An investor's job is to deliver liquidity to their LPs, but knowing when to sell is the hard part.
Things can change quickly. Dramatic market shifts can cause drastic shifts in valuations and the paper value of a firm’s portfolio.
In this edition of Signature Block, we dive into a topic top of mind for many fund managers: Knowing when to sell a position in a portfolio company. This is one of the hardest parts of investing and can have a massive influence on a fund’s overall performance. As Fred Wilson points out in his post Selling:
Your returns will have as much to do with selling as buying. And buying is a fairly rational decision. Selling tends to be emotional. And that is why selling is the hardest part of investing.
This post goes into this hotly debated topic and includes details on liquidity options available for fund managers to consider.
If you only have a few minutes, here are some key takeaways:
- Selling doesn’t necessarily mean you don’t believe in the company. It’s even harder to decide to sell when you’re bullish on a company, but sometimes it’s wise to sell a portion of your position.
- It’s possible to sell in a manner that doesn’t hurt the long-term interests of the company. Founders often do not want their investors to sell as it creates operational overhead and potentially negative market signals. Having a strong relationship and alignment with the founders, management team, and the board may be necessary to close a deal.
- There is no right approach to knowing when to sell, but having an approach is important. Some fund managers have sell targets and others have less structured approaches, but having an approach to sell is a useful discipline to cultivate as a fund manager.
- Realizing returns is a fund manager’s fiduciary responsibility. Returns aren’t real until they are realized. Making good decisions on when and how much of an investment to exit is part of the job.
Approaches to selling
We collected perspectives from fund managers on how they approach selling, including their strategy on when to sell and their approach to doing so.
How Harry Stebbings @ 20VC approaches when to sell
Harry points out that making good decisions on when to sell is his fiduciary responsibility to LPs. He has a specific return target and how he approaches this for companies in varying spaces.
More from Harry:
For years we have been told the best investors lean into their best investments. The truth is the best lean out opportunistically along the way. There is a time to sell a portion of your stake as a manager with fiduciary responsibility. I lean towards selling 30-50%, returning a significant amount or all of my original fund in cash back to my LPs (have done this before) and then hold the position, retaining the upside.. Also depends on the space, in consumer and consumer social, advocate more aggressively for selling along the way. The hype cycle of consumer means heat and traction do not have the sustainability of enterprise ARR and so more weight placed on selling some portion earlier there.
How Hunter Walk @ Homebrew approaches when to sell
Hunter has one of the most systematic approaches we came across (he wrote about Homebrew’s approach in detail). Every time a portfolio company raises a round, they formulate an opinion on whether they’re “buyers” or “sellers”.
He also talks about the importance of acting in the best interest of the company and the best interest of your fund (and some don’t dos!), as well as how to proceed when that alignment breaks.
More from Hunter:
1. Every time a portfolio raises a new round we should be ‘buyers’ or ‘sellers’ — that’s not to say that we buy or sell into every round, but objectively we should want to be on one side of the table or the other. We should have an opinion, although one that’s informed by our own fund strategy. That is, we should be buyers or sellers as a concentrated early stage fund, not trying to say “well, if we were a growth fund what would be do.”
2. We should strive to execute decisions that are both in the best interest of the company -AND- in the best interest of Homebrew. I’ll caveat this below but we want to be protective of the longterm interests of the company, the CEO, and the coinvestors. You don’t try to reprice the company on your own. You don’t bring investors on to the cap table via a secondary transaction that are going to be problematic. And so on.
3. Pigs get fat but hogs get slaughtered. Even if we believe a company has tremendous longterm upside, it’s not inappropriate to take some money off the table in order to manage that risk. As we’re recently reminded, markets go down, not just up. Just be aware of the incentives, emotions, and other factors at play. It’s ok to behave one way before you hit your DPI target and another way after, but understand how those factors produce better or worse possible outcomes. This is also true with regards to recycling. If we can sell partially out of a position and put those proceeds into one that we believe has more incremental upside, that’s accretive to our results.
4. We’re aligned with the founders and the rest of the cap table until we aren’t. All the preferred stock is pari passu and behaving honorably in the best interest of the company? Great. The founders are taking some money off the table in secondary but still very much locked in on building and making funding decisions that are consistent with that? Great. In these cases there’s very little additional complication. But if this breaks, we need to reconsider how we think of our own positions. Not in darkness, but expressing concerns first and then doing the best version of what we can to treat the company fairly but also do our fiduciary interests for our LPs.
Tactically, the easiest way is to sell to another investor currently on the cap table or work with the company founders/execs to sell some of your shares into a structured secondary as part of a financing. Any time you need to sell without the company's consent or outside of a funding round you run into process, price discovery and relationship challenges. Not to say it's impossible, but complexity increases dramatically.
How Semil Shah @ Haystack approaches when to sell
Semil’s approach for exiting an investment is case-driven vs process-driven. His point about having a good relationship with the founder and the board is an important factor to consider: In order to give clearance to sell, the founder and board often need to believe that it won’t have a negative consequences for the company.
More from Semil:
We don’t have a explicit strategy for selling portfolio holdings but we have done about a handful of times, perhaps more than most small/new west coast seed funds. If we were to ever have a more detailed strategy (which is, of course, first dependent on continued success in being in strong companies), it would likely be modeled off of what USV has done, and what Fred and his team have written about before here.
How to sell is one of those VC truths that's much easier to pontificate over on Twitter than to actually execute on properly in real life. In order to get one of these done, the VC who wants to sell has to have a warm relationship with the founder, the board, and a broker/agent, as well as some arm-length's trust in the broker's client who will buy the shares, if it's not going back to an investor on the cap table. It's more than this -- the founder especially has to believe that your selling action won't raise red flags for other shareholders or create headlines.
How Sheel Mohnot @ BTV approaches when to sell
Sheel has a clear approach for determining when to exit an investment by targeting a specific fund multiple. He also touches on the importance of market timing. Liquidity is more likely to be available during bull markets, but returning capital to LPs in tougher markets creates more goodwill.
More from Sheel:
Generally once a position is worth 3x the fund sell 1/3rd to return 1x the fund (if there is liquidity). Also sell if you think the company is overvalued and you aren't very involved in the company anymore. Also market timing for LPs is nice – we recently sold our entire position in a company for 25x+ our initial stake and it felt REALLY great to return capital to investors in this [bear] market.
How to go about it: For the hot names you will get a bunch of inbound. Negotiate to get a price you like. For less hot names, just talk to the investors leading the next round and see if they want to add to their position. A lot of times they do and don't mind buying out earlier investors.
How Paige Craig @ Outlander Fund approaches when to sell
Paige has a detailed process for selling his positions. It starts with setting fund return goals. Like other good approaches we’ve seen, Craig evaluates the value of his portfolio quarterly to inform his decisions.
More from Paige:
I’ve been pretty systematic selling personal holdings and also generating liquidity for my venture funds. I have a pretty detailed process that begins at fund formation by setting fund return goals. We evaluate our FMV every quarter and we have a reasonable expectation of beating these return goals I build a theoretical returns analysis showing LPs how we can generate cash today and the trade-off against future IRR and multiples.
Alongside this process, we maintain an active dialogue with a couple of dozen secondary buyers and our head of ops maintains a list of verified buyers. When we decide to pursue liquidity we have a ready group of buyers.
Finally, we’ve been doing this consistently for the last decade and have a solid reputation for doing good deals and not selling buyers our garbage.
How Chad Byers @ Susa approaches when to sell
Chad has distinct approaches for portfolio private market liquidity and public market liquidity. For private market positions, they tend to hold their winners given the extent to which winners dominate returns in venture. Their approach for portfolio companies that have public-market liquidity events: sell 1/3rd immediately, 1/3rd after 6 months and 1/3rd up to their discretion.
More from Chad:
I've spent a huge amount of time trying to learn from the greats. The net: there is no 'right' model as you suggest, but certainly some models that make more sense to me.
Two types of liquidity:
1. Private shares (secondary or acquisition)
2. Public shares (either via IPO or acquisition)
For private shares, we have less of an official strategy. However, if we love a company, even if it's a huge position for us, we tend to hold (we subscribe to the model that in a power law business, hold the winners). If we feel we have a company that is overvalued but we aren't extremely long term bullish, we've done secondaries in the past which have been a good decision. However, the net for me on these is winner are the things that really drive the numbers. Being a 'trader' on the majority of your positions maybe change returns by .x of a fund, but unlikely to ever be a meaningful driver.
For public shares, we've landed on the following model:
• 1/3rd immediately (either first-day lockup expires or immediate on direct listing)
• 1/3rd 6 months after
• 1/3rd up to our discretion
Here’s why — The first third books your win. If you do seed, you likely have a huge position by the time you hold public shares. The second third allows the stock price to stabilize after the market has been hit with lots of supply from VCs doing distributions. The last third allows you to have an opinion on the stock/market — however, you can choose to distribute this third anytime, including alongside or after the previous thirds.
Deciding to sell alone is challenging. Actually executing a sale can be even harder. Fund managers can sell private positions to:
- Secondary brokers and marketplaces
- Secondary funds
- AngelList LP transfers
- Investors in following rounds
Below are the pros and cons of each option.
Secondary brokers and marketplaces
- Aggregation of demand in “one place”
- Useful for evaluating the market’s appetite and potential buy price
- Typically help with legal, compliance, and ops support to close the transaction
- Lack of transparency of who the buyer is initially (to ensure the broker isn’t cut out)
- Price discovery can be challenging outside of a funding round
- Fees charged for intermediating the transaction
- Need clearance from company
This is the best option if you have relationships with secondary funds and understand their investment criteria. 137 Ventures is an example.
- Lower fees as cuts out the middleman (e.g. brokers)
- These buyers often have an existing position in the company, making diligence and company approval easier
- Price discovery is challenging without multiple offers, especially when outside of a funding event
- Easier to complete when there’s a preexisting relationship with secondary funds
- Need clearance from company
Investors in following rounds
This is the best option when timing aligns with a funding event (more frequent in bull markets!).
- Pricing is set by the round, establishing clearer price discovery
- Easier to get clearance from the company as the buyer is already on the cap table
- Timing needs to align with a funding event
- Funding rounds are less frequent in tougher market conditions
AngelList LP transfers
This is the best option for funds (or SPVs) on AngelList that want to provide liquidity options to their LPs while continuing to benefit in the long-term upside. AngelList Transfers is relatively new (more info here).
- Buyers are qualified by AngelList after passing suitability and compliance requirements
- Smooth execution of the transfer with legal, compliance, and ops support provided
- Only available for funds and SPVs on the AngelList platform
- Transfers aren’t a fund or SPV liquidity event and do not count toward traditional DPI metrics
If you’re a fund manager, thinking of starting a fund, or just curious, subscribe to Signature Block if you haven’t already. If you think this might be useful for others, share on Twitter.
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