A Graceful Exit – Managing Shareholder and Limited Partner Liquidity

“There’s a trick to the ‘graceful exit,’” Washington Post columnist Ellen Goodman once said.  “It begins with the vision to recognize when a job, a life stage, or a relationship is over – and let it go.” For the venture capital industry, such wisdom could not apply more. In our view, founders, management, and partners should manage the end of an investment or relationship as carefully as they do the beginning.

Most investors and companies invest significant time and energy in securing capital, hiring a CEO, or finding a strategic partner. But they devote considerably less to lining up the right shareholder or limited partner when they want to sell or leave a job. When an employee or other shareholder is looking to cash out, how are they treated? How does the exiting partner or management team member treat the company and remaining stakeholders? For whatever reason, most leavers simply want to move on; they give short shrift to the personal and professional benefits of maintaining relationships and connections. More often than not, the exit process is an afterthought or is seen as a waste of time.

But this is a mistake. Among other things, employee morale and business momentum can suffer when endings are less-than-happy. We are often contacted by frustrated former employees or other shareholders who get “stuck” holding shares they want to sell but who are prohibited from doing so. In some cases, the issuer in question has imposed an embargo on transfers. Or it may have simply decided against taking the steps necessary to understand and explore the secondary market.

In our experience, the most successful organizations and general partners treat “leavers” with a great deal of respect and understanding. There is no one-size-fits-all formula or process, but generally speaking, they try to exercise good and fair judgment, identify rationales behind decisions to leave, and understand how those who are exiting–and those who are not–might be affected.

They also seek to ensure that when ownership changes hands, it does not adversely impact the value of the business or other relationships. For many venture firms and funds, that knowledge can be hard to come by. However, our experience in addressing the inefficiencies in venture capital with flexible liquidity solutions has given us insights that can be helpful. Below we have outlined best practices in the two secondary markets in which we operate:

1. Venture funded growth company with exiting employees or shareholders who want to sell

• Get to know prospective secondary market buyers. Engage trustworthy shareholders who have a long-term orientation and who can add value to your business extending beyond their financial investment. Needless to say, references should be checked.
• Consider offering liquidity to all employees, not just senior managers or those who have left. While it undoubtedly makes sense to favor certain individuals, especially top talent, discrimination in regard to shareholder liquidity can have unintended consequences, including undermining firm-wide morale and incentivizing would-be stars to leave before their time.
• Engage your board of directors to ensure they approve of your liquidity approach. To avoid any unwelcome surprises, there should be an alignment of interests across all key constituencies throughout the sale process.  In certain situations, your board may have reasons or information you are not privy to that leads them to prohibit shareholder transfers.
• Assess how secondary activity will impact your 409A nonqualified deferred compensation plan. Will any particular sale be considered a market transaction that may factor into a future 409A valuation? How much impact will it have?
• Don’t allow “phantom” sales to take place. The last thing any firm needs to see is untracked or synthetic secondary transactions, whereby ownership is effectively pledged to another party under the table. They can complicate future sale or strategic efforts.
• Don’t sweep secondaries under the rug. Private companies take, on average, 6-10 years or more to reach IPO or M&A scale, which means that secondary market transactions will almost certainly occur in the latter years. A proactive approach helps ensure that the process remains under your control.

2. General partner managed investment fund where the limited partners are seeking liquidity

• Evaluate whether all shareholders should have access to liquidity. If so, you might want to consider running a structured tender process.
• Ensure that the interests of buyers are aligned with yours. What are, for example, their economic incentives, time horizons, and degree of commitment to your objectives and future success?
• Determine whether liquidity should only be offered to exiting LPs or if, in fact, the entire partnership should be given the same. With venture investments taking more time to achieve exits, we often come across 15 to 20-year old funds that are prime candidates for wholesale liquidity.
• Don’t hold LPs hostage. LPs have entrusted their investments to you, which means they deserve cooperation and support when it comes to the exit process. Consider giving them as much of your time as you did at the outset.

In sum, we believe venture-funded companies and venture funds should rethink priorities when it comes to liquidity. A little time and attention when shareholders are looking to sell can go a long way toward creating an atmosphere of trust and collaboration, not only with departing stakeholders but also with those who remain. While it may seem like a lost cause with respect to the former, it’s likely that the latter will see such efforts as a sign that they are making the right choice in sticking around.  Over the years, some of the most “graceful exits” we have witnessed, in Ellen Goodman’s terms, centered on the “belief that every exit line is an entry where we are moving up, rather than moving out.”