Private company secondaries: The dealmaker's guide

Background

Vauban's activity has changed due to the recent COVID crisis. We have experienced an upsurge in demand on the startup Single-Deal SPV side for two types of deals in particular:

  • Bridge rounds and convertible loan notes of companies looking to extend their runways
  • Secondary transactions

What is a secondary transaction?

The typical way of investing in a startup is to buy shares in a funding round, when a company creates new shares that investors buy at an agreed price. In other words, investors purchase shares from the company itself.

A secondary transaction is where an investor buys shares from an existing shareholder instead. The current shareholder will generally be an earlier investor, an employee who exercised their options, or a founder.

Startup shares can be lucrative holdings, but they’re illiquid; you can’t shop with them. In times of financial crisis, for a multitude of reasons, people tend to favour cash and liquidity and are more likely to sell their shares.

On the investors’ side, savvy dealmakers scout for opportunities to offer promising shares at a discount to their investor base.‍

Sourcing secondaries

As mentioned, secondaries opportunities are generally sourced from three types of current shareholders: Earlier investors, founders and employees.

An earlier investor

  • An early angel investor that needs cash: Life happens, and the angel investor might be at a stage where he/she needs cash to buy a house or face unexpected expenses for example.
  • An investor (Venture or Angel) that doesn't believe in the direction the company is taking and wants to exit
  • A venture fund that has reached maturity: Venture funds are cyclical. At some point, they have to return cash to their LPs and if the company is not at a stage where it can IPO or be acquired, Venture capitalists will consider secondary transactions as an exit.

A founder or an employee

We can group these together as their motivations to sell their shares will generally be motivated by the same reasons:

  • A need for cash to finance a life project or to face unexpected expenses.
  • A disagreement with the strategy of the company.
  • A need to cut the relationship after having been ousted.

SPV to structure secondaries

Why should you use an SPV to structure secondary transactions?

Secondary transactions generally happen in a very discreet manner as they could send wrong signals to the market otherwise. The founder/employee/early investor looking to exit for cash will typically prefer to discreetly sell all of the shares they want to sell at once, rather than having to complete multiple transactions with several investors.

On their end, investors will welcome the opportunity of being able to invest at a low minimum and with minimum hassle.

This is where dealmakers come in. They will find secondary opportunities through their networks and source investors for the deal, charging carried interest for their work in the process. This is why the use of an SPV is mandatory.

How to structure a secondary transaction with an SPV?

  1. Find a founder/employee/investor that wants to sell their holdings in a sexy startup.
  2. Ensure that the prospective seller has the right (or can obtain it) to sell their shares. You can generally find this information in the Articles of Association of the startup, which in some jurisdictions (in Europe) you can easily find on the website of the corporate registry (Companies House in the UK, for example). If not, you will need to request this information from the corporate secretary or one of the directors. This shouldn’t be a problem for any existing shareholder.
  3. Find investors that are interested in buying these shares. Secondaries can be very attractive as they are often priced at a discount compared to the startup’s market value (the valuation at which the company last closed or is about to close a funding round).
  4. Create an SPV and get the investors to invest in it.
  5. Buy the shares from the seller with the SPV. Note that in some jurisdictions, the purchaser (here the SPV) will have to pay stamp duty (in the UK, it’s 0.5%) on the total consideration value.
  6. Wait hopefully for an exit in the form of an IPO or an M&A. Or sell your holdings through another secondary transaction.

Conclusion

Investors are now (through the SPV) holding shares in a promising startup that they bought at a discount, with (generally) a low minimum and the dealmaker that sourced the secondary, found the investors and created the SPV has gained a carried interest of 20%.

The founder, employee or early investor that sold its shares on its end, has sold its shares in a single transaction to the SPV, minimising associated hassle and noise.