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.
Really nice article. I must be daft — it took me a second for me to realize you meant Limited Partners by LPs.
LPs is pretty common, I reckon.
i love that conclusion and i couldn’t agree more. it’s a trend i’ve also been noticing; less IPOs exit isn’t necessary a problem here. i just wonder if enough other people are catching on with the cash on cash.
So are IPOs generally a poor idea for the company?
WOW Fred,I am techy first but I love to read about economics, finance and such things. Over the years I have learned how VC Funds operate and investments and such things. This was one of the best and a truly educating posts.Thank you for sharing some of your vast knowledge base.-Mo
Good to see a nice meaty econ of VC article again. They are the reason I started reading your blog and I really appreciate the work and thought you put into them.Keep up the good work
Fred, I agree. Undoubtedly good PE/VC firms are realizing that long-term relationships with LPs (their “customers” in one sense) are enhanced by not sticking them with a bunch of stock (net of inflated carried interest, of course!) at a price that cannot be realized by the LPs on their own in the public market.Further to this is the recognition that there is a wide variety of ability amongst LPs to even deal with public securities when received in a distribution: some, probably a lot of shops, have a simplistic “we know nothing so let’s sell ASAP and move on” rule while others make varying degrees of effort to do analysis and decide what to do. The exception that proves the rule is at the extreme other end of the spectrum; I know of one family office that holds stakes in several now-large public tech companies originally received more than ten years ago from VC fund distributions. That strategy is impossible for many LPs, who have their own varied investors and limited-life investment structures to contend with.
agree — as an LP I would much prefer to have a calm, rational disposition of public equities and a distribution of cash. been burned a few times by VCs who shovel out the IPO shares as fast as possible, either because they know the share price is bound to decline, or clumsily causing it to decline by making share distributions and sending a subtextual signal that says “sell” and so causing share price to decline when LPs do sell. (at a loss to have any opinion about the future share price trajectory of a company I inevitably know little about and with zero desire to learn, I always simply sell)also agree — when the scuttlebutt that “venture returns have been poor because of a lack of a vibrant IPO market” is wrong (and self-serving — moving the blame from poorly performing venture capital managers to some nebulous abstract public market influence.And of course, M&A exits can provide healthy lucrative exits, as much or more than IPOs.At the risk of being a broken record, venture returns have been poor because way too much capital is chasing the too little (overall) returns. Just because VCs raise more money from LPs, and, ergo, invest in more deals (or invest more in deals) doesn’t mean that more exits or more lucrative exits magically appear.Certainly a frothy public market does help — for example, some companies that otherwise would not have lucrative exits at all achieve them via the ultimate manifestation of the “greater fool theory” (raising capital from retail public market investors).But unlike in Lake Woebegone (where “everyone is above average”) while there may be an infinite desire for alpha, there is not an infinite supply.Maybe the current credit crunch will slam LPs portfolios enough that they will forget about chasing harvard and Yale — and alpha — and go back to conservative portfolio management and reduce the huge oversupply of capital in VC
It’s hard to know what to sell when you receive shares rather than cash. That’s one of the reasons that you pick a fund to begin with – the managers know the industry. So when the company goes public and the LP gets shares, suddenly he/she has to understand the industry.
Very nice article. Firstly, very well written. Secondly, a conclusion drawn on the basis of actual market position. For me, it was really surprising because I have thought about this and decided that when I become a VC, I am going to go for sales or mergers rather than IPOs (at least for the most part). Of course, I came to this decision with only theoretical knowledge and some common sense (or that is what I thought it was). But you have given it an empirical basis. It’s nice to get validation in practice.
Fred,Your piece on disttributions was well done and I agree with your conclusion that M&A will account for the vast majority of exits in the coming investment cycles. I also agree that it is rare for a venture backed company to make a sustainable and successful public company. However, I do think the lack of a truly robust IPO market has hurt venture returns because in many cases, the “competition” for an acquisition was the threat of an IPO. Corporate buyers today recognize that it is very difficult for emerging companies to get public and therefore do not have to factor that into their acquisition planning. I have no desire to return to 1999 but a more receptive IPO market would help venture exit valuations of all kinds IMO. Unfortunately, the infrastructure (research, investment banks such as Robertson, ABS, Montgomery, etc) is largely gone so I don’t expect major change on the horizon.
First, VC’s distribute stock for many reasons, but enabling pension funds to manage their own tax situation isn’t one of them, since pension funds don’t pay taxes. The GP’s wealthy partners and friends of partners do, however.Second, blaming poor VC returns on the IPO market is ridiculous. VC returns are poor because the quality of the underlying investments the VC firms are making is poor. The IPO market is always open to high quality companies as there are trillions of “long only” asset managers who need to be fully invested and who have cash. If it appears that the IPO market is “closed” it is because there aren’t companies of sufficient quality in the pipeline…Finally, if you are an LP who wants to get out of your stock distributions whole you should hire a money management firm to manage those distributions. There are several firms who perform this service, called distribution managment.
Fred, great article. Is there any difference in the FCC reporting on the two transactions. Obviously selling the stock then doing a distribution shows as a major share holder selling. How does a distribution show in the reporting?Having been through this a venture backed, eventually public company you would think I could remember, but I don’t. Its really only an issue when support for the stock isn’t great, but I know from experience when a company is struggling registered sales by a 20% owner can be paaaaiiinful..Thanks again, great post..
Fred,Fantastic post. I’m a former LP (and now a public equity analyst), that agrees with most of what you are talking about. The issue of liquidating public equities is a tricky one, however. In my experience, GPs are able to extract more economics from the LPs when funds are heavily oversubscribed. I see managing distributions as an economic issue, where there is a frequent conflict between GPs and LPs. Large LPs (e.g Funds of Funds) have dedicated distribution management functions. Now, if the GPs were to take on that function, that increases overhead, coming out of the pockets of the GPs. Furthermore, let’s say that GPs hold onto these investments for 6-12 months. If the post-IPO return matches the market (which should lag the return in the venture markets), LPs would still pay carried interest to the GPs FOR MANAGING PUBLIC STOCKS. I would be interested if a) venture firms feel they have much expertise in post-venture investing, and b) if they are willing to stake their carried interest on it, if the market were to blow up.The big issue that is hard for me to understand is that valuation of venture-backed companies and of IPOs are mostly dissimilar. In venture investing, you are often investing in a portfolio of fat-tailed opportunities. In post-venture investing, the curve has shifted significantly to the left.