Pandora

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.

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