Detail of VC Distributions: Who Gets the Money in a Startup Investment?
“Venture Capital is about capturing value between the startup phase and the public company phase” — Fred Wilson, Union Square Ventures
All Venture Capital funds seek that the companies in their portfolio have a liquidity event to be able to perceive the real returns of their portfolios. The investors of the VC funds, the Limited Partners, are aware of the life horizon of their investments, since in an average fund the period of exits occurs between year 5 and 10 of the investment vehicle, and they generally seek returns that are above the industry average, and preferably in the first quartile. Usually, Limited Partners expect a return on their investment of 3 times the committed capital (Cash on Cash) and at least 25% internal rate of return after 10 years, to consider their investment successful.
Different types of distributions
Even though these returns are very attractive to investors, sometimes LP’s are not entirely satisfied at the time of receiving the distributions, because despite the fact that the capital that is committed at the beginning of the life of the fund is in cash, distributions to Limited Partners can be made through cash or shares. Cash distributions are carried out when the startup pays dividends to Venture Capital funds, has a liquidity event through an M&A, when the Venture Capital fund sells its equity stake in the secondary market, or when the startup is listed on a stock exchange and the VC subsequently sells its shares to make cash distributions.
The payment of dividends from a startup to its investors is something atypical; however, when Private Equity funds participate throughout the growth of the startup, they can implement recapitalization and dividend payment strategies in order to reduce the risk of the investment and increase its effective return. M&A is the preferred exit strategy for investors. A strategic financial buyer usually acquires all the shares of the target, for this, the majority of investors must give their affirmative vote to carry out this transaction. On other occasions, investors who enter the very early stages of startups and achieve a significant return, participate in the secondary market to ensure their profits, selling part or all their participation to other investors with a different vision of risk and investment horizon. After hitting a record USD$85bn in 2019, secondary market volume dropped to USD$61bn in 2020, representing 27.7% decrease YoY. The IPO is another of the preferred exit strategies for entrepreneurs, since they list the company in a public market providing liquidity to investors with the opportunity to have a partial or total exit, and the possibility of retaining a shareholding with long-term vision. There were 480 IPOs on the US stock market in 2020, an all-time record and 106% more than the number of IPOs in 2019, which was 232.
Usually, cash distributions are the preferred mechanism for fund managers and Limited Partners, as it provides immediate liquidity to investors. In addition, the valuation of the startup is defined, which simplifies the calculations of the financial profitability of the investment and the carry earned by the fund manager.
Some drawbacks to receiving the cash out distribution could be the potential loss when you stop earning more due to a potential investment appreciation. When the exit is very early in the investment cycle of the fund, you run the risk of not being able to reinvest this capital or, to reinvest it at a lower return.
Another type of output can be distribution through shares. From 25% to 33% of the distributions in Venture Capital will be made underthese terms (Dan Primack, 2011). This condition occurs when there is an IPO and the Venture Capital funds, after the lock-up period, distribute the shares to their Limited Partners. Another form of exit is through the popular SPAC; this is, a capitalized vehicle listed on a stock exchange that acquires a startup, performs a reverse merger, and in this way the startup is listed on the stock market. They have the possibility to sell them on the secondary market or to hold their position while waiting for capital appreciation. Sometimes M&A transactions are not for cash but for stock exchange; which could lead fund managers to distribute shares to their LPs.
One of the advantages of this strategy is that it allows LPs to have a potential capital appreciation and a greater return on their investment. However, it is also exposed to the deterioration of the startup and a potential depreciation in the price of the share, as happened with the investors who had received WeWork shares. Another disadvantage of stock distributions is the difficulty in calculating the carry for the GP, therefore, it is considered a 5 to 15 day moving average after the initial listing to hedge against the potential volatility of the stock the first trading days.
Startup exit mechanisms are varied, with each impacting differently on how fund managers distribute capital gains to their investors. But, und Managers will always be motivated to maximize the value of their investment, and to have liquidity events that favor the interests of all those involved in the partnership.
Hector Shibata. Director of Investments & Portfolio at ACV a global Corporate Venture Capital (CVC) fund and Adjunct Professor for Entrepreneurial Finance.
Gonzalo Soriano. VC Investor at ACV.
ACV is an international Corporate Venture Capital (CVC) fund investing globally in Startups & VC funds.
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