The IPO window may be opening, but for investors, getting liquid is still complicated

Venture capitalists and their financial backers may be feeling a skip in their step this week, following the recently successful IPOs of several tech companies, including the cloud software companies Nutanix, Apptio and Coupa Software. In fact, media outlets are already tallying up who’s going to make what off each of the deals.

If only it were so simple.

While there’s plenty of reason for the startup industry to be feeling a wave of optimism, it’s rarely so straightforward as it looks to exit a public company, and it may be even trickier today than in past years.

One primary reason is float. In recent years, more startups have been offering smaller batches of shares to test an uncertain market for tech offerings, as well as to drive up demand through some scarcity. These smaller floats seem to be having the desired effect, at least in the shorter term. But to keep a company’s share price from plummeting once their lock-up period has expired, VCs have to take more care than ever in making distributions to their own investors (or LPs).

“Most companies, even if they’re at a billion-dollar market cap, there’s no float these days, so you have to plan carefully, including selling in tranches,” says managing director Naveen Chadda of the venture firm Mayfield. “If you sell on day one, the stock will take hit, so exit planning is extremely important.”

As you may have noticed, LPs have also grown somewhat impatient. While they continue pouring money into venture firms, those same firms  — some of which hold stakes in more than a dozen so-called unicorns — are also under pressure to act quickly given the eye-catching paper returns LPs have been shown in recent years — and the real returns on which they’ve been waiting.

“Our LPs are very clear with us, which is they are paying us to manage private and not public money,” Marc Andreessen of Andreessen Horowitz told this editor at a recent event, explaining that for the most part, the idea is to pay back the firm’s investors and fast.

It can be a complicated dance. There’s that matter of price, for starters. While some of tech’s newest issuers are flying high at the moment, things can change quickly for a stock, as any public market investor can attest. Already, one analyst, Trip Chowdhry of Global Equities Research, has publicly suggested that Nutanix and Apptio will “be joining the previous junk IPOs” of Zynga, Groupon, and Twitter whose share prices haven’t held up over time.

VCs also have a different set of rules to abide by once their portfolio companies go public. “We look at it as our job to get the company to a point of liquidity, and once [its stock is public], we want to move out of that stock, says Brian O’Malley of Accel Partners. “But we want to do it in a measured pace and in coordination with the management team,” he says.

Often, such coordination centers on legal reasons. VCs on the boards on newly public portfolio companies face the same restrictions on buying and selling stock as any other insider with access to material nonpublic information. It’s highly rare that a VC gets accused of insider trading, but it’s also not unheard of. (In one high-profile case in 2002, famed investor John Doerr was named as a defendant in a class-action lawsuit over alleged insider trading, though the complaint against Doerr and his firm, Kleiner Perkins, was later dismissed.)

As stated in most limited partner agreements, it’s also up to venture firms’ discretion when to exit their position in a company, which can be both a luxury and a curse. During the go-go dot-com days when newly public companies routinely watched their stocks soar by several hundred percent, plenty of VCs made the choice to hang on to some of their position.

Partly because so many came to regret that decision, long-term positions in newly public companies is “the exception versus the rule” today, says O’Malley. At Accel, anyway, he says it would “take a pretty strong level of conviction by the deal sponsor” that there’s still a tremendous amount of upside in the shares. “It isn’t, ‘Could we can get another 20 percent more out of this?’ but, ‘There’s another 2x to 3x the opportunity from here.’”

Pay me my money down

Either way, if they’re lucky and the IPO market opens more widely, both VCs and their LPs may be staring down yet another issue soon, which is exactly how those LPs get paid — in cash or stock. It’s not a sexy topic, but it’s an issue that can sometimes endear a venture firm to its investors and, in worst case scenarios, alienate it from them.

Chris Douvos, a managing director with Venture Investment Associates — a fund of funds group that commits capital to venture capital, growth capital, and private equity groups – says the default position of most LPs is: “Give us our cash back.”

“Of all the places I’ve worked,” Douvos says, including Princeton University Investment Company – “it’s, ‘I want cash.’ The dogma among endowments has been to focus on blowing out of these positions as soon as possible.”

It’s understandable why. When a company goes public and enough of its venture investors distribute shares right after the company’s lock-up period expires, its share price tend to drop. That doesn’t impact the VCs, who get to calculate their carried interest based on the higher trading price before that drop, but LPs can be left with shares that are trading down owing to the increased inventory of that company’s securities.

That it’s not a bigger deal owes to the different preferences of different LPs. For example, Beezer Clarkson of Sapphire Ventures, who oversees a $400 million fund that has backed more than a dozen early-stage venture firms, agrees that cash is far preferable to most LPs, but she notes that there are certain LPs for whom stock is better. High-net-worth investors who want to better control their capital gains are one exception. Another are institutions that invest in public equities and already have in-house teams that manage public positions.

“Relative to the costs that may be incurred from [doing distributions] badly,” Douvos laments that LPs aren’t paying more attention to the issue. He calls stock distributions “a big pain in my ass.” But even Douvos seems more focused right now on whether the IPOs keep coming, which is a much bigger concern for all involved.

“I think we’ll see a number of good IPOs,” he says. “The quality of venture-backed companies is higher today than ever.” A challenge with every IPO window, he says, is “you get great companies initially and, over time, lower quality companies go out” that turn off public market investors.

The question is always how many companies get through before that happens. “If you ask VCs about their best companies, they’ll name almost all of them,” says Douvos. “But the markets won’t accommodate them all.”