Liquidity Tools for Emerging Managers
Earlier this year, the Kauffman Fellows published its Liquidity Tools for Emerging VC Managers. KF often provides valuable content, but in our opinion the five solutions KF offered are not very useful: none are very scalable; some are vague; most are economically unattractive; and all of them seem fairly unlikely to happen — because, as they noted, the billion-under-AUM secondary market players focus on PE and later-stage VC.
So instead, we offer our list of alternative tools for early stage investing liquidity. We think these are much more widely applicable, feasible, and appealing to “emerging managers” and investors.
1. Diligence: Invest in companies with clear exit horizons. As part of your investment analysis, screen out opportunities with vague future timetables, weak or no exit plans, or entrepreneurs that give any hint of reluctance to exit. It is, of course, acceptable to invest with no particular concern about near-term liquidity; as large VC funds need to invest in companies with the potential to return the fund, quick liquidity is not happening. But if you care about creating liquidity in a shorter-time-horizon, INVEST IN COMPANIES THAT CAN EXIT SOONER! Obvious, really.
2. Investment thesis: Positive return without follow-on rounds. As one facet of #1, you could invest in companies with the thesis that they can grow, exit, and return attractive ROI without big VC rounds. Outside of Silicon Valley, most M&A happens at < $30 million, can happen quickly if the exit point requirements are huge, and can combine both liquidity with attractive ROIs. The math to generate a 3x ROI on a micro-VC fund (or, as it used to be called, an angel investing portfolio!) does not require 100x ROIs. Tailor your investment thesis to a reality that includes earlier, lower-but-attractive ROIs.
3. Clear expectations: Set them! Assuming you do #1, make sure your portfolio company knows that you invested because of the stated “3–5 year exit” plan (or whatever it is). Make sure everyone knows that failure to work towards this goal is as serious to you as lies on SPA reps. Make sure everyone knows that “exit” is a business process (not just a short sales process); have “exit progress” as an OKR with the goals, objectives, and tracking that requires. Get all these expectations down on paper. Read Basil Peters or Mac Lackey.
4. Deal terms: Structure investment terms to facilitate liquidity. Include redemption provisions. They’re in the NVCA model docs, Certificate of Incorporate, Section 6. (Footnote 69 might say “Note that redemption provisions are uncommon” but they’re only uncommon if you let them get taken out! They’re pretty common in the southeast.) If they’re too dramatic, make them disappear automatically after the angel round; or include alternatives like gradual liquidity (e.g. paying out up to 1x liquidation preference via dividends) if, say, EBITDA is positive or the founder’s salary is goes above $x. Make sure #3 includes notice that you plan to use these rights now you have them.
5. Board seat: Get one! Have the round’s board member know that “driving to an exit” is part of their mandate. Get a standard board slide on progress towards exit, and what discussions have been had with potential strategic acquirors — and make sure it gets addressed each meeting. Make sure everyone from the board chair down knows the clock is ticking and this investment is not supposed to last forever.
6. Magical 10% rule: Be proactive at getting liquidity in future rounds. Use the Magical 10% Rule and be proactive about asking for partial liquidity from new financing. Make sure this is on the portfolio company’s CEO’s mind when are engaging with new funders. An early investor’s partial liquidity is a rounding error in a big follow-on round, but not a rounding error for your portfolio — so make sure you get it! (To be fair, the KF article does hint at this — “While these direct secondaries historically occur when managers sell into a higher priced round” — but it’s secondary to the suggestion of between-round selling.)
7. Pain in the @ss: become one. Early stage investors should be supportive, but they should also hold people accountable when they are not making acceptable progress towards their plans — and this includes exit plan. Ask whenever you receive a shareholder update. Whenever you speak with the entrepreneur, ask how EXIT is going, not just how THINGS are going. Periodically connect the CEO and Board Chair with a friendly investment banker from your relationship stable. Generally ramp up how much of a pain you are as the years go by, and everyone gets encouraged to exit. If you set expectations in #3 above, people have few grounds to complain.
8. Diligence for LPs: Invest in EMs that get this! LPs: if you invest in an EM that has not thought about exits, who can you blame if you don’t see liquidity? See #1 above, but for LPs do your diligence on DPI (the cold, hard cash distributions made by the fund) not just the glamorous TVPI (the supposed multiple of written-up book value of early equity after follow-on rounds).
None of this is to say that liquidity is easy — it is not. At VentureSouth, even conscientiously trying to implement these approaches, we have investments that have lasted longer than a typical marriage and seem no closer to exit. But it is possible to drive early exits deliberately: the average life on our positively-exited portfolio is 2.0 years, in part because we seek companies under #1 and #2, set expectations in #3, structure deals accordingly in #4–5, and, over time, become #7 if things drift.
And it doesn’t require trying to get secondary market funds with multi-billion-dollar AUMs to take out an individual “micro-LP’s” position in a micro-VC fund, pre-selling your pro rata rights, or figuring out what “Structured Liquidity” is!
