I’m seeing more and more growth equity financings come to market with an over-sized component of the financing allocated to existing shareholder liquidity. I’ve seen enough of these transactions to consider it as a trend and to wonder what is motivating it.
Founder Liquidity in Context
Whereas liquidity isn’t typically a feature of venture financings, it is often – but not always – a feature of growth equity financings. A modicum of liquidity for key management team members or founders can act as lubricant for a growth equity investment, particularly where the management team founded and has successfully bootstrapped a successful business. The founder liquidity component of a financing can de-risk a management team’s personal balance sheets, enabling the team to rationalize the dilution and loss of control that are inherent in taking growth equity capital. So, how much liquidity is reasonable?
How Much Founder Liquidity Isn’t Too Much?
The answer depends on whether the management team wants to be part of the Company going forward. Presuming that management desires to be involved or is required to be involved, then it is reasonable for the founders to pursue an amount of liquidity that de-risks their personal balance sheets, subject to ownership considerations. I like to look at the specific use of proceeds for the founder liquidity component of a financing. A short list of good and reasonable uses of proceeds follows:
- Pay off the mortgage, second mortgage;
- Pay for kids college education; and
- Pay off credit card debt.
The logic behind this short list is that a management team member that doesn’t have to think about providing shelter or education to his/her family will be happier, more productive at work and able to dedicate the time, attention and effort to the business that is required of growth-stage entrepreneurs. A modicum of founder liquidity in the context of a true growth equity financing can serve the entrepreneur and investors well.
That said, the amount of liquidity that is reasonable must be measured in relation to the seller’s total ownership stake in the business. It is imperative that a management team member who is critical to the business’ ongoing success retain the majority of their ownership in the business. In some cases, this requirement may limit the amount of liquidity that can be made available. In general, I feel it is reasonable for a founding management team member to sell between 5% and 25% of their ownership stake in the context of a growth equity financing. If a founding management team member wants to sell more than 25% of their stake, one has to wonder how much the team believes in the business future.
If the founding team wants to sell more than 25% of their stake and a $ value that exceeds the de-risking level outlined above, the transaction may be best structured as a control transaction, rather than a classic growth equity investment. There is nothing wrong with a founder pursuing a full control sale; it just means that institutional growth equity firms aren’t the right target investors for the opportunity.
What is Driving the Drive Toward Liquidity?
As I said, recently I’ve seen more and more investment opportunities positioned as growth equity financings with unusually high founder liquidity requests. It is my sense that this trend is driven by increasing – and in some cases unrealistic – expectations on the part of founding management teams. More often than not, the unusually high liquidity requests are associated with opportunities represented by investment bankers. Perhaps there is some self-selection bias here – entrepreneurs who desire liquidity see the need to engage a banker. Or, perhaps the bankers – seeing a hot market – view founder liquidity as a way to increase deal-size and their transaction placement fee. I can’t say which – if either – of these dynamics is at work. My best guess is that both dynamics are factors and that they are mutually reinforcing.
For the most part, the market is remaining disciplined, at least in the segment and company size range where my firm, Meritage Funds, is operating. Regardless, the frequency with which I’m seeing unusually high requests for liquidity can’t be interpreted as anything other than hot market conditions exerting their influence on banker and seller expectations.
First Thing First
The focus of growth equity investments must, first and foremost, be on providing the company with adequate capital to execute an accelerated growth plan. Founder liquidity can be an important, albeit secondary, consideration in such a financing. The company’s capital needs come first.
(Cross-posted @ Non-Linear)