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Breaking Down the Secondary Transaction in Venture Capital
a newsletter about VC syndicates
Alex Pattis & Zachary Ginsburg
May 15, 2024
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This week we shared 5 deals across 4 different syndicate leads via Deal Sheet, ranging from Seed Stage to Pre-IPO ($500m+ ARR). Deal Sheet is our paid offering that provides accredited investors top weekly venture capital SPV investment opportunities and at discounted carry.
Stanford founded AI application alongside General Catalyst
Initialized Capital & Lightspeed backed fintech platform
Leading gen-AI search engine backed by Salesforce Ventures
Gaming studio founded by the founders of the worlds first trading card game ($1B+ Revenues)
Accel backed AI data infrastructure platform with $500M+ ARR
You can sign up for Deal Sheet here or book a call to learn more!
Breaking Down the Secondary Transaction in Venture Capital
As the secondary market has become increasingly active and more attractive to LPs/VCs/Syndicate leads alike, we are dedicating this week’s post to a full breakdown of how secondary transactions work. The secondary market is playing an increasingly pivotal role in investor liquidity. Given the limited number of IPOs and a tight M&A market, the secondary market has emerged as a primary avenue for divesting private company shareholdings.
In the syndicate/SPV ecosystem, we are seeing an increase in transaction volume and number of deals being done into later stage & pre-IPO companies, and for good reason. This secondary trading explosion, specifically with SPV leads, is happening for a few key reasons:
SPVs/Syndicates are often the only way an individual, accredited investor can access secondaries. Minimums to acquire secondary stakes are typically at $100,000+ or much more; meaning smaller check writers can’t get access outside of SPVs that bundle smaller checks. The SPV has provided an avenue to access many of these later stage & pre-IPO opportunities.
Due to the lack of exits in private markets, many individual, accredited investors are interested in investing in shorter time horizons to liquidity. Investing in growth stage & pre-IPO opportunities shortens that potential 10+ year window (for early stage companies) to maybe 1-5 years depending on the company.
There’s significant valuation arbitrage in certain private companies due to the lack of available information; secondary markets are far less efficient and smart investors are searching for these deals.
Getting primary access to “hot” late stage rounds can be extremely difficult; secondary markets have increasingly become a place to access otherwise inaccessible opportunities.
With the tech M&A market has been difficult due to a tough FTC, among other factors, and private markets having ample capital solutions allowing companies to stay private longer (i.e. capital solutions are available for private $50B+ EV startups), the secondary markets will likely play an increasingly larger role for liquidity for early investors and a great opportunity for individuals and institutions to continue to get into great later stage companies outside the typical primary funding cycles that take place.
So, on that note let’s get into everything you need to know about secondaries…
What is a secondary?
In the private markets, a secondary transaction refers to the buying and selling of pre-existing investment interests in private companies or funds (we’ll focus on companies for this piece). It's essentially a way for existing investors/founders/employees to exit their positions before a company has a liquidity event e.g. goes public (IPO) or is acquired.
Here's a breakdown of key points about secondary transactions:
Who's Involved?
Sellers: These can be early investors (like venture capitalists or angel investors), founders or employees wanting to partially cash out, or funds looking to rebalance their portfolios.
Buyers: These can be other institutional investors (VC firms, private equity firms), secondary funds specializing in these transactions, Syndicate leads or individual accredited investors seeking access to private companies.
What's Being Traded?
For the purpose of this conversation, shares in private companies (direct secondary) are what’s being exchanged. These can be common shares (e.g. founder, employee shares typically) or preferred (e.g. investor shares typically)
Other forms of secondary involve publics, buying stakes in existing private equity or venture capital funds (secondary funds). Again, not the focus for this post.
Benefits:
Liquidity for Sellers: Secondary transactions provide a way for investors to exit their positions and realize partial/complete gains before a company goes public (which can take years) or gets acquired.
Access for Buyers: Secondary markets allow new investors to buy into promising private companies that might not be readily available through traditional means because 1) they don’t have access to management at the company or 2) the company is not currently raising a primary round of funding.
Price Discovery: Secondary transactions can help establish a market value for private companies that aren't publicly traded.
For example, if a company raised a primary round of financing at a $1B valuation in 2021 but the shares are trading on the secondary market at $500M, this says quite a bit on where the market currently values this company, and in this example, a ~50% discount to the $1B previous round raised.
A footnote - while secondary markets offer price discovery due to lack of information, there are also significant inefficiencies, which can lead to amazing deals or horrible ones…You can check out our prior post going into this here on navigating secondaries.
Join us on May 22 + 23 to learn from the leading voices from firms like Kleiner Perkins, Ensemble, Greycroft, a16z, and many more. Experience how advanced AI, machine learning, and data analytics are transforming how startups are founded and funded.
How is a secondary different from a primary?
A secondary private market transaction and a primary fundraise are two distinct ways capital flows within the private equity space. Here's a breakdown of the key differences:
Secondary Market Transaction: Focuses on the buying and selling of pre-existing investment interests in private companies or funds. It allows existing investors/employees to cash out before an IPO or acquisition. In secondaries, the proceeds of the sale are NOT going to the company, but the seller (an individual/institution), and as such is not dilutive to shareholders.
Primary Fundraise: Raises new capital from venture capital/private equity funds that the company can use for various purposes like growth, acquisitions, or research and development. These are funds that go directly to the Company to fund its initiatives and is dilutive to existing shareholders.
Parties Involved:
Secondary Market Transaction:
Sellers: Existing investors, founders, employees or funds.
Buyers: Other institutional investors, secondary funds, syndicates, or individual investors.
Primary Fundraise:
Sellers: a private company giving up equity for growth capital
Buyers: Venture Capital/Private Equity, Family Offices, Angel Investors, Syndicates, Endowments etc.
Why are secondaries hot now?
There are several factors contributing to the increased activity in private market secondary trading:
Increased Liquidity Needs & Demand:
Staying Private Longer: IPO timelines have shifted from 5-8 years from inception to IPO to 8-15 years until IPO.
LPs want Liquidity: Many venture capital & private equity funds invested heavily in the past decade. As these companies mature, investors in those funds might be looking to free up capital for other investments. Secondary markets provide a way to achieve this before an IPO, which again, now is taking a lot longer than previous cycles.
Lack of M&A/IPOs: Given the lack of M&A & IPOs, selling secondary is a way these funds can distribute capital / DPI to show realized returns to LPs after many years being illiquid.
Employee Liquidity Events: Employees of private companies often receive stock options or restricted stock units (RSUs) as part of their compensation. Secondary markets allow them to sell these holdings before an IPO or acquisition, providing them with liquidity and potentially some return on their investment. TLDR: due to lack of M&A & IPO’s, these employees have personal needs for cash and therefore many are motivated to liquidate earlier via secondaries.
Faster Return Potential: Secondary transactions can offer investors a faster route to returns compared to waiting for a company to go public or be acquired, which can take a long time and is unknown.
Increased Availability of Capital in Secondary Funds: Dedicated secondary investment funds have raised significant capital in recent years. This influx of capital allows them to be more active buyers in the secondary market, further fueling its growth.
Online Secondary Trading Platforms: The emergence of online platforms for secondary transactions has increased accessibility and transparency, making it easier for investors to find potential buyers and sellers.
Great Deals: Due to inefficiencies in the secondary markets, there are great deals to be had.
Preferred vs. Common Stock - what's the difference?
As a buyer of secondaries, I am typically either buying common stock from an early employee or founder and preferred stock from an early/previous investor.
One of the main reasons to understand the kind of stock you own or are exploring buying is the liquidation preference. In a liquidation, common stockholders receive whatever assets remain after creditors, bondholders, and preferred stockholders are paid.
Preferred stock is almost always going to be better to buy, however there are certain “hot” companies where there typically is no access therefore common is the only option available. Many times there is some discount associated with common stock given the lack of rights and preferences associated with this share class (specifically it is paid after preferred).
One of the only times common may be a better buy is if the company is certain to IPO and common is trading at a discount to preferred; in an IPO, preferred will convert to common, so it may be better to give up on the liquidation preference (and other “preferred” share benefits) to get the discount on price to get common.
It’s quite possible to do an entire post on common vs. preferred stock, but we wanted to focus on an overview of the entire secondary process, but here is a chart that summarizes a few key points. Additional information on our past article discussing navigating secondaries here
What is the role of brokers in secondaries?
Brokers play a key role in the secondary investment ecosystem, aggregating supply/demand to find a fair market value for private shares. Many times, identifying an opportunity to buy existing shares in a company from an early investor or employee is difficult without direct access to the company (e.g you know the founder well, an employee well, a cap table investor well).
While traditional VC’s and early-stage investors spend their time networking with founders to source deals, the secondary sourcing process is different on the sourcing aspect, focusing efforts on existing shareholders willing to sell all or a portion of their shares in a company. They may be working top down with a private company that wants to centralize their secondary process with one brokerage that they believe is best positioned to facilitate all transactions, but many times it’s up to the buyers to find sellers and the sellers to find buyers without the support of the company itself.
This is where brokers focus and spend a lot of their time…with buyers & sellers!
There are 2 primary ways in which brokers spend their time to facilitate transactions.
They have a seller looking to liquidate a position: The broker will spend time looking for buyers who are interested in purchasing the seller's position.
They have a buyer looking to purchase shares in a specific company: The broker will seek to identify shareholders that might be willing to sell.
Brokers are trying to build liquidity in a company and make a market.
That being said, you do not need to work with a broker to facilitate a secondary transaction. With brokers, there is typically a fee to the seller and/or buyer. There have been multiple scenarios where we have purchased secondary shares because we have direct access to a founder, an early employee, an early investor and were able to facilitate, agree on price and raise the capital (given we do this via SPV’s) without a broker playing a role here. However, we frequently partner with a broker who has more significant exposure across the buyer & seller spectrum.
“Shareholders and accredited investors turn to Forge’s team for their decades of collective market knowledge and experience, and insights into the private market. Our team leverages the best-in-class technology and data on the Forge platform – including access to our global interest book – to benefit private market stakeholders. As the only public company in the space, we are supported by an industry-leading compliance organization.” - Charles Smead, Managing Director, Co-Head of Marketplace @ Forge Markets
"Brokers have always played an important role in the price discovery process for buyers and sellers. Even modern day marketplace platforms still have to be operated by broker-dealers from a regulatory standpoint." - Ted Pispidikis, Security Specialist, Capital Markets @ Hiive
Agreeing to Terms with Sellers
This part can get challenging especially with our SPV (i..e, backwards approach to a traditional fund). As a Syndicate Lead, we will negotiate terms with the seller before going to market to raise funds for acquiring shares. The negotiation on price here is not all that different from any negotiation on price for any product between a buyer and seller and as there’s more liquidity in these markets, it’s become easier to determine a fair market clearing price, however the SPV process can add a layer of complexity.
Given, we raise the money after we secure the allocation with SPVs, we need additional time to raise the vehicle. Most of the time this is not an issue with sellers, when we are asking for an additional 1-2 weeks to set up the vehicle, raise the capital, get wires, and then sign and initiate the transfer/ROFR process. The added complexity here is that startups move quickly and things can change within 1-2 weeks.
For example, we raised a million+ vehicle for a pre-IPO SPV recently and had agreed on terms prior to the fundraise. During the SPV capital raise, some significant news came out on the company that massively moved the market (30%+ change in price per share). We are not in a position to sign a binding LOI at the time we initially negotiated the price as we need to raise the funds, so when major events happen that move the market, it adds an extra layer of complexity. In this scenario, we were forced to renegotiate on price and provide an opt out for our LPs who may not want to invest at this new pricing. It can complicate the process for SPV leads, and more difficult experience for Syndicate LPs.
The ROFR Process
A Right of First Refusal (ROFR) provision in a private company setting grants certain parties the first opportunity to buy shares before they are offered to external investors. In short, when you purchase secondary shares in a company, you will likely (but not always) go through this ROFR process or have your shares blocked altogether.
Here's a high level breakdown of a typical ROFR process:
The ROFR process is triggered when a shareholder (the Selling Shareholder) decides to sell some or all of their shares in the company.
The Selling Shareholder is obligated to notify the company and other shareholders (depending on the specific ROFR terms) about their intention to sell. This notification typically includes details like the number of shares for sale, the proposed selling price, and any other relevant terms.
Company ROFR (if applicable): The company itself might have an ROFR, allowing them to review the offer and decide if they want to purchase the shares at the proposed terms. This is often used to maintain ownership control or for strategic reasons.
Other Shareholders with ROFR: If the company doesn't exercise its ROFR, or there is no company ROFR clause, other shareholders with ROFR rights (like co-founders, venture capitalists, or employee stock option holders) have a chance to review the offer and decide if they want to buy the shares individually or as a group.
Matching the Offer and Negotiation:
Matching Terms: If a party with ROFR decides to buy the shares, they have a set timeframe (usually 30-60 days) to match the terms of the original offer proposed by the third-party buyer. This includes the price per share and other conditions outlined in the original sales agreement.
Negotiation: If multiple parties with ROFR express interest, there could be some negotiation regarding the price or other terms. The Selling Shareholder might have some flexibility in choosing the buyer within the group exercising ROFR.
Closing the ROFR Process & Transaction:
If ROFR is Exercised: If a party with ROFR matches the terms and completes the purchase, the sale goes through with them instead of the original third-party buyer.
If ROFR is Not Exercised: If no party with ROFR chooses to buy the shares, the Selling Shareholder is then free to sell them to the original third-party buyer or potentially seek other offers.
To note, I have been ROFR’d (and straight up blocked) before when attempting to purchase shares from a seller and needed to explain to our LPs in the SPV why the transaction did not go through. We usually have good intel on what the ROFR price and what a company’s policy is on blocking transactions is to avoid these getting blocked/ROFR’d at the last second, but in spite of best efforts, it happens.
So in summary, secondaries are not only here to stay but increasing in terms of their importance to the ecosystem. As these markets are typically more complex than investing in primary financings or publics, I’d highly suggest doing full homework on any name you buy. I am extremely active in secondary names, so if you’re looking for access feel free to reach out.
If you enjoyed this read through, feel free to review our prior articles on guides in VC:
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Sydecar empowers syndicate leads to manage their investments more effectively. Organize, manage, and engage your investor network effortlessly with Sydecar’s management and communication tools. Their platform also automates banking, compliance, contracts, tax, and reporting, freeing up syndicate leads to focus on securing deals and strengthening investor relations. Elevate your syndicate operations with Sydecar.
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