Thoughts on distribution strategy and CEO/firm misalignment

Much has been written about how to start a venture firm, how to raise money from LPs, how to build one’s product and reputation and how to invest. Precious little has been written about how to return value to LPs and the venture firm/CEO dynamics associated with this process. This is one of those areas that while there isn’t a “right” answer, I believe the question subjects itself to a rigorous thought process and decision trees that are well-articulated and robustly debated. I recently shared some thoughts on the topic.

And I later added some more nuanced observations on the possibility of CEO/firm misalignment.

I am not going to cover the same ground as I did on Twitter, but to perhaps add some depth to the thought process and to posit some of the factors early stage venture managers should consider when deciding how to best distribute value to LPs.

Let me start with the following qualification: I am writing from the perspective of a seed stage investor who is seeking to return value to LPs. This necessarily means that we’ve been invested in a company for, say, 7–10 years, and that our LPs are investing in us for our very early conviction and company-building skill in partnership with formidable founders and their teams, not our public market decision-making. This is very different than the multi-stage or growth stage firms, where a meaningful amount of their returns can and are expected to be garnered post-IPO and where they kind of have to be given their fund sizes. We aren’t subject to such pressures of scale — our pressures are somewhat different: picking great founders, products and markets with scant data. This is our job. Managing a public stock portfolio is not.

Until September 2016 our firm had demonstrated a measure of founder, product and market-picking skill, done so at the seed stage and in a manner that enabled us to own significant stakes in each of our lead-managed investments. But it wasn’t until the IPO of The Trade Desk (TTD) that our achievements were objectively recognizable at scale and represented an unusual opportunity for us as a firm and as a partnership in one fell swoop. It would validate our ability to help take a company from PowerPoint-to-IPO. It would highlight our ability to see value in a seemingly crowded market by backing a great founder with a keen vision for turning a category on its head. And, from our duty as stewards of LP capital, it would crystallize our ability to deliver extraordinary realized returns to our investors who had confidence and belief in our approach and skill as seed stage venture investors. Firm implications. Fund implications. Partner implications. There are a lot of factors we had to consider when thinking about how to take this now-public stock and to put actual value in our investors hands.

Had we demonstrated success as a firm?

Had we generated an attractive return in the fund?

Do our LPs care about timely distributions?

And this is all separate from our specific view of the stock’s value at IPO, but that certainly was a variable in how we thought about the timing of our realizations. Another reality is that at the time TTD went public, IA owned 17% of the company. The good news is that we had generated a ton of value. The bad news is that (a) I sat on the Board which rendered IA an affiliate under Rule 144, sharply limiting our ability to exit the stock freely in the public markets, (b) even without my sitting on the Board IA would still have been deemed an affiliate because of the magnitude of our ownership (and, therefore, the ability to exert control). So the goal here was to intersect and optimize three distinct variables:

Value;

Speed; and

Certainty.

With an IPO priced at $18 and valuing the company at ~$800 million, we did not believe this represented the underlying value for the business. Remember, “Adtech” was a dirty word with the road littered with carcasses of companies that had been public market darlings until they weren’t, so there was a big implied discount even in light of their spectacular growth rate, attractive margins, and business model defensibility. So we elected to not participate in the IPO. But as I mentioned in my Twitter-spew, we had negotiated two demand registrations that gave us a bunch of flexibility to navigate around the three variables above.

Our initial plan was to (a) realize better value than the IPO price, while (b) being able to move a large block of stock without hurting the price, in service of (c) increasing the stock’s free float to make subsequent trading more efficient for everyone, while (d) returning a significant amount of capital to IA Fund I investors. The post-IPO stock price movement validated this approach, and within a few months of IPO we were able to use our first demand registration to sell approximately half of our position at $36 per share. There is no way we could have moved 9% of the company any other way, and this enabled us to return 1.5x net to our Fund I investors while sharply reducing the overhang of IA’s massive shareholding. We felt this was a great “initial win” that was a truly firm defining moment. We had been around when the first lines of code were written all the way to a $1bn+ exit. IA had “made it”.

Our plan for the remaining stock was to look for opportunities during open windows post-earnings to sell down or distribute over a 12 month period. The stock had run so far, so fast that we didn’t really think we’d be able to garner massive incremental value on a per share basis, and we were worried about the rapidly changing political climate and the implications for the financial markets and stock prices. Yet when TTD reported its first earnings as a public company, the stock rocketed up to a level more than 50% from where we had used our first demand registration. It was trading in the mid-upper $50s and crossed $2bn in market cap. Even with the political turmoil, the company just continued to appreciate. At this price, more than 3x the IPO price within a handful of months, we felt compelled to use our second demand and to move another big chunk of stock. While this wasn’t reflective of our long term view of the business, we did feel that we owed it to our investors and the future of the firm to solidify a top-returning Fund I and to de-risk both the fund and the franchise. And so we moved another 7%+ of the company at $52, enabling us to return 4.5x net to investors while still holding on to 1–2% of the company. The feeling of getting this done and sending all this money back to our investors was indescribable. We felt so incredibly validated and so proud, as well as so excited for the good things that our investors were going to do with their proceeds.

But there was one big issue with all this which we hadn’t fully internalized until it happened: the misalignment between the company’s CEO and the early stage investor around the IPO, before, during and after.

Think about this. We back a founder and their vision within months of the company being formed. We invest over multiple rounds and build a deep, multi-year relationship with the founder and the team, invariably going through tremendous struggles and near-death experiences before coming out the other end with an exciting, valuable, high growth business. Then years go by and the company has achieved IPO scale. We as seed stage investors would like to get an exit at some point within, say, 7–10 years, while founders might intend to run the company forever. So when a company has achieved IPO scale, and especially when the company in question doesn’t need money (as TTD did not — they generated mounds of cash and truly built the business on $8m in capital), what’s the motivation for the founder supporting a public exit? Some CEOs embrace it, others don’t. And when there is a public/private market arbitrage (meaning that while there is abundant capital for private secondaries, I’d argue that the pricing isn’t a true proxy for a public market security, as you’re able to access a much broader array of investors in a public format than otherwise), it can lead to tense discussions where nary friction had been experienced in the prevailing 5, 7, 10 years.

In TTD’s case the CEO did want to take the company public, which made things easier. However, when it came to strategies for turning our stock into distributable proceeds, tensions arose. Ultimately we used our contractual right and exercised our second demand registration, but it created a rift that was the result of our misaligned timing and goals. We did what we believed was truly best for our LPs (massive net cash returns), our business (securing a top decile first fund as well as our brand and reputation) and the company (removing the largest source of overhang in an organized manner through a registered offering in conjunction with the company), but the CEO didn’t want us to do it when we did, and therein lies the rub. And regardless of whether or not we were “right”, e.g., we got what we wanted and the stock continued to climb after the IA overhang was substantially removed, when disagreements between partners go to the legal documents you know that things are in a bad place. And while I wouldn’t have made different decisions, I would have sought to game out future scenarios much more thoroughly and discussed this at length with the CEO such that our decision to use the second demand wasn’t made under such a compressed time frame. This is perhaps the biggest learning of this episode and something which we aspire to process with our pre-IPO CEOs much more fully than we did in this circumstance.

To wrap up the TTD story, we distributed the remainder of our stock at much higher prices over the subsequent two years, delivering ~6x net to investors on this position. Our average exit value was $2.25b versus an IPO value of $800m, roughly a 3x from the initial decision not to sell in the offering. It was a fund and franchise-making investment that changed everything for IA. Do you know where TTD is trading today? Over $28b. Yes, you got that right — 35x the IPO price over a 4 year period! The company is a truly generational company and public investors have been rewarded handsomely for backing the CEO and the team. Truth be told, we don’t lose any sleep over this reality as we did our job and did it well. We’re not paid to hold public market stock for long periods, and investors who wanted to hold onto the shares we distributed were able to do so. I did.

So how do we think about LP liquidity going forward? Because of TTD and DDOG in particular, IA Fund I will be a 10x net fund. This has given us a few things that we lacked heading into the TTD IPO:

1. Fund I is a generational fund and “made” the firm.
2. Fund I demonstrated that we can identify, help build and exit great, category defining companies.
3. Fund I put enormous gains in LPs accounts, giving us a lot of latitude in how we think about the timing of realizing value in the future.
4. Fund I showed us the importance of building a great LP base that trusts us, is aligned with how we manage the business and is focused on long-term value creation and not short-term distributions.
5. Now that IA is viewed as a serious firm, we can focus on optimizing value for LPs without concern for “proving ourselves” .

All of this means that in subsequent IPO circumstances, we can truly analyze our exit parameters much as we assess our follow on investment decisions: what is the risk/reward of specific investment at this particular time and how does it fit with our portfolio? This gets to issues of value, timing and position concentration. We don’t view post-IPO exit decisions any differently than we view opportunities for secondary sales. They follow the same decision rubric, irrespective of whether the exit is to public or private market investors.

One final take-away that really impacts our thinking about future exits is this:

TTD at $28b? DDOG at $34b? My brain couldn’t comprehend the power of these models or how the market would come to value them. And when we look across a bunch of our other companies, they have some similar characteristics that would lead us to believe that they could compound value at extraordinary rates over a long period of time. So perhaps massive registered secondaries won’t be the exit mechanism of choice in the future, but steady stock distributions to smooth our exit proceeds and exit valuation. We’re not sure. Circumstances will dictate. But one word of advice: be early and communicate often with your CEOs about your plans. While they invariably will change, gaming out different scenarios and how it might impact your firm’s exit behavior will save you stress, anxiety and perhaps a long-term relationship.