For VC Investors, Illiquidity Is a Feature Not a Bug
Last week the firm I co-founded, Flybridge, announced that we had raised our latest set of funds ($150 million across a seed fund and an opportunities fund), crossed $1 billion in assets under management, and celebrated our 20-year anniversary.
These milestones for our firm come at a time when the market is reeling. Since November 2021, the NASDAQ is down 23%. According to Truist, the revenue multiple for “hypergrowth” public software companies (i.e., those with year over year revenue of > 25%) fell from 26x in November 2021 to 12x today.
As I was reflecting on these events over the weekend, it reminded me once again of one particular, subtle aspect of the venture capital model and what makes it so uniquely successful as an investment approach. The fact that VC is so dramatically illiquid — i.e., investors are unable to easily sell their private company positions and convert their holdings into cash — is a feature rather than a bug of our model.
Buy Low, Sell Never
Savvy investors have a maxim: “buy low, sell high”. As savvy as we aspire to be, venture capitalists are unable to execute on that maxim. We have shackles around our wrists when it comes to selling. Once we invest in a company, we are literally incapable of selling the private securities that we purchase — even if we wanted to — until one of two things happen: the company goes public (and then our ability to sell is restricted for six months after the IPO) or when a company sells in an M&A transaction.
The median age of a VC-backed company that achieves an IPO is ten years. That means for a VC’s most successful exit, they have no opportunities to sell that company for over ten years. In theory, that sounds like a terrible arrangement for investors. A public company investor would have the ability to make the decision to sell that security literally every second of every hour of each and every day for those ten years. Doesn’t Finance 101 teach us that options have value and that liquidity is a benefit, not a liability?
The Power of Waiting
But where these financial theories fall short is when we examine human psychology. For an investor to have the power to sell a particular stock from, say, $1 all the way to $100 — that is, to achieve a 100x return on their investment — and not execute on that power every minute of every hour of every day requires an inhumane amount of discipline.
The famous investor Howard Marks of Oaktree opined on this phenomenon recently in one of his periodic memos, Selling Out, where he notes that investors sell when assets go up because they want to lock in their gains (i.e., they’re nervous that the profits may go away) or they sell when assets go down because they’re worried that losses will compound — which is what appears to be happening right now in the stock market, particularly in tech.
As Charlie Munger of Berkshire Hathaway once said, “The big money is not in the buying or selling, but in the waiting.” VC investors are brilliant at waiting. Not because we are smarter than other investors but because we are structurally required to wait. We never stare at our portfolio and ask ourselves in our weekly partners meetings, “should we sell this stock?” Because we can’t. We literally don’t have a buy/sell decision to make. We have to keep holding on until the company either goes public or sells in an M&A transaction. Often for over a decade.
The Power Law
The reason waiting is so powerful for VC investing is that we don’t construct our portfolios in the same way that other investors do. We are not trying to minimize losses and have a good “batting average” of solid winners across the portfolio. Instead, we are all following the power law. We want a few companies to achieve ridiculously outsized returns.
As my partner Chip Hazard writes in his seminal blog series on VC investing, “The power law states that a small number of wildly successful investments drive overall returns for the industry.” Analyzing Cambridges Associates data, Chip concludes that “the top 10% of companies generated 57% of all returns.” Power law returns can result in 50x or even 100x gains.
The conclusion is obvious: if we sold those companies on the way up at, say, 5x or 10x, we would miss those unique power law opportunities to drive outsized returns.
MongoDB Case Study
As we examine Flybridge’s portfolio performance across our recent funds, we see this clear pattern. Our top-performing company in one of our older funds was MongoDB. The company was founded in 2007 and we co-led the series A in 2009 at a price of $0.66 per share. MongoDB went public in 2017. During those eight years, there were many ups and downs. The company had three CEOs. During these ups and downs, we were essentially frozen out from selling.
MongoDB went public in 2017 at $24 per share. We were locked up for six months and so were again unable to sell even though we had achieved a massive gain on our initial investment. At the six-month mark, we suddenly had the power to decide whether we should sell or not. Given the magnitude of that decision, it consumed our partners meetings. We elected to distribute roughly one-third of our stake at the six-month lock-up, one-third at twelve months, and one-third at eighteen months. Our final distribution was made at $145 per share which for that final distribution generated a return on our initial investment (we “doubled down” subsequently on the company in later rounds) of 212x. Note that we distributed shares to our investors rather than sold the stock because we believed so strongly in the company’s future.
If we had been more patient, we would have done even better. Today, even with the recent sell off, MongoDB is trading at $300 per share and at one point hit a maximum of $590 per share. Thus, because we had the power to sell — and executed that power — we missed the opportunity to generate another 2–4x and further compound our extraordinary gains.
And Then There’s Sequoia. Patient Sequoia.
Arguably the greatest VC firm in history, Sequoia, understands the power of waiting so much that they have decided to institutionalize it even further. By creating their evergreen structure, Sequoia declared “the 10-year fund cycle has become obsolete.” Even in their announcement, titled “Patient Capital for Building Enduring Companies” Sequoia emphasizes the power of waiting and wants to further tie their own hands to prevent themselves — and their limited partners — from selling too soon.
Sequoia was one of our co-investors in MongoDB. They sold after we did. The head of the firm, Roelof Botha, observes in an interview with Crunchbase, “if we believe that these companies have the ability to continue to grow faster than the market at large, we should hold on to the shares…It’s our duty to be more patient with distributions [i.e., sales].”
Today, we have another high-flying portfolio company that is valued at over 200x our cost basis. They are executing a private financing this quarter that should value it at over 400x. If I had to stare at a stock ticker every minute of every day and worry about whether the price was going up or down, I would lose my mind.
No wonder traders and hedgies are so high-strung. We venture capitalists, we just thank our lucky stars that our positions are so darn illiquid.