E260: How Founders Access Liquidity in Pre-IPO Companies

0:00You have a unique background. You come from a fourth generation real estate family. How did the global financial crisis both affect you as an individual and as an investor? And how did that affect how you are today? Oh, man. I mean, that's a whole lot to cover, but it does really inform kind of who I am and what we did. I mean, I actually graduated college in 2009. So kind of the worst year to graduate college in probably a couple of decades. Um, you know, my family's background is real estate. We did real estate for four generations. We actually were lucky enough to sell a real estate portfolio in 2007, late 2007, right before the real estate market blew up.

0:40And that really allowed us to get a lot of liquidity and actually my immediate family to kind of reform a much smaller family office and really be able to start investing in other things than just real estate. Before that, we pretty much reinvested everything we had as a much greater family back into that family business. And so we didn't have a lot of cash or liquidity to invest in other private alternatives, let alone public equities. And so getting that liquidity event really unlocked the ability for my family to begin to develop a portfolio for me to begin to be able to explore my interest in private alts.

1:11And so, you know, we started out like many folks not knowing what we were doing. And so we invested in fund managers. And then from fund managers, we started doing directs. And then from directs, I started realizing what were my real interests? What were my strengths? What is something that I wanted to kind of take to the next level? And I think a lot of what we're going to talk about today is kind of what we built with Colson Equity Financing. And as you mentioned, you're investing in funds and you decided to start this fund yourself, Colson. What made you want to become a GP when you were an LP?

1:43And tell me about how that came about. It goes back again to real estate, actually, interestingly enough. So, you know, my first job out of college was I moved to Tucson, Arizona and working under a partner of the family and someone who became a mentor of mine. We were buying real estate subdivisions, model home communities that had gone back to the banks for 10, 20, 30 cents on the dollar. And it was just an incredible buying opportunity. And it's where we felt most comfortable to kind of lean back into immediately after getting liquidity, you know, before we'd done any other private alts. And I remember we were buying properties.

2:16You know, they had gone back to the banks. There was no home builders that were buying them. So the developers lost their shirt. And I remember I asked my mentor, I said, how do you have the chutzpah basically to buy these things when it feels like the economy is coming, crashing down and the world is coming to an end? And he said, well, Philip, we're going to own them for cheaper than anyone else can ever build them for again. And so it's just a matter of time before those valuations recover and we're going to be able to hold them and then sell them back to these home builders. And that really stuck with me.

2:42And that's exactly how things played out. We were experts in space. We knew the underlying value and we bought them low. And so that always stuck with me. It was something that I wanted to be able to replicate when my family and I started investing in venture. But it took me until 2018 to really be able to find an opportunity to begin to start to do that because so much of venture is about direct investing, right? Whether it's buying secondaries, which is more of a niche strategy, or whether it's investing directly into businesses or through a fund. And so in 2018, I ran into my now partner, Sam Bulo, and he had a really interesting situation that's actually pretty common for any of your listeners that are executives or even founders of some of these venture growth companies.

3:20He had worked at a company for many years and he had a large pool of vested options. And he left that company about 18 to 24 months before the company's IPO. So he had 90 days to exercise his options. Otherwise, they were going to expire worthless. And he was really up against a hard one. You know, he didn't really want to walk away and let those options expire. He didn't want to take a loan because loans have personal guarantees and terms. And those weren't tenable for him. I mean, it's like you have one hyper concentrated part of your net worth and you're going to risk everything else. No. And then he didn't want to sell secondary.

3:51Right. Because he believed in the upside of the business. He didn't want to give away half his shares to own the other half. And so we worked with a lawyer and an accountant after spending, you know, 20, 30 days in denial. And he came up with a rudimentary version of the structure that we now use where he found an investor. and that investor was me. And he said, hey, in exchange for fronting the money to cover my exercise costs, you know, we pay my strike price and pay my taxes, I'm going to own a bunch of shares. And then I can post those shares as collateral for your cash advance. And then when this company exits in the future, we can share on the upside together.

4:21And that really was a pretty interesting structure for me. And I was already investing in the company. I said, yeah, let's do the deal. And then like any good story, it snowballed eight or nine of his colleagues said they needed the same thing. We created an SPV. We took care of them. And that really hammered home to me that this was not only valuable to him, but actually generally a problem for kind of late stage executives. So then if we kind of fast forward a few more years, actually in the interim, Sam had gone and worked in some other businesses. I was kind of hiring him as an interim CIO for my family office, but we kept on staying in touch and we kept on talking about going into business together.

4:55And in 2022, something really interesting happened in venture growth. And this is where I'm going to tie together the kind of distressed real estate assets with this model and my thinking as an investor. What happened in 2022 is everything had gone up, up, up like a roller coaster. Valuation rise in 2021. It was too frothy and everything came crashing down in the venture growth space. And what that created was a really interesting problem for both investors and shareholders and option needs. So if we take the kind of founder executive perspective, right, the people we serve, they had shares or the right to purchase shares through vested options that in companies that they believed in, but they didn't have the liquidity to pay for the strike price and pay for the taxes.

5:36They also couldn't get any liquidity unless they were willing to sell at a secondary at a really steep discount. And so we had people who were very rich on paper and couldn't get access to liquidity. And so having a model that didn't force anyone to sell at a depressed valuation became very, very attractive. And then for investors, we all know the famous adage, don't catch a falling knife, right? It was a buying opportunity and it has been for the last several years. This is why the secondary market has exploded. But it's hard to know what's the fair valuation for the company. What if it drops further?

6:04You know, I think I'm buying at a good price, but what if it drops further? And when we're able to recreate a company for 10, 20, 30 cents on the dollar by using structured finance, by using this equity financing model that we created for Sam and his colleagues back in the day, we could unlock doing opportunities and deals in a variety of industries with a variety of companies. And so we decided to form a fund at that point and launched this as a generalized strategy, you know, trying to do portfolios of 15 to 20 names. And so that's been really the journey that we've now been on. We had raised a first fund, deployed about a little bit more than half of that to date.

6:39A lot of that was deployed in 2024, and we're now deploying the latter half in 2025. It was this strategy and the connection back to how do you create a distressed real estate-like opportunity with healthy businesses in the venture growth space, right? The businesses don't need our money. It's the individuals that need our money. And how do we make this a really interesting, unique risk return profile for investors to be able to get access to these names and at 70, 80 % discounts? To use a private equity analogy, it was a distressed seller in a good asset, perhaps overvalued, but you had more than enough collateral on the downside.

7:20So you didn't worry of whether it was marked exactly to market, whether it might be 20, 30 % overvalued because you had that downside protection. Totally. My partner likes to say, if you hit the side of the barn door, right? We just have to hit the side of the barn door. We have so much downside protection. As long as we can underwrite against failure, right? We can account for valuation risk really, really well. You can't be off by an order of magnitude, but as long as you're within striking strike zone, iterations of this strategy has been around for about a decade, at least that I've been aware of.

7:50Maybe you could double think exactly what problem are you solving for the senior executives, whether it be liquidity, tax, and any other problem? How would you define the problem that you're solving for executives? That's a great question. And there's actually two problems that we're solving. And so we have to think about who our counterparty is, right? Are we working with a shareholder, which is typically a founder, or sometimes an early investor, like a family office that has a big, you know, unrealized gain and a hold? Or are we working with an executive who has options? And the problems that they're facing are similar.

8:22They both need liquidity, but they actually have different underlying problems. And so I'll talk about both of these. But at the end of the day, like what we're really trying to do is there's found the founders and executives of the best companies don't want to sell. Right. They don't want to sell. If you gave them an alternative to having to sell, they would take it. Right. And that's what we're doing is we're giving them a second choice. We're saying, hey, you don't need to be a secondary seller to get this. And at the same time, right, they're rich on paper. They've been at this five, seven, 10 plus years.

8:48And at a certain point, when you're worth 100 million on paper, it makes a lot of sense, you know, both for your family's sake, from a portfolio management's sake, to take your, you know, take three, five,$10 million off the table. So for founders, what we're doing to oversimplify it is we're kind of creating the equivalent of a cash out refi on their shares, right? They have embedded value, they're rich on paper, poor, cash poor, and we help them unlock their first five or 10 million. And this becomes very sticky and viral within the company. So if there's one founder, then typically the other founder wants it and it spreads.

9:17And what we're trying to create for them is the alternative to having to sell typically at a discount, right? Secondaries typically sell at a discount, sometimes not. Pay taxes. And then most importantly, giving away their upside. So that's kind of the value proposition to the founders. And we can talk a little bit more about what they need to believe about the upside to make this transaction worth it for them. But it gets a little bit more interesting for the executives. And the executives are people like my partner, Sam. So they work really hard, typically at below market salaries, because part of their compensation comes in the form of options that best over time.

9:49And as these vested pools of options accrue, what people typically do is they don't typically exercise along the way. Why? Because they don't have the cash or they're afraid that if the business isn't for sure going to be a success, that they're going to have wasted their money or that their options are going to go underwater, any myriad of reasons, or they're just busy working for the business. And the longer they wait, the higher the valuation of the business goes. And the internal valuation of the business, which is the 409A, increases as well. And that's what determines when you go to exercise, you pay your strike.

10:19Oftentimes, the later stage businesses, the bigger liability is not being able to cover the strike price, which is to own your shares. It's being able to pay the IRS in that same tax year. And being able to cover that is really painful. For some of the multi-billion dollar companies we've talked to, it's$5,$7,$10 million per executive. They don't have that kind of cash unless you're a repeat CFL or something like that. And so they need somebody to come in and exercise earlier, right? If we can exercise at year five or six or seven, one, two, three years before an exit, we can literally save those individuals millions of dollars in taxes.

10:52The other thing that we can do is we need to start their long-term capital gains clock. So if you're a typical executive, you ignore all this. You wait until the very end, right before the IPO or after the IPO, and you exercise. you're paying the absolute highest tax liability, and you may not even have capital gains when you go to sell. A lot of this could be taken care of ahead of time by thoughtful collaboration between a group like us and one of those executives, or a founder who wants liquidity and wants to diversify their wealth. And talk to me about, as an investor, so assuming that you can get into the round, which you can always in some of these companies, and some of them aren't raising money, but assuming that you can get in the round, When does it make sense to invest as a traditional venture investor versus via the structure?

11:37And what are the inherent tradeoffs? Yeah. So the dynamic that we set up with the founders and the executives that we're working with is they give us downside protection and we share in the upside together in the future, right? So if we kind of break that apart a little bit and we think about, you know, how is this going to kind of play out for everybody in a few different scenarios, right? And if we take the investor perspective here primarily, since that's what your question is focusing on, equity financing, having that downside protection, having a paid-in-kind interest rate that we're making a dollar-denominated agnostic performance off of cash that we're advancing and having some equity participation in the collateral pool, it allows us to outperform in down outcomes.

12:19It allows us to outperform in flat outcomes. And it typically allows us to outperform through up to a 3X, sometimes even higher. And so when you want to do an equity financing structured approach to a later stage company is when you're realistic about how much growth is likely left in the business, right? If you told me I'm 100 % sure that this business is going to exit 5x up or 10x up, I'd say if you can buy secondary, you should buy the secondary, right? Or if you can invest in that last round, you should invest in that last round because you're going to get all the upside. However, right, if you can't get access to those rounds, we can probably create access through this structure.

12:57The company doesn't need to be raising money. We could be before a round, after a round. The company might not even raise more money at all. We just need one individual who wants to work with us to generate liquidity to create the access. And so when I look at this, I'm really focused on data. I like to play money ball. And if we look at most late stage companies, right, that are series D, E, F companies, you know, even if they haven't raised that many rounds, they're seven, eight, nine years old that maybe have one round left, or maybe they've raised their last round. We look at the data and we said, where's the bell curve the fattest?

13:27What's the most likely outcome from a late stage venture growth company? It's not a 5 or 10x. It's actually somewhere between a 0.7x to about a 2.5, maybe 3x. That's where the vast majority, 80 % of the companies are going to exit. The outliers are the ones that are going to do better and a lot worse. And so if we bet time and time again where the bell curve is fattest. And we put ourselves in the position to get doubles and triples, 20 % to 30 % IRRs in a third to a quarter of the time that it would take to typically wait if you were an early stage investor to get your money back after 10, 12 years.

13:59That's the kind of investment approach that we take. So that's the investor that would want to bet with equity financing would be somebody who's realistic, who sees a great company, but who knows that the upside isn't going to be a 5 or 10x still. When you run your portfolio simulations, what's the standard deviation, what's the expected return from an IR standpoint, from a return standpoint, and how does that compare to similar venture funds? The way we think about this is we only work with businesses that we think are past the binary outcome and that we think are one to three years away from an exit.

14:33And we have the ability to be pretty wrong around valuation. And also if things take longer, three, four, five, six years, we also have really good time value of money. So we have a lot of room to kind of be wrong. But as long as we can kind of pick a business that's past the point of failure and hasn't a plan to exit, we have a really good application. And then what we do is we underwrite and we say, hey, we want to believe we can make a 2x equity multiple and a 20 % IRR, assuming no future growth in the business, right? The business that exits flat and our best guess, man, it's going to take two years or three years or four years.

15:03We want to be able to double our money, assuming no growth. And then if there is growth, we want to continue to be able to participate in that growth through part of our transaction that gives us equity. And we want to be able to do really well, even if the company exits flat or down, right? That's how we're getting these doubles. We get almost a double still if the company exits 50 % down. And so that's what we're really targeting. you know I it really depends on the asset class and the fund and what stage of growth people are looking at right I wouldn't presume necessarily to quote the data off the top of my head but but my perspective is if we can have a really good shot at a double to a triple you know a 20 to 30 percent IRR with an average hold in a deal we're doing you know three years that's a bet that I want to make I want to make that bet and above 3x you're still capturing the upside it's just not But it's just not as great as if you had invested into the product.

15:57So I'll give you an example. We did a deal where if it's a 4X, we get a 3.4. If it's a 5X, we get a 4.2, right? We're sharing some of the upside with the founder. That's important, right? Because it allows us to win the deal, align ourselves with the founder, make it so that they choose us as opposed to taking the secondary. And I say that's the best money to give away is a little bit off the top if it creates alignment, if it helps us avoid the negative selection bias of people who don't believe in the future of their businesses, right? If we can avoid that, which I think is probably maybe the single - And that's because if they don't believe in the future of their business, this becomes extremely expensive form of debt for them.

16:32Whenever we present a quote to somebody, we don't just say, hey, here's a quote. You do the math. You know, figure out if this is better or worse than your secondary. We give it to them in an Excel document, lets them play when model out different outcomes for themselves. We actually hope they have a secondary offer. We say, here's our quote. Here's their secondary offer. You can pick it in. You can put it in or tell us it if you want, or you can keep to yourself, put in your taxes. And then tabularly and graphically, we're going to show you different outcomes, apples to apples comparison, Colson's financing versus your secondary.

17:03When are we better? When are we worse? And typically what a founder or executive has to believe as far as future growth is they usually have to believe they can double the valuation of the business before they exit. And if they can do that, even if it's a flat secondary, the power of the appreciation of keeping their skin in the game overcomes the cost of our financing. their alternative right again is selling often at a discount paying taxes and giving away that upside and so they're worse off if the business goes down and they're better off if the business goes up and so we put that choice that menu in front of a founder or executive and we say you make the call and if they make the call to work with us what do we know regardless of what they told us even regardless of the data they've shown us about the business which on occasion can be inaccurate we know that they actually believe in the upside because they're betting in their our own self-interest.

17:48And so we pay a lot of attention to the psychology of the people that we work with. And if someone turns us down and takes the secondary, I go, great, we didn't want to do that deal. They don't believe in the upside. They're not willing to bet where their own money is. You mentioned you went from investing in via SPVs to your fund one. Now you're moving on to fund two. What learnings do you take from fund one, perhaps some mistakes or some things that you wish you knew that you're now applying to fund two? Actually, I'm going to give you a compliment here. You and your partner the other day when we were talking to you, you said, Colson, you guys have structural alpha.

18:23And I love, they were the first person to use this term. And I loved it because a lot of people use alpha, this term, like manager alpha, you know, and it typically has to do with like manager's ability to pick, right? Like maybe it's their network or they're better at underwriting. It's like, maybe, right? It's kind of hard, you know, to quantify that. It takes, you know, maybe a decade to prove that you have alpha, right? But what's really interesting about our model is we can show you with the math that we have structural alpha. And so what I mean by structural alpha, well, it's the equity financing structures, the downside, it's the pick, their stock fee that steps up over time.

18:56And we were able to model this in portfolios of 15 to 20 companies. So for our first fund, we modeled this in a portfolio of what we expect to be 15 names. And it was pretty shocking just how badly we could do. So not only do we not have like manager alpha, like we actually are like bad at picking companies. like we select horribly, we could have four companies fail, three exit 50 % down and eight exit flat. So we don't pick a single company that increases in value across the whole portfolio. We've had four mark us already, so that's probably not going to happen. But let's just assume that happens.

19:30We would return in a four-year hole, a 1.5x and a double-digit IRR to our investors. And how is that possible? We have to remember, we underwrite to make a 20 % IRR and a 2x equity multiple on a flat exit, right? Flat exits and 50 % down exits aren't failures for Coles. So the power and the structural alpha that you've so eloquently called out and gave us a term, finally, to call it is super, super powerful. And then if we imagine, well, what if we still don't have any alpha, right? But let's just say we're not worse than the market. We just pick how we would expect the market to perform, that kind of bell curve I was talking about.

20:07We just pick on average. We're an average manager, but we still have the structural alpha. Well, then we're getting 2.3 to 2.5x, 24 % plus IRR net of fees. And then if we say, well, Colson's actually decent at picking and some of this positive opt-in bias that I was describing that only founders that believe in the upside would want to work with us, that serves us a bit. We do a little bit better than just the average of the market and we get the structural alpha. Now we're in the high twos, even 3x equity multiple 20 to 30 % IRRs, right? And that's super, super exciting. There's two other, there are actually three other learnings that we have.

20:45Second one is we're super sticky. So this is all about education. So once we're in a company and we work with an executive or a founder and we educate them about this, we do a transaction. Inevitably, the co-founder wants liquidity, right? And then we say, well, what about the options, right? Do you guys have options? What about the C-suite? And so we come in, we do three, five, maybe a$10 million transaction. And then there's going to be two to three times that amount of liquidity needs within the company. And so we become sticky and a programmatic solution. And that's one of the things I'm super excited about when it comes to fund two.

21:18I want more discretionary capital so I can do more upfront. And also I want to lock in 90 days, a hundred days. We actually had one deal that the founders let us keep open for 10 months. We did three closings on it. Same terms. The final closing was two months before a markup because they valued having this liquidity so much they wanted us to keep it open. So we're super sticky. The final two, access. I think access is huge, especially for high net worth individuals, single family offices, multifamily offices, and RIAs. Support for today's episode comes from Square, the all-in-one way for business owners to take payments, book appointments, manage staff, and keep everything running in one place.

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