Distribution of appreciated stock to limited partners is the venture industry’s definition of winning, the equivalent of a happy ending in the movies. Most of the time, the sooner the stock distribution occurs, the better for all involved. However, everyone loses if the stock is so thinly traded that limited partners can’t find buyers for their shares and stock prices deteriorate due to new selling pressure. This is not unusual, and even winning companies face extended thin markets. But the premature transfer of shares to limited partners may jeopardize the happy ending that keeps them satisfied and ready to jump into the next fund.
The venture capitalist’s decision to distribute thinly traded shares is inherently complex because of the varied, even divergent interests involved and the potential impact in the marketplace. In the short-term, distributing shares allows the venture manager to add points to his internal rate of return scorecard and “share the winnings.” When done well and when consistent with long-term goals, execution should also enhance relationships with all constituents – with individual and institutional limited partners, portfolio companies and allied venture firms. Because their timing affects so many parties, distributions require a balancing act in which the VC calls on his judgment, experience and communications skills to maximize the gains for all involved and to ensure that neither he nor his constituents suffers any significant negative consequences.
Distribution of portfolio shares affects not only bank accounts, the attitude of limited partners and the reputation of the venture manager, but also the portfolio company’s stock price, liquidity, image and financing prospects for months to come. Share distributions often cause big ripples in a small pond, inevitably rocking the boat of thinly traded stocks. The appropriate response for the VC is not forgoing the distribution, but controlling it.
Everyone involved must understand that the timing of stock distributions is an art, not a science. Even the most successful venture groups don’t get it right every time. The best protection a venture manager has against unhappy constituents is information, education and trust, and the principles defining the distribution process are best explained at the outset of a fund – certainly well before irate limiteds or chief executives protest.
Overall, the better informed all parties are, the more they appreciate the risks of acting on short-term self-interest. Well-informed limiteds then become focused on the process of building value in portfolio companies, rather than on purely financial considerations such as selling newly received shares simply to balance their portfolio. They rightly view a distribution as a key stage in a successful company’s growth cycle. Similarly, the prudent CEO must understand that the venture fund’s limited partners’ need for liquidity is part of the evolution of his company. His future range of financing options depends on how well he educates all his investors about the potential of his stock, while accommodating their liquidity needs.
Effective in-kind distribution strategies take into account these key factors: balanced priorities, good timing, IRR, profit and tax considerations, disclosure and investor perceptions, liability and legal ramifications and, occasionally, courage. For sophisticated investors, a successful distribution alone can provide an important and complex measure of venture performance.
Balancing Interests Small and Large
The varied interests of limited partners, particularly between large and small investors, came into sharp focus for me after a recent distribution at Forward Ventures. In response to varied factors, including strong performance of the stock on small volume and insistence from an individual investor that he automatically “owned” the stock once it became tradable, we distributed a substantial block of stock in a company. Shortly after, and to my surprise, I began hearing complaints from principal institutional partners that “the venture capitalists are bailing out of this stock too soon” because the volume wasn’t sufficient to accommodate significant sales. The L.P.s were stuck with illiquid stock. The “right” decision, made for sound business reasons, isn’t always right for everyone.
Generally, individuals are eager to accelerate distributions, believing their “small” allotments can “easily” be liquidated without injuring larger positions. However, a sustained selling pattern of small positions can lower the stock price and damage the returns of the remaining stockholders. Understandably, individuals generally want to accelerate access to “their” shares, but some institutional investors often have little interest in rushing to assume management responsibilities for stocks they don’t follow and can’t sell.
Even institutional holders at times don’t share parallel agendas. At a recent conference on venture capital investing, one plan sponsor indicated it routinely held every stock it received from its venture managers. A second said it tries to sell everything it receives, not always an easy task and likely to undercut thinly traded stocks. This tension between investor strategies exists in many distribution situations and must be acknowledged; access to buyers may not be the same for all partners, and some of the largest investors may feel disadvantaged by early, illiquid distributions.
The Downside: Avoiding Disruptions
In addition to affecting immediate constituents, venture distributions affect other shareholders and fellow venture syndicate members in profound and different ways. The most dramatic and visible influences are mirrored in the price of the distributed shares. Perception and appearance matter here because one party may gain and another inadvertently lose as result of a sequence of perfectly reasonable actions.
Stock volatility often has far more to do with liquidity than the inherent value of the company. In a “high variance” security, where price varies as much as 50% or more in a six-month period and daily volume is a small fraction of the total anticipated distribution, sales of shares immediately following distribution can reduce the stock price anywhere from 20% to 40% or more, according to David York, head of venture services for Hambrecht & Quist. In the longer term, a substantial overhang of sellers can effectively cap the stock price for months.
Liquidity thus must be a first question when considering a distribution. When a stock is so thinly traded that limited partners cannot sell all or a portion of their distributions near the current market price, one must ask: Is the distribution prudent? If the investor can’t readily exit the stock, he becomes a de facto – and often reluctant – manager of that position. Premature distributions may force limited partners to hold shares they neither understand nor want to manage. The result can be increasing discomfort among larger partners as prices drop to accommodate sales of smaller positions. Would they not be better off with the venture capitalist continuing to manage the stock on their behalf?
Although the venture capitalist may distribute at a high price, maximizing personal returns and the fund’s IRR, are the fund’s principal investors pleased when they must sell for less? As most general partners enjoy a profits interest, distributions that consistently lower the prices of distributed shares may leave the impression that the G.P. prospers at the expense of the limited partners. In addition, performance measures, such as IRR based on unrealizable returns, can impede future fund raising. One limited partner pointedly told me he evaluates his managers based on the price he gets on liquidation and not on distributed prices. If this is significantly different from published returns, The VC may have some explaining to do.
The nature and needs of a specific industry or company must also be recognized as important variables. In biotechnology, for example, where a CEO must regularly raise funds to survive, an ill-timed distribution that undercuts his stock may well offset hard work by management that has built shareholder value. Since venture managers are rewarded on the basis of share price, they must be effective in delivering realizable value to their investors. Prolonged soft stock prices, especially caused by venture distributions, will hardly endear the investment manager to his limited partners, CEOs, company shareholders or venture syndicate partners.
Early on, savvy venture managers realize they cannot make everyone happy every time. Indeed, alerting all parties to inherent, predictable conflicts is one of the best ways to persuade them the process is orderly, consistent and, in the long-term, fair. While a venture capitalist’s legal and fiduciary responsibilities to his investors prevent him from treating all affected parties equally, good management avoids having the less-favored constituent end up feeling misled, misused or disadvantaged.
Waiting for Liquidity
In a perfect world, a venture manager would distribute only when the marketplace provides all partners with an immediate option to sell (or hold) at a good price. Perhaps the best way to deal with the challenge of thinly traded stocks is to wait for the company to grow until the stock becomes “thickly” traded. However, this is not always a practical option. Some companies will never develop sufficient float to provide real liquidity. Particularly in the life sciences and health care, where the cycle of Food and Drug Administration approvals significantly delays access to revenue, the time frame required to generate liquidity can be long, even after a company has achieved substantial ($500 million-plus) valuations in the public markets.
In fact, a venture capitalist is under considerable pressure to accelerate distributions, despite a thinly traded stock. If he distributes early and the IRR continues to climb after distribution, the venture capitalist can report this “as if held” number. If he holds and the stock drops, he will have a tough time selling an “as if distributed” number.
Because IRRs are a key measurement of venture performance that encourages early distributions, some ramifications of this standard need to be addressed. In a company that moves quickly from start-up to an initial public offering at a substantial step-up in valuation, a venture capitalist’s IRR rarely climbs higher than it is at the moment the lock-up comes off. The passage of time measured in months quickly erodes triple-digit IRRs, even when the stock price is climbing.
One effective Forward Ventures strategy for dealing with smaller holdings has been to distribute all the shares within days after they become tradable. While the “earliest time point possible” method relieves decision pressure – and may well provide as good a strategy as any to maximize fund performance – it works less well with larger blocks of stock. Since lock-up periods are easily calculated from industry practices and publicly disclosed information, a rigid pattern of distributions tied to tradability will be anticipated by short sellers, whose sales can drive a stock price down ahead of a distribution and further damage both the G.P.s and L.P.s.
Another approach to minimize the impact of distributing larger blocks of stock is to return them in a series of smaller chunks. A venture manager can avoid flooding the market and can gauge the sell-versus-hold behavior of his limiteds with relatively small amounts of equity to calculate the potential impact of future distributions. However, small distributions have limitations as well. Many limiteds are more likely to hold a larger distribution but will sell what they consider to be de minimis positions. Small returns add to administrative overhead and can actually increase the selling pressure on a stock. Even a “small” distribution can be large relative to the market. A distribution that exceeds the daily float by more than an order of magnitude can have a significant impact. (Remember that currently NASDAQ counts one trade – the sell and the buy – as two transactions.) Occasionally some of our companies trade no shares at all.
Block sales of entire positions that return cash to limiteds can increase the institutional following for a portfolio company and soak up all potential liquidity in a single transaction. But, if a fund has not been designed to return cash from the outset, many limited partners may be disappointed not to receive their own allotment of shares. The impact of cash distributions can fall disproportionately on tax-paying (individual) partners, who generally prefer to control the timing of sales in their portfolio to match cash needs and tax considerations. Hybrid distributions of both stock and cash might meet everyone’s requirements but are not practical. However, the following may approximate the hybrid concept.
With all this complexity, one wonders what compelling solutions remain that protect the venture family, ensure good rewards for risk-takers, and validate the entire distribution process. Another possible solution came from a Forward Ventures limited partner, who suggested a “sub-fund” model into which limited partners contribute the shares they wish to liquidate on distribution. The sub-fund – under the management of a market-maker or other trading group, but not the venture managers – would liquidate the shares in an orderly and confidential manner. Such balanced arrangements could benefit all affected parties: large limited partners wanting equal access to liquidity, smaller partners uninterested in managing liquidation, CEOs who benefit from orderly trading and brokerage houses able to concentrate commissions and gain larger block trades.
While operating within the broad price and time parameters set by the venture capitalists, the sub-fund process is controlled by selected market-makers. Those partners electing to take distributions in kind might be subject to a 90-day lock-up period. If the market-makers cannot complete an acceptable transaction within the lock-up period, the shares would be forwarded to the limiteds. Under those circumstances the venture managers might want to reconsider the liquidity issue in future distributions.
The sub-fund can be a win-win scenario, resolving a wide array of venture and investor needs: the aggregated block of shares would satisfy institutional buyers, perhaps helping attract strong, new backers for the portfolio company, provide liquidity for all limited partners, and support stable stock prices. Because holdings and timing would be confidential, short-sellers would have difficulty anticipating specific trades or gauging the impact on liquidity. Moreover, the venture capitalists would then measure their IRR both when the funds are committed to the sub-fund and when final distributions of realized profits occur. Though existing funds and investors would have to voluntarily join new sub-funds, perhaps limiting their effectiveness, the general idea could be included in upcoming funds.
Needed: Industry Solutions to Industry Problems
Because stock distributions affect the entire venture community, effective new approaches require an industry-wide perspective. We all will benefit from the dissemination of the best strategies. Given the inherent internal conflicts, our solutions to the challenges of distributing thinly traded stocks can never achieve perfection. As a result, we must also work on adjusting perception to fit reality. Frank discussions with limited partners implement measures of performance that encourage optimal behavior and will improve returns to all venture investors. The most influential limited partners with the widest commitment to the industry stand to benefit most from such changes. When members of a venture syndicate are disadvantaged by an ill-timed or mismanaged distribution, the largest limited partners are the ones most likely to find their gains in one fund offset by losses in others. Augmenting the IRR yardstick with measurements such as return on investment, which measure the ability to build value over the life of the fund, could reduce the pressure to make early, possibly risky, distributions of thinly traded stocks.
Finally, in making distributions, the successful venture firm must consider legal ramifications, short- and long-term. When asked how venture capitalists can minimize their legal and strategic risks, Richard Testa of Testa, Hurwitz & Thibeault, said, “Stick to what you do best. Minimize your involvement in public companies.” Good advice. However, with more sophisticated public investors receptive to early IPOs, a company is often listed before a venture capitalist’s work is done and substantial liquidity is established in the company. Because venture managers are obliged to pursue efficient financing in the public markets, they can find themselves with more value left to build in stocks of companies that appear “full-grown,” but which are not yet ready for distribution because of limited liquidity.
Overall, clarifying priorities, taking all known variables into account, especially the impact on stock price, creating innovative solutions, such as sub-funds, and communicating to all our limiteds what we are doing and why – these are important elements in successful distributions. Dividing the spoils need not divide the partnership that created the profits.