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Solving venture capital's distribution dilemma

October 19, 2012: 12:21 PM ET

For many VC firms, getting into a hot company is easier than getting out.

FORTUNE -- The venture capital industry has done a decent job this year of bringing companies to the public market, including successful IPOs for companies like Facebook (FB), Splunk (SPLK) and WorkDay (WDAY). But it has struggled to find the right balance when distributing shares to its own investors.

The most significant challenges have been around lock-ups, or the period of time after IPOs when insiders like VC firms are prohibited from selling their shares. Over and over, VC-backed companies have seen their share prices get decimated in the days leading up to lock-up expirations, with shorts anticipating volume spikes. But VCs have nonetheless continued to dump large blocks of shares, often marking their distribution prices to either the actual day of distribution or to a five- or 10-day trailing average leading up to distribution. This is a big problem for limited partners in VC funds, many of which are forced to immediately liquidate because they don't have equity trading desks. Even those who are able to hold the shares until they (hopefully) rise are forced to pay carried interest to the VC firms at artificially high prices.

There have been a few cases where VC firms have chosen not to sell -- such as with Yelp (YELP)'s investors, which squeezed the shorts -- but they have been exceptions to the rule.

VC firms have clearly heard the complaints, with one recently asking one of its investors to conduct a thorough analysis of trading activity surrounding lockup periods. The investor, Morgan Creek Capital Management, has shared its results with Fortune. It also believes that it may have found a novel solution.

First, the top-line results from the study, which included 115 companies that went public between Q1 2008 and Q2 2012 (excluding any that had fewer than 35 days of post-lockup performance):

* On average, there was a 6% decrease in share price from around 10 days prior to lockup expiration to the actual expiration date. More specifically, Morgan Creek pegged the prices to 90 days before lockup expiration – finding shares typically traded more than 4% higher 80 days before lockup expiration and more than 2% lower at the time of lockup. Shares then dropped another percentage point in the following 10 day period, before returning above par at around day 120:

Source: Morgan Creek Capital Management

• Morgan Creek attributes the volatility to increased buying by shorts prior to IPO. Worth noting, however, that shorts continue to increase their buying post-lockup expiration – perhaps expecting that the reduced share prices will force insiders to dump additional shares sooner than they otherwise planned. For example, look at the Facebook case study:

Source: Morgan Creek Capital Management

• For VCs seeking liquidity without screwing their LPs on distribution price, the data shows that the best post-distribution results come when issuers conduct secondary public offerings. Share prices tend to increase post-secondary, after falling just prior to the offering (yes, there could be some self-selection bias at work here). Only issue for VCs here is that distribution prices might come in artificially low, thus suggesting that firms should really use averages from both the pre-distribution and post-distribution time periods.

The overall point here is that it has become very difficult for VCs and LPs to align distribution prices.

Here's one solution: Morgan Creek is now willing to sign agreements with its GPs whereby the GP preemptively tells Morgan Creek the specific day on which it plans to distribute shares. And, by doing do, Morgan Creek can then form collar arrangements or short the shares, as it sees fit, in order to protect itself. Two caveats: (1) The GP must provide the date at least 45 days prior to distribution, (2) There is an escape clause for GPs, in the case of unexpected events that cause significant decreases to the share price.

Yes, such an arrangement sounds perilously close to insider trading. But, so far, Morgan Creek's lawyers have told them it's okay, as the information is not specific to the underlying company and because LPs aren't actual insiders.

A couple of the fund-of-funds GPs have already agreed to try it, and I could really see this becoming an industry standard. Well, again, so long as its legal...

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About This Author
Dan Primack
Dan Primack
Senior Editor, Fortune

Dan Primack joined Fortune.com in September 2010 to cover deals and dealmakers, from Wall Street to Sand Hill Road. Previously, Dan was an editor-at-large with Thomson Reuters, where he launched both peHUB.com and the peHUB Wire email service. In a past journalistic life, Dan ran a community paper in Roxbury, Massachusetts. He currently lives just outside of Boston.

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