Getting Out is Tougher Than Getting In

One of the things you have to contemplate as a seed investor is how to get out of an investment.  There is a “liquidity premium” that investors have to pay.  You put money in, and it’s locked up.  But, because of that premium and the upfront risk you are taking, the return when it happens is generally very good and much higher than traditional stock market returns.  VC investing is beating the public markets pretty handily right now.  The public markets are on a tear too.  Data shows that VC funds outperformed the S&P 500 from 2003–2013 by 3–4 percent every year.

Still, you need to get out.

When I was trading, it was easy to get out.  You asked for a bid or offer and you hit it.  Not so in startups.  Because of a lot of factors, startups don’t IPO as quickly as they used to.  Seeing companies like Uber, Airbnb, Lyft, WeWork and others avoid public markets ought to be telling people something.  Sarbanes-Oxley is killing the IPO market.  So is Dodd-Frank.  It can take years to figure out the best route to go public which is why the new Uber CEO said they will go public in 18 to 36 months.

There is liquidity, but it’s big huge private equity funds and family offices buying stakes in companies at later stages.  That has become a viable exit for a lot of startup investors.  However, in term sheet documents there are always “change of control” clauses that limit the freedom of selling shares to new entities.  Generally, there is a right of first refusal with existing investors.

Sometimes you look at a startup and try and think strategically about exit.  If it’s targeting the banking sector, you might look at banks who have been acquisitive, or banks that might become acquisitive in order to compete.  You also look at outliers.  Some company that might want to enter the fray and will buy a startup in order to do that.  However, there is no sure and true path.  Speculating on exit is about is precise as macroeconomists predicting the future.

The key is finding an entrepreneur that can build a valuable company.

I saw this Fortune article on Netscape co-founder Jim Clark.  I thought what he had to say was spot on.  The whole article is worth reading, but I am pulling some quotes that I really like.

I also think companies stay private far too long. Microsoft went public after four years, the same year we did at Silicon Graphics. I think their market cap was under $100 million. Okay, maybe it’s risky for the public, but at least you give the public a chance to ride that out. 

Staying private robs the public of a chance at higher return.  We are penalizing people that cannot afford to participate in early rounds of funding because the IRS rules won’t let them.  That’s stopping people from having the chance to build wealth.

You’ve got to give employees liquidity. If you don’t, you’re holding them hostage. You basically have – you have slave labor. They’re tied to you, they can’t really sell the stock, and if they do they’re going to sell it at a discount, and it’s never a fair valuation because it’s all arbitrary and it’s all done in private. You’ve got to make a liquid public security to be fair to your employees, otherwise you’re just screwing them.

It’s not only the early investors, but the employees that have to earn a return.  They invest their human capital in the startup.  Many employees of companies like Uber are sitting on paper gains.  They also have huge tax complications from options they have received.

There are a bunch of unicorns out there, and arguably, they’ve gotten overinflated. You get to a point where the market isn’t going to pay what the private investors paid, so people are going to have to take a down round to go public.

This is why investing at seed and Series A is the way to play the game.