Buy, Sell or Hold?

Navigating Illiquid Exit Opportunities

There has been an emphasis in the last several years in the venture ecosystem around access, or getting into great companies, but there is a much more important part of the business: exits, or getting capital out of great companies.

Of course when LPs are investing in funds, they are focused on what managers will do, and that is invest into new deals and manage their portfolio. But the rubber meets the road at exit, which is often many years down the road in early stage venture investing. Of course without massive value accretion in the portfolio, being good at managing exits will simply never matter, but when it does come to that point, it’s a vital part of the business. Put another way, you need to make sure that you win in your winners.

Price Targets and Analyst Ratings

Traditionally equity research analysts post a price target and a rating for a company. The three options for ratings are: BUY, HOLD and SELL.

Based on the perceived difference between the current price and the price target, the analyst will offer a strong or weak recommendation on the stock.

In the public markets, any investor can choose to BUY, SELL or HOLD their position or a portion of it, and these options are always on the table. While quarterly earnings and other news reports tend to draw the most attention and transactions, the financial instruments are liquid, and can be transacted at any time. The result: most of the time most investors are a HOLD, which is a decisive inaction.

Illiquid Investments

All of venture investing falls into the illiquid private equity investing category. Along with preferred stock, lack of public information, and off-market deal access, these are the key features of the asset class from a financial perspective, but let’s skip over to the end game: exiting an illiquid investment.

Of course if a company is acquired, there is forced liquidity, and if a company goes public, the decision on selling or distributing stock is a whole different subject.

The key distinction between illiquid and liquid investments is that for illiquid investments, when a moment of liquidity exists, there is no HOLD, just BUY or SELL. Meaning that in a moment of liquidity (i.e., there is an active offer to buy secondary), if you are not a seller, then you are by default a buyer and vice versa. Every time the opportunity arises to sell secondary stock, an investor needs to decide if they are a buyer or seller at that price. Why? Because there may not be liquidity windows in sight for a long time, so a HOLD is effectively a BUY, and BUY is a BUY&HOLD.

An example: And investor invests $100k into a company. The company raises 2 more rounds of financing and now there is a liquidity opportunity. The original investment is now worth $2M and there is demand for that $2M chunk. The investor now must make a decision: BUY or SELL (and how much). In other words, how much exposure do they want to the current risk/reward profile of the company? Knowing what they know about the business and its current valuation, how much would they invest now? And…is there a better risk/reward profile elsewhere for the proceeds of a sale?

Note that I did not mention entry or exit valuations here because they are totally relative and context-dependent. The entry valuation could be $5M or $500M and the current valuation could be $100M or $10Bn. The methodology stays the same. You need to ask the question: how much do I want to invest at the current valuation and what is my next best alternative for any proceeds from the sale?

There is another potential pitfall here: mixing knowledge of the business with emotional attachment. Working with a founding team for several years results in both in-depth knowledge, but also creates an emotional connection. These two things must be separated in order to make a clear decision about buying and selling.

Angel Investing vs. Fund Investing

The simple example I just walked through works great for an angel investment… but what about an investment in a closed-end blind-pool venture fund?

There are two main factors that a venture GP needs to consider:

• Each investment has recourse on the others in driving the overall outcome of the fund, meaning that an original $1M investment which is now a $20M position in a $40M fund might have another 2x upside, and while venture is not about 2x’s, returning half the fund vs. the whole fund on an investment makes a big difference (even thought it is an objectively great outcome in either case).
• The next best alternative question becomes much more complicated because LPs may have a wide variance. They are each different diversified asset managers and trying to please all of them is nearly impossible.

In either case, it comes down to the judgment of the GP on the future prospects of the business. As mentioned above, this is more difficult than it seems because the in-depth knowledge also comes with attachment and hopefully a healthy dose of optimism. That optimism is a requirement for any early stage investor - without it, you’d be crazy for ever getting involved in early stage venture.

Why is this so Difficult?

There are so many factors that influence exit strategy (aka harvesting). They include: tax optimizations like QSBS, pressure to deliver cash, macro market conditions, founder signals, and proprietary info, among others.

Our approach is to develop the methodologies and models to support a dynamic strategy. This means setting clear priorities and thresholds that allow you to remove the emotion from the decision in the moment, and then update those models and thresholds based on the latest market conditions and company prospects.

Another key aspect is managing personal expectations. The likelihood that you exit a position (public or private) at the local maximum price is very low, and it’s easy to get frustrated and self-criticize when you don’t. Instead, it is much more effective to remove the emotion, sit down and build out an exit plan early, try to stick to it, and focus on the wins.

One of the best known examples of this approach is Fred Wilson of USV consistently selling secondary in Coinbase. On the way up, people thought he was crazy for selling, but when all was said and done, he posted the highest total cash return of any investor on the cap table. And I believe this is case more often than not. Why? Because when things seem like they are headed in a really good direction is often when you’re already at the top. And this is extremely hard to judge because we are all human. It is far too easy to look at specific examples and let that guide decisions rather than focusing on building a method that will work across a variety of scenarios for the best total outcome over time.

I illustrated a sell-down strategy in my post here. This is not meant to be prescriptive, but if you don’t have a model in place, then when the question gets asked “do you want to sell secondary in this round?” you may not even know where to start and get caught up in the emotional loops that result in bad decisions, lost opportunities and regret. You ought to at least have a pre-existing framework to fall back on rather than just an instinctual response to an investment question, especially because the skillset here is very different from what got you into this great company in the first place.

Also a shout out to David Frankel, whose discussion on 20VC about distributing stock vs. cash post-IPO prompted me to think more deeply about this subject.