🔍🚨Navigating the Secondary Market

As early stage venture capitalists, we focus our investments on primary financing rounds into startups. A primary financing provides new capital to a company in exchange for ownership. In a primary investment offering, investors purchase shares directly from the issuer (e.g. the Company) with the proceeds going to the business to fund operations, growth, etc. These rounds are typically widely publicized as Seed / Series A / Series B / etc.

But there is another type of financing that has become extremely popular with retail and institutions referred to as secondary financings. In a secondary transaction, the venture capital firm is buying or selling ownership stakes in an already established company – the proceeds of the sale of those shares aren’t new issuance (thus non-dilutive) and aren’t being used to fund the company but rather are providing liquidity for early shareholders, founders and/or employees.

My first personal investments were actually secondary transactions into Airbnb and Coinbase 5+ years back. Those ended up performing well (Coinbase ended up returning almost 10x in a few years), but at the time I didn’t understand the very real risks with these purchases that could have led to disaster for me and likely will for many who don’t understand what they’re buying.

So why this article right now?

The secondary market is growing quickly and also extremely hot right now – partially justified – but these secondary opportunities often carry unknown risks and many haven’t done the homework to understand them fully.

To underline, secondaries can be unbelievable investments and can actually allow LPs to get access to a high performing company at a discount to fair value and/or provide an opportunity to invest in to hard to access companies in general – you can read a prior article discussing why that is here – but extremely high caution is needed.

You can be completely wiped out in secondaries, even if a company sells for hundreds of millions, if you don’t know what you’re buying.

So what should LPs look out for here:

1. PREFERENCE STACK & SENIORITY STRUCTURE

When a private company sells to a buyer, the proceeds of the acquisition are distributed to investors in what’s referred to as a distribution waterfall - the order in which proceeds from a liquidity event (like an acquisition) are distributed to the various stakeholders in a company – a typical distribution looks like in order of preference 1) secured debt, 2) unsecured debt, 3) preferred equity, then 4) common equity.

As you can see, debt holders sit above preferred shareholders, who in turn sit above common shareholders in terms of payout priority. The further down the waterfall, the higher risk you face of receiving little or nothing if the proceeds don't exceed the amounts owed to groups above you. Common shareholders are at the bottom and thus carry the greatest risk from liquidation preferences and debt obligations reducing their potential payouts.

Preferred equity is what’s typically given to investors in startups and common equity is typically given to founders and employees. Most preferred equity is acquired with a 1x liquidation preference – meaning investors who provided $1 million in equity financing in exchange for preferred shares with a 1x liquidation preference would get their $1 million returned in the event the company is sold or goes bankrupt before common stockholders receive any payout. 

Though liquidation preferences can be higher (1.0x to 3.0x or more), higher liquidation preferences are sweeteners, but usually only provided to investors in underperforming companies or higher risk scenarios.

Unfortunately, many if not most of the secondary transactions I’m seeing today are for common shares, not preferred shares. If a Company has a ~100% probability of IPO’ing / going public (take Stripe), acquiring common may not be an issue as the preferred converts to common at IPO. But for every other deal, buying common equity may very well leave you with little nothing even if the Company has a mediocre exit.

Why? If it’s not clear already, it’s due to the preference structure and stack; preferred equity is paid out before common receives anything.

Let’s take an example (one loosely based on an actual portfolio company) – let’s call it “Company A”

Company A was founded in 2017 and experienced incredible growth over the first four years, reaching $50M in revenues and raising over $200M dollars, all at a 1x liquidation preference, and valuing Company A at $1B. Unfortunately, growth has slowed dramatically and the Company was forced to sell for $100M. 

The $100M was enough to pay partial cash distributions back to preferred shareholders, but not enough to cover their full $200M investment raised, and so common shareholders, due to the seniority structure, were paid back nothing despite the $100M exit. Believe it or not, a story like this is all too common today. 

We very recently had a company sell for ~$30m with common holders getting zero.

But what’s really scary in this market is that people are buying common shares for mediocre businesses at huge discounts thinking they’re getting a deal when in reality, they’re probably getting screwed…

Let’s take another example to showcase how:

Company B raised $350M over several rounds (all at a 1x liquidation preference) and was most recently valued at $1B in a 2021 raise. 

Unfortunately, Company B’s growth slowed dramatically and the Company’s prospects are modest at best. However, on the secondary markets I can purchase Company B’s common shares at a 90% discount to the 2021 raise of $1B or at an implied valuation of $100M. Wow great deal right – even if the Company sells for just $200M (an 80% discount to the last financing) I’ll double my money! WRONG!

Well as it turns out Company B did sell for $200M and I received nothing for my common shares – why? Hopefully you know but it’s because the $200M in cash distributions from the sale were less than the $350M in preference that must go to debt holders & preferred shareholders first, leaving common holders with nothing.

BUYER BEWARE! And moral of the story – be careful buying common, especially in businesses that are not absolute best in class or that you can’t fully diligence.

2. OVERPAYING FOR COMMON EQUITY

Hopefully from the last example, it’s clear that for companies that may not IPO (e.g. ~99% of startups), common shares should be worth less than preferred shares as preferred shares have liquidation preference priority over common shares. Thus if you invest in secondary common stock, even in big names, be very careful not to overpay.

Per the above, the preferred liquidation preferences could easily eliminate any value for secondary buyers in an acquisition. The common shares may seem tempting based on overall valuation, but ultimately provide no payout due to their subordinate position and thus you should always be paying less for common shares than preferred for any business that doesn’t have ~100% IPO certainty. 

There was a really bad practice during the 2021 bull venture market in which common secondary was being sold at the same price per share as the primary financings in Series B/Series C/etc. rounds  that took place alongside them. This may seem like a good deal because you’re technically getting in at the same valuation as other institutions, but again due to preference priority, your common shares come with extra risk and thus should be discounted appropriately.

3. DEAL STRUCTURE

When I bought Coinbase shares in 2018, the only way to acquire those shares was via a Forward contract. A Forward contract allows an investor to agree today to purchase shares at a later date at a predetermined price. The actual share transfer and payment happens in the future - often tied to a liquidity event like an IPO or acquisition.

This Forward structure is in contrast to Direct Transfers, which are most secondary transactions I see today. Direct transfers allow the share transfers to happen immediately with the buyer owning the shares right away.

So why engage in a Forward contract at all? I see investors do it to avoid having to get the company’s approval and to bypass the right of first refusal (ROFR) process altogether. 

ROFR stands for Right of First Refusal, and it gives existing shareholders in a company the right to purchase shares before they can be sold to another buyer in a secondary transaction, so even if a seller agrees to sell you his/her shares in a private startup, the Company may block it or give it to another investor – a forward contract can avoid that. ROFR periods are typically 30 days, so Forward agreements can also lead to a faster transaction. 

While there are a number of issues with Forward agreements, I’ve found two big issues. One is counterparty risk - 1) If the seller fails to deliver the shares at maturity, the buyer could have no recourse. What happens if the Seller dies or the company refuses to acknowledge the forward come transfer time, among other issues. The forward contract is essentially an IOU, though I will say secondary marketplaces have gotten very good at assuring share delivery.  2) The second is delays in share delivery – I lost hundreds of thousands of dollars in potential profit after Coinbase was listed publicly because it took months for share delivery. 

I personally would participate in Forward’s again, but never put together a syndicate for one; again buyer beware.

IN SUMMARY:

• Preferred shares have liquidation preference over common shares. In an acquisition, preferred gets paid first. Common shareholders are at the bottom of the payout waterfall and thus carry additional risks of those shares being worthless even if preferred investors get paid back in full. 

• Don't overpay for common shares. They should trade at a discount to preferred in almost every case due to added risks. The exception perhaps is a Company that has a 100% chance of going public in which case preferred shares convert to common.

• Understand the company's full capital structure and preference stack. If you don’t, you do not understand your risk level. 

• Perform full diligence on secondary purchases especially; co-investing is a much riskier strategy given the increased risks of secondary transactions.

• Forward contracts, while allowing some benefits for secondary buyers, can lead to delayed share delivery and carry counterparty risk, such as failure in share delivery. Understand what you’re buying. 

I want to caveat this all but underscoring secondaries can be great opportunities – we’ve made ~10x in a short period on individual name that were only made available to us by investing in secondaries; the article is purely to help educate folks on how to better evaluate opportunities that may arise, specifically some often overlooked, but critical criteria like preference stack. 

I would be very curious to hear what the major marketplaces like EquityZen, Setter Capital, Hive Markets, Forge, and others provide more education or share this piece (or comment) to provide more transparency in this ecosystem, but I digress. 

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✍️ Written by Zachary and Alex