Leap of faith in secondary markets dealing

Booming Markets?

“Secondary markets are booming”. This is what one venture capital partner mentioned to me recently “but you need to be brave”. The first part of the sentence makes sense - venture deals are growing exponentially backed by a high number of IPOs ($162.4bn has been raised in public markets in 2021 so far). 

The second part of the sentence provoked me to prod further. How easy is it to get into the doors of some of the more exciting startups. How hard is it to bridge the liquidity gap? How to deal with the asymmetric level of information?

What is a secondary?

If you are reading this article this definition may be a given. But let’s all be on the same page: Secondaries are usually identified as a sale of shares by an existing shareholder to an external party. There are two potential exit events: 

1. The startup is raising funds and is allowing shareholders to cash out, and 

2. An existing shareholder (usually a founder) is asking to partially or fully exit between rounds. 

There is no public exchange to sell shares on, so shareholders need to rely on private market players: angels, venture capitalists, investment banks and other institutional players. There are a number of investment platforms looking to democratise these corporate events (notably Forge, and recently CartaX).


So what’s all the fuss?

As a general rule of thumb private markets are subject to asymmetric information, but in a secondary deal that isn’t fundraising (e.g. No.2 example above) you will have even less information (probably limited to the last fundraising deck and updated financials). Even if you are in the fundraising stage you might not be leading the transaction and have minimal data.

Another topic of complexity is the legal confines of what can be sold and the class of shares on offer. Companies racing through the Series A/B/C/etc alphabet soup will have more and more convoluted share structures with restrictions on transferability. You (or your lawyer) will need to brave through company documentation in a language you hopefully understand!

However, the bigger problem is that it is a seller’s market, especially for the more attractive startups. You will need to commit to a deal well before you have LPs lined up to meet the demand. Otherwise, you face steep competition from one of many interested buyers. You take a leap of faith, and may be required to complete within a very short period of time. LPs may fail to commit or simply pull out at a very late stage leaving you to fill the gap.

Solutions?

The first two issues can be solved through experience and expertise. The third one is a real thorn. You have to have thick skin and deep pockets and/or have an alternative solution:

  • Bridging loan: consider using bridging debt until you source another investor, but the costs are high and sometimes outweigh the potential returns. 
  • Dry Powder: keep some stash on the side. This has a big IRR disadvantage but needs to be weighed against not delivering on your promise to the seller. Some VCs will use a combination of Single Asset structures as well as drawing from their main Fund pot to de-risk themselves. 
  • Legal vehicles: using a legal vehicle as opposed to direct investments allows you to fractionalise ownership one layer above the startup. That way any interim funding can be syndicated without triggering any pre-emption rights. Usually we see this in the form of a partnership vehicle.

Happy secondary-ing!

Arik Oslerne