80% of all venture backed companies that went public had stocks that traded below the offering price within a year of the IPO. The fact is that very few venture backed companies make great public companies. Sure there are exceptions. Google, Cisco, Apple to name a few. But those are the really great companies. For every one of them, there are hundreds that were busts as public companies. And all the parties at the table, the VCs, the managers of the portfolio companies, the investment bankers, and the public market investors are smart enough to know this is true. That has resulted in a the dearth of IPOs that everyone blames poor returns on. But I think we are just seeing a market adapt to the reality that most of the venture backed companies should be sold instead of foisted on the public markets.
So another factor at work in this cash versus stock discussion is that most venture funds will be generating more liquidity via trade sales and less via IPOs. So there will be less stock to even think about distributing.
I don’t think the practice of distributing stock will go away completely. There are times when it is the best thing for everyone. But those situations are rare and getting rarer. The rise of a cash on cash business in the venture industry is a positive trend that in the end will likely benefit everyone involved.