VCs, the new liquidity providers

By Allan Leinwand

Some of my colleagues and I were talking about how the investing climate of venture capital has changed given the capital efficiencies of Web 2.0 companies. Web 2.0 companies can leverage open source software and commodity hardware to build very interesting businesses with limited capital required – often less than $500,000 total. Once these companies do prove to be interesting, they are quickly acquired by the big players in the space for both the technology and the team (the acquire-to-hire phenomenon).

So, how does a venture capitalist who wants to put multi-millions of dollars into a company put money to work in this environment? One method that seems to be getting more popular is to have the venture capital go toward providing liquidity for the founders (buying secondary shares). This method can serve multiple purposes:

1) It gives the venture investor the desired ownership;

2) It providers some liquidity to the founders who may be living on sweat equity; and

3) It aligns the financial interests of the company and investors.

An example might be an interesting startup company that we’d like to invest in that only requires $1 million of investment to become profitable. The founders of the company may value themselves at $7 million given their user adoption rate or revenue traction.

If we invested only $1 million we would own a small percentage (say 12.5 percent) of an $8 million post-money valuation. If we invested $3 million in the company we would own 30 percent of the company. We still inject $1 million into the company to get it to profitability, but the other $2 million of investment goes to the founders to buy 17.5% of ownership.

So, we get the ownership we desire, the founders get liquidity (while still retaining an interesting ownership percentage) and we achieve alignment between the venture investors and company to build a successful business.

This investment strategy assumes that the founders of the company understand the balance between greed and fear. If they are absolutely convinced that they have a home run, then greed takes over and there is no price that can allow venture capital to buy ownership. While some venture capitalists think this investment strategy has its perils, we are seeing it as a potential way to invest in capital-efficient companies with compelling business models.

What do you think – would you sell off a portion of your company for some liquidity or does greed overpower fear these days?

Allan Leinwand is a venture partner with Panorama Capital and founder of Vyatta. He was also the CTO of Digital Island.