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Secondaries in VC : When do they make sense?

This article is more of a question to the readers. We – the discussers – did not know honestly and just had some ideas. Meeting up with some ex colleagues and other VC folks over the weekend, we were re-visiting the secondary transaction for a privately held company. We completely ignored any particular rights and assume a free market without pre-emptive rights for existing investors.

We all agreed pretty much that secondaries come at a discount. New financing rounds have a premium versus secondary transactions. Why? Because nobody sells a stake in company that is expected to outperform. And there typically is a different kind of competition. If you would have competition on a secondary transaction, you would have a clear case of pre-emptive rights being applied.

(Interesting enough, if you assume pre-emptive rights, and nobody exercises them, this depresses the pruchase price, unless the existing shareholders are known to be clueless and under-positioned to execute on an opportunity, in which case bidding contests might become more interesting and realistic again; but in which case bidding war will be accompanied with further secondary offers for the other shareholders not initially selling).

Reason 1: Seller is moron, buyer is smart

In the very rare case, the seller doesn’t see the business case. The buyer might believe in it. Sees a discount. Buys. Probably rarely the case. Unless we are looking at an early entry into a overall market play. The market play could be a diversification play [Have to cover this segment from risk spread perspective] or a consolidation plan [Want to consolidate here and want a cheap stake into a potential M&A candidate later on]. Etc.

Reason 2: Buyer wants information rights at a discount:

Secondary at discount might be a good option to scout and get info rights on e.g. board material, information rights, etc. Could be an interesting concept to scout a potentially interesting investment before the bidding war of a new round. Given that the company might flip from downside case to upside case soon and VC interest is going to rise. The rise could also be driven by an anticipation of sector interest. Maybe nobody likes the market, downround is iminent, looks like a discount case, but the momentum is in favor of the stock.

This also might be viable for someone that has a major stake in a competitor and wants to buy a small stake in the target. We were assuming it to be unlikely, but not impossible, that someone is bidding for a minimal share amount (e.g. 1 share) at a high multiple of the current price, to obtain information rights about a competitor. We were also positive that such “competitor-invested” bidders are more likely to run at high bid promises initially to obtain information access pre-purchase, but most will step back from buying ownership.

Reason 3: The hostile takeover A

Similar to above, maybe goal is to get an early way into a future big-stake investment at a earlier stage discount. Using this information – and this isn’t speculative, as everyone saw it during exit transactions – to publicly slam the valuation of the company and to  possibly prevent a good round from happening for this company; to in essence push the company close to insolvency and push competing bidders out of the race, to increase the bargaining power over the company .
Simple case include investor X showing interest in company A, information shared with potential co-investors, and information leaked to press. Both co-investor info and press saying the deal was happening at the deal fell apart. Both possibly ruining reputation of the company and increasing cash out risk. INcreasing the bargaining power of investor X and helping investor X to buy a high conviction investment at lowest price.

Reason 4: The hostile takeover B – Kill to Shoot to Moon

Another option is do run a consolidation game on the cap table or in short ” a recap ” and use the game to kick out non-performing investors and governance, to kick out shareholders and management, and to optimize the entire company for a buyer or exit and push for the exit. This can easily happen later stage, or is possible early stage with founder reverse vesting schedules more common among rookies. Triggering a bad leaver clause after purchase, buyer might be able to force a recap and change of control. Making way for new control and incentive structures and onboarding key people to either drive the company forward or prepare for a quick flip to a strategic buyer. This can be interesting from IRR perspective at low market volume of deals, or even based on MOIC considerations if the mismanagement prior to the takeover was massively depressing the value.

Reason 5: Value add case A and B

Another, and we assume it to be more rare,  case where seller doesnt have value added function for the investment. Could be tax choiced, could be lack of experience. Could be lack of value added network. Seller might misjudged risk-reward context of company and might be willing to sell. In this case, a secondary of parts of holding could be effective.

Probably, if access to network and (human) resources and credibility are an issue where original investor is not able to deliver, there is a “critical mass effect” (non-linear value multiplier) not achieved before selling the company to a third party, there might be a case for either (a) buying out using a secondary, or (b) buying – adding  value – and selling back.

Case A: The buyer has real value add and a story
In this case, buyer has skills that seller doesn’t have. After using this skills, buyer is willing to hold and reap rewards. Seller will try to use this for increasing the discounted sales price.

Case B; Buying – Adding Value – Selling Back
Talking about (b) E.g. Investor might sell 40% of its stock at a 20% discount to B. B buys with a put option of 20% upcount to sell stock back to Investor. B by adding value to the company, made 1.5x MOIC. Could be a proposition to add value to an investment via network without taking a long-term holding.

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Feel free to write private messages or comments if you identify more reasons for secondary transactions in pre-IPO, venture-funded companies. (Apart from “I need cash” reasons, of course.)

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