Liquidity Solutions For Your Venture Portfolio

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When entrepreneurs sell their business, one of the key areas of interest tends to be direct venture investments. The reasons are plentiful, ranging from a desire to back the next generation of innovative companies, to ‘giving back’ the knowledge and money that they perhaps received from their early backers, to hoping to benefit from some of the eye-watering outcomes of the recent decades (Uber, Airbnb, and similar). Getting started with such direct investments is worthy of far more than one post (as I had tried to do in a two-part introduction to venture capital last year - see Part 1 and Part 2). But one key thing that every (aspiring) venture investor should know: Venture capital is a very long-term asset class.

First, there’s the best-performing companies - your outliers, your unicorns. They tend to stay private for longer and longer, locking up most of an investor’s gains in a concentrated position. Of course, such an outcome is not something to complain about - maybe you’re happy to avoid reinvestment risk. But at some point, you might also want to take some money off the table.

Then there’s the underdiscussed middle-to-right part of the return distributions. It is the companies that do well, but are no outliers - the companies that become profitable, avoiding the need for future priced rounds. With no secondary or exit in sight, investors face the danger of getting stuck with paper gains that long to be realized.

And lastly, there’s the adverse outcomes: companies that don’t reach an exit but default somewhere along the journey, yielding no or little return to the investors. Those are not the outcomes that drive your return - but if you’d expect up to half of your companies to default, every cent you can recover over a full write-off might be meaningful.

In our daily conversations, many business angels complain about those liquidity-related matters. In a time like today without an active M&A environment and a closed IPO window, they take it for granted that liquidity might be rare to come by. After all, as a small angel investor, it’s unlikely that you can force a full-on exit.

But there’s a number of ways where you can take your destiny into your own hands. Let’s tackle a few uncommon approaches to creating liquidity in your venture portfolio.

Secondaries

Admittedly, secondaries are probably the most common toolkit in the angel investor liquidity playbook. Unlike funds that have to deal with the signaling risk that might come from selling out of a company before an eventual exit, angels are sometimes even welcome to sell to allow for new and/or institutional investors to increase their stakes without further dilution.

If you’re an active angel, you likely know about secondaries already, or might’ve even been proactively asked by the founder of one of your winning start-ups whether you want to sell some of your shares. But how about facilitating a secondary in the absence of a proactive request by the founder? In my experience, it’s something that surprisingly few angels think about.

Of course, a secondary might not always be an option. Let’s think about the aforementioned three categories of outperformers, stable performers and underperformers:

• For underperformers, secondaries are unlikely. Unless you want to sell your share for a symbolic dollar and/or a debtor warrant (Besserungsschein), it’s not worth spending time on.
  

• For outperformers, the secondary might come by itself. In the case of a well-performing company, we were often contacted by the founders and/or new investors whether we wanted to sell some of our shares, often at small discounts or even at the price of the prior round.
  

• For the stable performers, the work to facilitate a secondary might pay off. They are often companies that manage to raise decent financing rounds (although they might take longer), and where the founders or investors might not proactively suggest secondaries. But it’s exactly there where I see the underutilized path to liquidity.

Perhaps it’s obvious, but to achieve a secondary, you need to know that your stable performer is raising a round in the first place. You might be getting regular investor updates, but fundraising might be more of an ongoing and less of a rapid process as you’d see for an outperformer. If you know you are looking for liquidity, it might pay off to stay on top of the companies where you’d consider (partially) divesting your stake. Once the round is closed, an investor might be less willing to put more money on the table for a secondary until they’ve seen their initial investment reach certain proof points.

Of course, even if you know of a round, there’s no guarantee that the investors in a financing round (where secondaries are most likely to happen) want to buy your share. But if the founder knows that you are looking to sell, you might even do them a favor: After all, if they are not the highest-flying company, being able to offer a new investor the ‘sweetener’ of decreasing their average entry price through an additional secondary transaction (at a discount) might even help their chances of closing a round. But be mindful - if you really want or even need liquidity, you need to find the right line between delegating to the founder (i.e. giving them some degree of control at which price they offer your secondary) and staying in control (some founders want to have no responsibility whatsoever in spending time to market your secondary from which they have no benefit).

Lastly, a word of warning: Make sure that your desire for liquidity doesn’t actually harm the company. Unless you have a valid reason (i.e. you need to sell your shares for a restructuring of your holding company, the portfolio company is ‘non-core’ to your long-term strategy, etc.), aggressively selling all of your stake might raise some red flags in the company’s financing process. 

Buybacks

Buybacks are a less common, but still relevant exit path for an angel investor. 

Typically, buybacks take place in the context of a Management Buy-Out (MBO). In an MBO, founders/management buy back a company from their investors, often through the use of some form of structured financing (debt, earn-outs, seller notes, etc.). Since structured financing helps to stretch the desired payout to investors over a timeframe and/or to tie some of the value to the company’s performance, they typically imply that the company is an outperformer or stable performer. (Buybacks can also be a form of liquidation - more on that in the next section.)

How does a buyback come to be? There’s a few variants: It could be that founders have had enough of institutional investors and their need for an eventual exit, and want to buy back their shares. It could be that a larger investor requires liquidity (i.e. end of fund term) and is willing to find an amicable solution instead of a lengthy, structured exit process. Or the founders raised a large round in the past but pivoted away from a venture-appropriate business case, choosing to return capital to investors through a buyback while continuing to run their business.

So as in our prior section - how can you facilitate a buyback?

You could see it as a secondary. Especially for a profitable start-up, slowly buying back some (preferred) shares from investors at a fair price can be a great use of funds. Here, you would handle it like a secondary, talking to the founder whether a buyback is an option from them, either in context of a financing round or as a stand-alone transaction.

Or you could proactively suggest it to the founders as a strategic option. 

To give a practical example: In one of my family office jobs, we had a portfolio company that was clearly a ‘stable performer’. We had invested at a reasonable valuation, and they had used investor funds to come to high six / low seven figures of annual profit. However, growth had been limited, and the company was based in an industry that had become somewhat out of favor. Despite their profitability and investor input, they had also been very careful in terms of trying out new strategic paths.

In terms of strategic options, the founders had only ever considered another financing round or a full exit. But they had never thought about a buyback, and they turned out to be very open to it: While an exit seemed unlikely given the state of their industry, using cash on hand (that was only earning low figures of interest) to buy out investors at a fair multiple seemed like a great use of funds - while also coming with the ‘benefit’ of giving them full control of the company and their future. Through a bit of structured financing (partial seller note), we were able to quickly close the deal. The result: a win-win for both sides.

As with the secondary, two final remarks. 

First, know that you can’t force a buyback. Especially if the company doesn’t have the means (cash/profitability) for it, a buyback is unlikely to succeed and thus not a good use of time. 

Second, be realistic about pricing. Buybacks are often done on the basis of financial metrics (i.e. multiple of earnings) instead of the forward-looking multiples in the venture world. Or they might even just be based on a gut feeling - for the aforementioned deal, we simply settled on a multiple of our investment that felt fair to both sides.

Liquidations

Lastly, let’s look for some liquidity in the least likely of places: Among your underperformers.

Unfortunately, failure is a frequent occurrence in venture. While some fail in a spectacular manner (see WeCrashed, Bad Blood or Pyramid of Lies), the majority of companies see a quiet demise in insolvency or liquidation.

First, insolvencies. Companies either run out of money or know for certain that they won’t raise another round, filing for insolvency to allow for an orderly liquidation. In very few cases, insolvencies allow for outcomes that yield above-zero returns to investors, i.e. by selling off hard assets or IP, or even finding an acquirer looking to make a good deal. But especially in the case of early-stage start-ups, positive outcomes are very rare: Companies go into insolvency with unpaid debts, little marketable IP and few hard assets, and after paying the liquidator, there’s usually nothing left to be distributed to equityholders. Unless you want to go out and try to sell a soon-to-fail business from your portfolio at cents on the dollar, spending time here is likely not worth the effort.

Second, liquidations. In a typical liquidation, founders have runway left but realize that their business model won’t work out as intended (i.e. too many barriers, economics end up being different from expectation, etc.).Trying a new idea might require additional capital, but it is often easier to restart without any burdens of a prior business model - so they decide to simply wind down the company. 

Liquidations are more interesting, because I’d view their nature similar to buybacks. If a company is about to crash and burn because they spent too much money, there’s likely also little chance of recovery. Things are more interesting in the case of companies that are subject to fundamental (adverse) change in their business model.

Once again, a story from my professional career: One of my earliest VC investments was into a company looking to build an app in a promising niche. We invested in their angel round, and the founders really did their best (with very low salaries) to grow the company. However, along the way, they realized that the niche was not seeing the growth that we were all expecting - and we were left with a consumer app that was generating four- to five-figure profits every month. After team costs, the company was just slightly loss-making, extending their runway significantly. However, with little cash in the bank, a pivot to another model also seemed unlikely without new funding.

One variant could’ve been to simply run the company for a few more months to see if they could find a path to growth. For all parties involved, it seemed more likely that we’d just postpone a likely insolvency. So instead, we suggested a liquidation of a different kind. The founders settled our outstanding convertible notes for around 20 cents on the dollar, allowing them to retain the company and app that could provide them with a bit of ongoing income. Another win-win, given the circumstances.

While forcing a liquidation is not something you should do as a business angel with a minority investment, I think that teaming up with investors to push the option can be the appropriate thing to do. Especially when founders are clearly stuck and just postponing the inevitable, telling them that you as an investor are okay with an orderly winddown might even be a relief to them.

Remember the Power Law

As you can imagine, I am all for thinking about proactive liquidity solutions for your venture portfolio. Just as you are unlikely to change in your nature as an investor, founders and companies can be equally set in their ways - so if it becomes clear a few years in that a company is unlikely to go from underperformer  to stable performer or stable performer to outperformer, thinking about exit options is a valid way to go.

But it’s equally important to not focus on liquidity too much. After all, venture returns aren’t driven by downside protection (although that can provide some returns, as I shared in a Sifted article last year). They are, and will always be driven by the Power Law, or more precisely, those few winners producing eye-watering, double-digit return multiples.

And that’s where all of the three options can be dangerous to your returns. Venture is a game of optionality, and as long as a company is in business, they might still find the right business model and/or might make the right pivot that might put them on a path of rapid, exponential growth. Selling out of a winning company at a 20x multiple less than 5 years in might produce a fantastic IRR, but if you’ve diversified across 30-40 companies, you returned just half of your investments. Waiting another few years to get from 20x to 40x to 80x is what could move the needle to a fund returner.

So as with everything in life: Think wisely about your liquidity options. After all, venture capital is a long-term game - so be prepared for long-term illiquidity. If you did it right, it’ll likely pay off.

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