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📈The Market Resurgence of Secondary Investments in Venture Capital

First let’s define a primary investment offering versus secondary investment offerings

• In a primary investment offering, investors are purchasing shares directly from the issuer aka the company. Most venture capital firms are typically – but not always – engaging in primary issuances. Startups engage in primary investment offerings to raise money to hire employees, buy equipment, rent offices and fuel growth, among a number of other reasons.

• In a secondary investment offering, investors are purchasing shares from sources other than the issuer (i.e. the company) including from employees, former employees, or other investors. Secondary markets allow employees, founders, early investors, etc. to receive liquidity on their ownership.

Why would someone engage in a secondary offering?

As a basic example – I acquired shares in Company A at a $10 million valuation in 2010. Company A has performed extremely well and is now valued at a $1 billion valuation today in 2023 i.e. the valuation is 100x from when I invested. Unfortunately, Company A is still private and hasn’t gone public so while my investment is up substantially from 2010, I can’t freely sell my position on a stock exchange to realize my gains. A secondary transaction solves this, allowing me to sell my position to another investor in the private markets and realize my gains, while allowing a new investor to initiate ownership in Company A.

The secondary market for private companies was extremely quiet in the VC syndicate ecosystem in 2022, but has started to come back strong and are some of our largest SPVs at Calm Ventures in 2023.

So why did secondary transactions come to a halt in 2022 in the first place?

The short for brevity: Macroeconomic headwinds including fast rising interest rates (and higher costs of capital), high inflation, quantitative tightening, reduced demand for certain goods and services, among other factors, led to an extremely difficult economic environment that lead to:

• Significant uncertainty in the economy

• Locked up debt and equity markets

• Reduced public tech company valuations, many that fell 50%-90%+ in the public markets

• Reduced personal discretionary income and overall individual wealth

• Reduced confidence and interest in risk assets like VC and tech

• Etc.

So in short, the macroeconomic sentiment was bad and asset prices were crashing with no clear visibility into when the markets would stabilize or at what price they would stabilize.

And worse, in addition to these macro factors that destroyed equity valuations, confidence, and wealth, high profile startups were making headlines for all the wrong reasons further reducing confidence in a venture capitalist’s ability to properly diligence an investment. The most notable example being FTX, which went from a $32B valuation to allegedly fraudulent in about a year’s time.

And private tech markets weren’t correcting fast enough in 2022. According to private market exchange and data provider Forge, the share prices of startups on secondary exchanges remained elevated far longer than their public company counterparts.

As a result of this slower pace of private market corrections, investors would essentially have to pay a premium to buy shares in a startup on the secondary market over its comparable public market equivalent. And this despite the disadvantages of owning a private company versus a public one – mainly a lack of information as the company is private, a lack of access to management, a lack of liquidity, lack of preferences or knowledge of preference stack, among other factors. It simply didn’t make sense to participate in the secondary venture market.

But things have changed in 2023….

Interest rates have begun to stabilize, which has helped dramatically improve the performance of US tech equity markets and public risk assets. As it stands today the 1 month treasury rate is higher than the 2 year treasury rate, which is higher than the 10-year treasury rate. This suggests that interest rates will decrease over the short and mid-term, reducing costs of capital and thus directly increasing equity valuations, all else equal.

While this isn’t necessarily a good thing as this phenomenon referred to as inverted yield curves has typically signaled a recession, the expectation that yields will come down after the fastest interest rate hike in history is directly leading to higher valuations, all else equal.

There are other factors instilling confidence (which are related to the interest rate stabilization) in the market including the fast rise of public tech valuations in 2023. The QQQ, which tracks exposure to the tech sector, as one example is up over 40% year to date.

Additionally, there are several key technology shifts – mainly artificial intelligence - that are driving demand for certain products, reducing costs for companies, while accelerating the go-to-market for new services. This is driving new excitement into the technology asset class as investors want exposure to AI and the companies that will benefit from it.

Additionally, while the IPO markup hasn’t opened up fully yet, it’s starting to show signs of life.

Instacart filed its S-1 as did Klaviyo – S-1’s are the initial registration form required for U.S. companies that want to be listed on a national exchange. Restaurant chain Cava Group went public this year and is up around 100% from its issuance price.

These are all helping instill confidence that the IPO window is indeed opening. Notably when investors receive liquidity, they typically recycle part of those distributions back into the VC asset class.

According to a recent article from The Information:

“In our monthly survey, more than 40% of the 660 respondents expected new listings to pick up this year, and almost 60% expected the pace to accelerate by the first half of 2024.”

Finally, some portion of the 2021 froth has left the late stage secondary market with private market valuations starting to finally stabilize and catch up to their public counterparts.

Several private market companies are finally arguably “cheaper” than public market counterparts. According to the Forge private market index above, the QQQ is outperforming the Forge Private Market Index, which reflects the up-to-date performance and pricing activity of venture-backed, late-stage companies that are actively traded in the private market. This suggests there are discounts to be had.

So to summarize:

• Interest rates are stabilizing and even expected to decrease over the short and midterm, directly increasing a company’s valuation all else equal

• Tech equity markets are booming – partially as a function of interest rates

• Many late stage private startups are trading at discounts to their public market counterparts

• AI has led to a new paradigm of investor interest

• The IPO window is opening up – or at least there is the belief it will, renewing interest in late stage private market opportunities

All are driving renewed interest in private startups.

But on to secondaries…

Many late stage companies are not issuing new shares via primary financings, and if they are, these new issuances are often going to a relatively small set of high profile large institutions.

In other words, the only way to access many of these late stage startup opportunities that now seem very compelling is via secondary market transactions.

And that is leading to the resurgence of secondary investment SPVs….

As stated, we at Calm Ventures are directly seeing this effect with two of our three largest SPVs this year via secondary investments. EquityZen, Forge, Hiive, Setter Capital and other private market secondary marketplaces have also reported an uptick in activity.

So what would I think about as an LP evaluating secondary market opportunities:

• In general, if you are not an expert in the venture and investing ecosystem, I’d prioritize your search on acquiring secondary shares in high quality companies that have recently (<6 months ago) had large priced primary financings led by top VCs - some of whom are first time investors into the business - to provide some basis as to what is the fair market value of the opportunity. Given you as an LP may have limited access to company information in secondaries, having a recent benchmark (in the form of a recent primary financing) provides more assurance around fair price, though candidly it will also leave minimal room to capture upside and capture inefficiencies in the secondary market.

• Invest in high performing businesses where there is meaningful publicly available information that can allow you to back into some rough estimate of valuation and/or comp the business. An example is Databricks – Databricks has some information public on its financials, growth, opportunity, etc. and it’s widely believed Snowflake will be a comp for the business. Another is Stripe, which has meaningful publicly available data and a comp in Adyen. Having this data and the comps, will allow you to back into some value for these businesses. Notably, just because a company has these attributes (publicly available data and a public market comp), DOES NOT mean you should necessarily be investing in these secondary opportunities of course as even if there’s public information and a comp, the deal may be heavily overpriced.

• Invest in companies in sectors where you have deep expertise or an advantage. As an example: if you’re a machine learning (ML) developer and see the boom in companies using Weights & Biases (a developer tool for ML teams) or other AI/ML dev tools, use these insights as a signal on companies worth acquiring as you have a unique information advantage.

Where do I like to play in secondaries as someone who spends all day in VC – I’m looking for two types of deals primarily. 1) investing in the best in class companies at or around fair value or 2) investing in secondaries for great companies in which the secondary market is undervaluing them.

Why would the secondary market undervalue them – let’s use Airbnb as one example. During COVID peak, the price of Airbnb on secondary markets were down 70%+ in some cases; if you held the belief that COVID would end, and Airbnb’s business would normalize or exceed pre-COVID levels, you could have bought Airbnb shares at an enormous discount due to everyone staying at home, and quite frankly (with the knowledge of hindsight) made a fortune. These opportunities are happening in lesser extreme ways all the time on the secondary markets.

What to look out for as an LP:

• When it comes to secondaries I’d avoid investing in average or sub-par businesses or any business with extremely bad press altogether. It is not worth it and you may get wiped out as you don’t know the state of the business given lack of information or the cap table preference stack.

• If the Company isn’t best in class, I’d try to avoid acquiring common shares (or per the above bullet altogether). If a company is likely to IPO (SpaceX, Stripe, Databricks), owning common shares is likely fine as preferred shares will convert to common. In any other situation, common shares come with meaningful risks. Common shareholders are last in line to be paid, which means they will be paid out after creditors, bondholders, and preferred shareholders.

• Try to avoid forward contracts and anything other than direct transfer of shares. I invested in a Coinbase forward in 2018 and it worked out fine, but forward contracts carry additional risks that I do not believe are worth it to LPs unless they are sophisticated and/or working with an extremely legitimate and highly credible GP or marketplace. Some may disagree with me here – but I’d focus on direct transfer of shares only.

So to conclude, I think the secondary market is extremely exciting today, presenting sophisticated investors an opportunity to buy pre-IPO businesses or late stage businesses at meaningful discounts in some cases. Unlike the venture asset class, these secondaries are usually taking place at the later stage, meaning the time to liquidity is much faster than the typical venture capital investment.

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✍️ Written by Zachary and Alex