Liquidity strategies – it’s all in the exit – NOT
One of the most common axioms of angel investing is that extraordinarily high rates of return are required to offset the high risk associated with any portfolio of investments in start-ups. The Angel Capital Association overview of angel investing points out that eight out of ten angel investments are likely to fail.
However, if we take time to dig a little deeper, it turns out that the actual failure rate in angel portfolios is dramatically lower depending upon the study you read. The radical disparity in these views lies in understanding of what we mean by “failure”. Failure to venture funds means not being able to make distributions to the funds investment partners on a given timetable, typically around ten years. If a company is still alive, maybe even growing, but is not a target for acquisition nor big enough to go public, it’s shares are not suitable to distribute to the funds investors.
This problem is so common the companies are frequently referred to as the walking or living dead. But they are not dead and finding a way to create liquidity for these holdings has a dramatic impact on the overall return to the investors.
The solution is to provide means for liquidity to the investors for positions in these portfolio companies.
Here are three simple ideas that can have a profound impact on angel investing by providing liquidity:
1. Create liquidity for founders and investors by ending the culture of “it all stays in until the exit”. This point is simple. Much of the illiquidity in angel portfolios is self created by an unspoken by widely enforced rule that all money remains in the company. This idea is derived from the concern for adequate funding for the company. Money spent buying existing shareholders shares does not provide any capital to the company but by allowing some portion of each round, say 15%, to be spent buying shares or notes from founders or other angels would likely create far more investors going forward and provides a way to ease-out founders that no longer fit in.
2. Convert back to a note at some pre-defined date, say five years into the deal. BWA uses this kind of put with a 3.7x on paid in capital after five years which amounts to a 30% annual rate of return. The note is a fixed principal repayment with a predefined rate. This allows both parties to have a predefined exit option from the beginning.
3. Explore the emerging private exchanges and encourage share trades amongst existing investors.