VC distribution system is (still) broken

March 9, 2012: 10:14 AM ET

Pandora distribution shows that VC interests remain unaligned.

Last January, I wrote that the VC distribution model was broken. The problem persists in 2012, and we've got a new example to prove the point.

On Tuesday, Internet radio company Pandora (P) announced quarterly earnings that fell well short of expectations. Shares plunged in aftermarket trading, and opened the next day down nearly 25%. And they still haven't recovered.

Just before earnings were announced, however, Pandora shareholder Walden Venture Capital chose to distribute 10% of its current holding to limited partners. And it marked its IRR to a prior trading average. Not certain if it was a 5-day or 10-day trading average, but either one would have been far higher than what LPs could actually get for their shares on the open market.

To be clear, the overall ROI for Walden VC investors on Pandora is still outstanding. Their cost basis is just 43 cents per share, and the stock's recent "lows" are still over $10 per share. Moreover, Walden VC previously did a pair of Pandora distributions that went in the opposite direction (i.e., shares rose post-distribution). And the firm still holds most of its position.

But none of that should obscure the distribution model's fundamental flaw: The alignment of interests is crooked, no matter if the artificial benefit accrues to the GP or the LP.

An obvious solution would be to distribute cash rather than stock – a strategy most LPs I speak with would prefer. But, if it must be stock, then GPs should stop using a trailing average to make their marks. Instead, take the 5 days prior to distribution and the 5 days post-distribution. Still not perfect, but certainly a marked improvement.

Get Dan's daily email newsletter on deals and deal-makers:

  • Cut Pandora some slack

    Let's slow the rush to judgment on this week's most controversial company.

    Pandora (P) has become the Internet stock that everyone loves to hate, just three days after going public. Here's a brief sampling of headlines from the past 24 hours:

    Pandora's pox
    Pandora IPO debacle
    Is the air escaping the tech bubble?
    Pandora finds another leg down

    Journalists obviously need to cover a stock's ebbs and flows, and analyze the underlying company (as I did MORE

    - Jun 17, 2011 2:47 PM ET
  • Did Morgan Stanley 'scam' its clients on Pandora?

    Pandora shares closed barely above their IPO price. Who's going to blame the bankers?

    Last month, Morgan Stanley (MS) was among those banks accused of intentionally under-pricing the LinkedIn (LNKD) IPO, as a way to generate easy returns for its wealthy clients. In case you forgot, here was the argument from Joe Nocera:

    "LinkedIn was scammed by its bankers. The fact that the stock more than doubled on its first day of trading — MORE

    - Jun 15, 2011 4:12 PM ET
  • Pandora tunes into huge IPO

    Pandora's IPO was a clear success, but does it signal static ahead?

    Update: Pandora began trading at $20 per share this morning, which gave the company an implied market cap of $3.19 billion. It briefly spiked to $24.99 per share, before settling into a trading grove of between $20 and $21 per share.

    Pandora, the Oakland-based Internet radio station, tonight raised nearly $235 million in an IPO that far exceeded expectations. And, MORE

    - Jun 14, 2011 7:20 PM ET
Current Issue
  • Give the gift of Fortune
  • Get the Fortune app
  • Subscribe
Powered by VIP.