The venture capital industry has remained largely unchanged in its investing style since the industry’s birth. We raise risk capital from our limited partners, take positions in pre-public firms and ride those positions until an eventual exit. Essentially we act like mutual funds, buying low and (hopefully!) selling high.
Is this the optimal trading philosophy for maximizing returns? This paper makes the case that we can increase internal rates of return (IRRs) and cash-on-cash returns by acting more like Venture Hedge Funds.1 Like hedge funds, we should identify opportunities to invest in short positions that relate to our long positions, thereby increasing returns from profitable investments.
Many venture-funded companies fail to provide an adequate return. When a venture partnership finds itself owning stock in a “winning” company that is precisely when the partnership would like to put more money to work in that investment. However, the only way that a traditional venture fund can increase its leverage in proven winners is to wait for the chance to reinvest during subsequent financings.
For truly winning companies, or for later stage companies, subsequent financings may never occur (think Google or eBay). Even if the companies do raise new funds, investors from previous rounds are typically limited in their subsequent investment amounts based on their pro rata allocation. What is needed is another way to increase a portfolio’s relative exposure to investments proven to be successful vs. those proven over time to be less successful.
Venture funds that adopt our proposed paradigm can increase returns from proven winners in their portfolio by securing permission from their limited partners to take both long and short positions related to their portfolio investments. Assuming they have structured their term sheets properly, they are then permitted to increase leverage in their portfolio companies by trading in “stock substitutes.” The sequence of events is broadly as follows:
(1) Armed with the understanding that a portfolio company might someday impact the market capitalization of its rivals, investors add information rights to their term sheets permitting them to utilize any information learned about unrelated third parties derived from their involvement with the portfolio firm.
(2) After the portfolio firm begins to thrive, the investor identifies third party companies adversely affected by the disruptive firm’s upcoming innovations. Shortly before the disruptive firm upsets the markets for the identified third-party companies, the venture fund buys put options (or similar derivatives with equivalent effects) on these rival companies before knowledge of the disrupting firm is widely known. Put options can last as long as a year, which provides ample time for the market to grasp the disruption created by the portfolio company.
(3) In due course, the portfolio company will announce that its product and/or market penetration has progressed to the point where its disruptive effects on the future profits of its rivals are obvious to the investing public. As the financial markets integrate this information, the rivals’ stock prices will fall speedily. The venture fund is then able to exercise the options (cash in the derivatives) at a profit.
We present three of many case examples. Academic researchers Whinston and Collins2 monitored the effect of 24 announcements by the airline People’s Express in 1984-85 stating the company’s intentions to enter new U.S. domestic routes. Each announcement averaged a $3 million to $6 million effect on the market capitalization of incumbents and had little effect on the price of People Express’s stock. This suggests that the potential gain from buying put options (or some equivalent derivative) shorting the disrupted rival may be larger than the potential gains from the long investment itself.
Even more critically, the gains from the put are earned immediately, whereas the stock appreciation gains from the underlying portfolio investment are delayed until the investor is able to exit. To reinforce the point: Investors in People’s Express ultimately lost their money in their investment. Nevertheless, they could still have profited if they had undertaken the hedging financial play.
A Battery Ventures-backed company named Phoenix Technologies announced in 1987 that it was planning to launch a product that would disrupt Adobe’s PostScript printer technology. Adobe’s stock dropped 36% over a two-month period.
More recently, on Feb. 8, Summit Partners-backed Sybari Software announced that it would be acquired by Microsoft. The next day, McAfee (NYSE: MFE) stock dropped 8.2% and Symantec (Nasdaq: SYMC) dropped 6.4 percent. The venture investors in each of these cases could have increased their returns dramatically (and immediately) by purchasing, at a suitable time, a put on the stocks of the direct rivals impacted by the actions of their portfolio companies.
In each of the above cases, the investors, as board members of their portfolio firms, had early insight into the eventual disruptive market dynamics. These insights, while not absolutely guaranteed, provided solid opportunities for investors to increase their returns in the underlying companies.
Because stock prices are volatile, there are risks that the stock price of the disrupted company may move upward for reasons completely unrelated to the asymmetric information possessed by the venture investors-thereby reducing, or eliminating, the value of the put. However, even without relying on any asymmetric information, the investor has a fair chance of either making or losing money when purchasing puts on the disrupted company. The asymmetric information shades the risk in favor of the venture investor analogously to the way that “card counting” adjusts the odds in blackjack. Moreover, we would estimate that put options priced in transparent markets likely have less inherent risk than our portfolio investment in the disruptive company itself.
In addition, put options have the potential to lower overall portfolio risk because their return depends far more on the arbitrage than on the general direction of the market. Our proposed strategy offers a possibility to multiply returns with arguably the same or less risk than before.
The current research cannot yet recommend a specific percentage of a portfolio to allocate toward purchasing puts. However, we would likely approach this issue by calculating the amount of capital allocated toward, but unable to be otherwise invested in, the specific portfolio company. The combined short and long positions related to a single portfolio investment would never exceed the maximum dollar amounts or percentages that the portfolio would otherwise invest in the long position. If there is no additional chance to invest long in later rounds in a specific, proven winner, then the remaining dry powder would be potentially available to invest in derivatives on stock substitutes. Following this logic (even when capping the derivatives investment at 1% of the total venture portfolio for any single short opportunity) we estimate that this strategy provides the chance to increase 10-year portfolio returns by up to 500 basis points on a cash-on-cash basis, and to increase 10-year portfolio IRRs by as much as 2.5 percentage points3 for each portfolio company presenting an arbitrage opportunity!
Is It Legal?
Some have expressed concern that our proposed strategies are not legal. The concerns relate to the usage of non-public information to make an additional portfolio gain. We have carefully trawled the insider-trading statutes in the United States and have discussed our example with lawyers and experts. Whilst we are not legal scholars, there is clear U.S. Supreme Court case law and commentary to support our position that the strategy we propose is legal. We particularly refer to United States v. O’Hagan (1997) and to an excellent article in the Stanford Law Review by Ayres and Bankman4, which discusses the legality of trading in stock substitutes.
The applicable United States Statute is Rule 10(b)-5 of the Securities Exchange Act of 1934. This rule states that one cannot “engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security…” However, as far as our case is concerned, to infringe this law, one must either be privy to material, non-public information known to insiders in Disrupted Public Company B (“Company B”) or one must have misappropriated material, non-public information about Company B (unknown to insiders) from an outsider who is somehow the owner of such information.
Venture investors in Disruptive Company A (“Company A”) will not fall afoul of any of the SEC rules if they take care of the following:
(1) They must owe no duty or have any temporary or permanent relationship to Company B. This means that the investors in Company A must take care not to be employed by, be directors of, or have any trading arrangement with Company B.
(2) They must likewise make sure that they owe no temporary or permanent duty to any trading partner of Company B, such as being a director of a major Company B supplier.
(3) They must also be sure that Company A itself owes no duty to or has any temporary or permanent trading relationship with Company B (or is in some way itself prohibited from using the information for its own gain). In other words, Company B is simply an unrelated player in the market competing with Company A. The only other issue of concern is that Company A’s investors have a duty to Company A itself if these investors use Company A’s non-public information. That duty is not necessarily broken if we benefit by using Company A’s information. The key is to ensure that we do not misappropriate the information from our portfolio company. We can address that issue by adjusting the boilerplate in our term sheets.
When funding new companies, we typically request a number of investor rights and preferences in our term sheets. To make sure that we are not deemed to have misappropriated information by later trading on such information, we should simply request explicit permission to use such information as part of our standard term sheet boilerplate.
Sample term sheet wording used by one of the authors is as follows, but one should always seek legal counsel before drafting specific term sheet language:
It is understood and agreed that the Investors may learn material non-public information about third-party public and/or private companies who are competitors, suppliers, investors, partners, or customers of the Company as a result of their serving on the Board, or as an investor in the Company. The Company hereby expressly disclaims any and all representations and warranties with respect to such material non-public information, including but not limited to warranties of accuracy and completeness; but grants to Investors unrestricted rights to use such information about third-parties, if any, without notifying the Company.
Clearly most investments won’t present arbitrage opportunities as striking as the cases above. However, the more successful the investment, the more likely you are to find yourself with a winning company who won’t take more of your money. Just as many of the term sheet conditions we all use are drafted to protect profits in special circumstances, this, too, is a standard clause we should embrace to increase returns in the right circumstances. This article summarizes one of the hedging strategies we are exploring to increase venture capital portfolio returns. We hope to spur additional discussion, thinking and research on this new paradigm.
Bill Hilliard is an active early stage venture investor and a visiting scholar at the Lester Center for Entrepreneurship & Innovation at University of California, Berkeley, Haas School of Business. He may be reached at email@example.com. Charles Baden-Fuller is Professor of Strategy and Management at Cass Business School, City University, London, UK. He is also the Editor-in-Chief of Long Range Planning – International Journal of Strategic Management. He may be reached at firstname.lastname@example.org.
If You’re Interested
For more detail on the relevant Supreme Court and SEC rulings, see “Raising the Returns to Venture Finance,” C. Baden-Fuller, P. McNamara, A. Dean and B. Hilliard, Journal of Business Venturing (forthcoming 2005/6), or request a copy by contacting the authors at email@example.com or firstname.lastname@example.org. The article discusses, in detail, the ethical issues and economic theory underlying our proposed strategy. It describes relevant case law in great detail and can provide a framework for discussing applications of our strategy with your fund’s counsel.