Zombie Investments, Part II

Five to Seven Years, Give or Take a Decade or Two

This is the second of a two-part article on investments that refuse to die.  You can read the first part here: Zombie Investments, Part I

What We’d Do Differently Today

In Part I, we looked at a problem that has become increasingly familiar to angel investors: investments that don’t exit, don’t fail and simply remain in the portfolio year after year.

The Zombies.

After more than twenty years in angel investing, we’ve come to believe that the best way to deal with some of these investments may be to start thinking about the problem much earlier.

In other words, the best time to think about getting out may be before you get in.

Bring Back Redemption Rights

When we began our angel careers more than twenty years ago, redemption rights—sometimes called “puts”—were relatively common.

A redemption right requires the company, after a specified period, to repurchase an investor’s shares according to agreed-upon terms. For example, after five years an investor might have the right to require the company to repurchase the shares for the amount originally invested.

Over time, many angels stopped asking for them.

The argument was understandable: if a company hasn’t produced an exit after five years, what are the chances it will have enough cash available to buy out its investors?

Probably not very good.

But we’ve come to believe that’s not the whole point.

Even if the company can’t immediately honor a redemption right, having the right creates leverage. It forces a conversation. And that leverage may help investors negotiate a more favorable and timely outcome—particularly when the company has evolved into a lifestyle business whose founder has little incentive to pursue an exit.

In hindsight, we think redemption rights deserve a place in virtually every early-stage deal.

Information Rights Aren’t Much Good Unless You Use Them

Most companies are perfectly willing, at the time of an angel investment, to agree to provide investors with regular financial and operating information.

A surprising number eventually stop doing it.

Years later, that becomes a serious problem.

How do you decide whether an investment still has meaningful value when you don’t have current financial statements? How do you decide whether to continue waiting, sell the security, abandon it or pursue some other solution when you don’t really know how the business is performing?

We’ve changed our thinking about this, too.

Obtaining information rights isn’t enough.

Those rights need to be enforced.

Today, we’d make sure appropriate information rights were included in the original investment documents—and we’d start asking questions the first time the company was late providing the required information.

Investors have a right to receive it.

Equally important, management has an obligation to provide it.

Give Investors a Way Out

There’s another lesson we’ve learned from funds that live far beyond their expected expiration dates: investors who started together don’t necessarily want to finish together.

Some members may be perfectly comfortable waiting another five or ten years for the last investments to mature.

Others want finality.

We’ve had clients establish an auction process that creates a small internal market among fund members. Those who want out can sell their interests, typically at a discount to perceived value. Those who continue to believe in the portfolio—and have the patience to wait—can increase their positions.

The remaining investments may then be placed in a lower-cost SPV, reducing expenses for those who choose to stay.

It’s not a perfect solution. But it recognizes an important reality: after fifteen years, investors who started in exactly the same place may have very different objectives.

Start Asking a Different Question

Angel investors spend enormous amounts of time deciding which companies deserve our money.

We analyze management teams, markets and financial projections. We negotiate valuations and investment terms. We debate how large the company could become and imagine what a successful exit might look like.

Those are all important questions.

But experience suggests we should add another one:

What happens if we’re still here fifteen years from now?

That question should affect the terms we negotiate, the information we require and perhaps even the investments we’re willing to make.

Some companies will soar. Some will fail. Some will take far longer than anyone imagined.

And a few will inevitably become zombies—too alive to bury, but not alive enough to go anywhere.

We probably can’t prevent every zombie investment. But better terms going in, better information along the way and a willingness to plan for liquidity before we need it can make them considerably easier to manage.

After all, five to seven years is one thing.

Five to seven years, give or take a decade or two, is something else entirely.