Should Venture Capitalist Sell Out To Secondary Firms?

Every once in a while, I read something and go "huh?"  The most recent was the report that 52.9% of venture capitalist think that VC is broken.

Per my post, I don’t think the model is broken and am disappointed in my colleagues who think it is. 

Today, I read another article about VC being broken in BusinessWeek.  The author believes that the VC model would work better if early-stage investors bought early and sold out to secondary funds before the companies ultimate exit.  He then argues these secondary investors make better board members of later-stage companies.  Huh?

This is absolutely the wrong thing to do.  It make no sense.  This why:

1. Secondary Buyers Never Pay Full Value for Shares.  I’ve seen a lot of secondary deals and even in the "named" transactions (Facebook,etc.) the secondary guys enter in a 50% discount to current value of the shares.  In other words, whatever value I’m carrying the investment at, I should expect to get 50 cents on the buck.  I understand the strategy from the secondaries and would do the same if I were them, but that certainly doesn’t help my return.  From an investor (my investors) standpoint, I’d always be selling for half of value;

2.  There Are Very Few Companies that Fit the Profile.  All of the author’s examples talk about the extreme outliers in VC investing, so at best this is an edge case scenario.  In most cases, the companies aren’t in a position to attract a secondary buyer as they are still too risky;

3. VCs Should Hold Their Winners.  The corollary for number 2, above is that VCs make a massively disproportionate amount of their returns from these Black Swans and to sell them early would depress overall VC returns.  As the model has been shown to work, one needs to hold their winners, not sell them too early; and

4. VCs Make Effective Board Members.  I don’t know all the secondary funds, but the ones that I do are financial engineers, not company runners.  I would agree that our specialty is early-stage counsel, but that doesn’t mean that we have nothing to add later in the equation and I’ve seen no evidence that secondary buyers have more to add than VCs. 

I applaud anyone thinking out of the box to improve the VC industry, as clearly I’m interested in VC success, but this is not the way to approach the problems.  Yes, some VCs are broken, but I still think the model works. 

  • Given that the majority of returns are driven by a small subset of winners, I don't understand how an early-stage VC can make market beating returns if they sell those winners prematurely. Unless the BusinessWeek author is suggesting that the VC can exit dogs at an inflated valuation early, but I don't think that is the argument.

    • Hey, if you can find me someone who will buy my failed investments then I’m very interested.  J

  • Definitely seems a bit backwards – sell your good investments (in many cases before realizing a possible change of control premium) and focus on your failed investments. Difficult market conditions always make everyone's head spin, there is not substitute for "hitting it out of the park".

    I also think that the business week author may be a bit skewed by the fact that he is an angel (not sure how active he is in the companies he funds) – although he does admit that he doesn't follow his own advice. I would contend that playing an active role on the board, building a great company, actually positions most VCs to be a great addition to the board not someone over their head.

  • I'm with Jason on this one. Tough exits at the moment are a sign of risk aversion by from a market in turmoil. Everybody faces similar issues. They are not uniqie to VC. I do not believe that VC is broken. In South Africa we have a far less liquid market that the US yet we remain optimistic that the market will recover and start-ups will play their part.
    I also believe VC has lots to offer on a board. We bring expertise specific to this stage of business. There is far less looking at spreadsheets and ratios and far more hands-on guiding of the business both operationally and strategically.

  • Scott

    Moving earlier stage makes some sense, but exiting to secondaries is just nonsense for 99% of investments.

  • Mark

    I agree with Jason, however, it is not unusual for a company wanting to go IPO to think about its balance sheet, management and board constitution prior to going public. What this typically might mean is an increase to the options pool to bring in new managers and board members or a "mezzanine round" to shore up the cash position. Both may have dilutitive effects but I don't think the VC selling out at such a discount is the right answer for either the company, its underwriters, prospective public shareholders or the VC.

  • I completely agree that prior to IPO a review of the board should be included.  I don’t think that VCs make particularly good public board members.

  • I don’t think that VCs make particularly good public board members.

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