The illiquidity dilemma
One of the key characteristics of early-stage investments is that the share positions held in the ventures are often illiquid until the very end of the journey: the exit. Venture-backed companies lack the centralized infrastructure of exchanges like the NYSE, making it difficult to match demand and supply and facilitate transactions.
This is why many founders and other equity holders are forced to sit on their positions, even if they gain significant value as the company evolves over time. As a founder, you can easily find yourself in the situation that you would like to take some money off of the table to alleviate some of the financial pressure that has come with taking a below-market salary. However, none of your stake in the company is available to you in cash. This is where a so-called secondary might be a viable option.
The secondary explained
In essence, a secondary is a transaction in which a shareholder sells a portion of their existing shares to another investor or third party. This is in contrast to a primary transaction in which an investment is made in the company by buying newly issued shares.
Secondary transactions used to be rare and were sometimes even considered a taboo in Europe but have become increasingly popular in recent years. Industry Ventures reports that since 2012 the global market for venture secondary deals has grown from $13 billion to an estimated $130 billion in 2023. This growth is fueled by the surge in primary VC funding and the ongoing trend of ventures remaining private for a longer period of time.
The exact set-up of a secondary transaction can work out in different ways:
- Founders selling common stock to interested investors
- Employees selling vested equity
- Early investors transferring shares to new investors
The most natural moment for a secondary to take place would be around a financing round in which founders may be able to sell a portion of their common stock to incoming investors at or near the original issue price of the preferred stock (not including discounts/ premiums). In certain VC industries, we see the first signs of frequent tender offers happening as well, in which companies facilitate their employees with frequent secondaries to cash their vested options.
The benefits of secondary transactions
Naturally, the secondary offers a great possibility for founders and other beneficiaries for liquidity. But also, on the buyside there are several benefits to mention. Especially in more competitive or oversubscribed rounds, a secondary might bridge the gap where investors would prefer to allocate more capital than the company needs. It also provides access to ownership in more mature and de-risked companies than primary investments.
Another benefit is a potential restructuring of the cap table, allowing certain (smaller) early-stage investors to cash out to reduce the pressure for a premature exit. Finally, these transactions provide a tangible selling option to employees, which helps the appreciation of these employee incentive schedules.
Besides normal investors, there are some firms with specific funds dedicated solely to secondary transactions that have picked up on the potential. Examples include Giano Capital, Flashpoint Secondary Fund, Balderton’s Liquidity I fund, Hambro Perks Access Fund, and the Nordic Secondary Fund.
Key things to consider in Secondary Deals
If you think a secondary might be a viable option for your specific situation, here are some things to bear in mind:
Pick the right time to bring it up: Secondaries can still be a sensitive topic. The first reason for this is the signaling effect of such transactions. Insiders selling their stock might make people wonder whether these people still have confidence in the long-term outlook of the company. Secondly, since founders are strongly connected with the success of the company, investors are often wary of the possible disincentivizing effect that early liquidity can bring.
Although we see Series-A transactions happening as well, the usual window for secondaries opens in Series-B+. By then, it is also easier to gain support, since founders have been able to demonstrate their commitment and ability to grow the company. Once the topic is on the table, it is important to strike the right balance between shares sold versus shares retained. Generally speaking, a secondary should keep the founder and investors’ incentives aligned, as the founder is able to relieve some personal financial pressure but maintain sufficient equity to remain motivated to keep growing the business toward a larger liquidity event.
Consider the amount and valuation: The economics of secondaries are all about weighing long-term versus short-term risk-adjusted value. This trade off cannot be viewed separately from market conditions. Whereas VCs at the height in 2021 were competing for a seat at the table, secondary negotiations look very different now. Conditions have definitely pivoted in favor of buyers. For some founders, this might be a reason to refrain from a secondary as they are not ready to accept valuation discounts. However, with late-stage funding under pressure and public market markdowns leading to a more shallow exit environment, the liquidity shortage for founders and early-stage funds will likely further exacerbate.
Carefully review the legal aspects: Usually, existing shareholder agreements will have numerous restrictions and investor protections in place that may need to be waived to facilitate the transaction, including:
- Right of first refusal
- Co-sale or tag-along rights
- Transfer restrictions
It is also advisable to diligently review the transaction with your accountant to ensure the tax impact is properly assessed.
Final take away
Over the past decade, the European VC Ecosystem has matured sufficiently for the market to fully understand the benefits of different secondary transactions. For founders, secondaries are an additional tool in the toolbox during their journey. When executed well, the secondary allows the investor to put more capital to work and the existing stockholders to take some of their gains off of the table while keeping incentives aligned. Given the current macroeconomic environment with rising interest rates and falling valuations, the market is very appealing for new investors to invest in top companies at attractive valuations.
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