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A previous article Secondaries: Founders and Investors defined a secondary as when you sell your existing shares to another investor. Secondaries don’t bring additional capital into a company, even if sometimes PR lumps primary and secondary into a single fundraising announcement. It’s really an exchange and so there are specific situations where they are really accepted. Going beyond that piece, this one will go deeper whether you are seeking an exposure or an exit.
1) Supply Vs Demand
Secondaries have practically become its own asset class in the last few years, with an increasing number of transactions and dedicated marketplaces. But as of writing this article, economic uncertainty has put the brakes – where there were more buyers than sellers now it has become the opposite. Indeed, the data below quoted by a recent TechCrunch article illustrates how sellers should expect more competition which means the process will take longer and / or they will have to offer bigger discounts.
2) Discount Rate
What is the right price for a share in a private company? Ultimately it’s whatever buyers and sellers agree to, the starting point is often from the last round of financing. One challenge is the company could have evolved significantly since then, for better or for worse. The second challenge is the share is not liquid like a public company’s i.e., it’s not as easy to buy and sell. This second challenge usually weighs stronger, meaning that there is a liquidity discount lowering the price, with 10-20% discount rates being fairly standard.
3) ROFR
The right of first refusal is the norm at this point among startups. It means that any employee or investor looking to sell has to first offer to the company itself. If the company declines to buy, they can still approve/disprove whoever is buying. Some common situations of not wanting to sell to a potential buyer: they don’t have a good reputation, they are competitive or too close to competitors, they are existing investors who would get too much power. A good practice is for sellers to run the subject internally, typically with the CEO, before it becomes a matter of formal approval at the board.
4) Liquidation Preference
When a company exits, barring specific clauses (founder shares, liq prefs etc), the returns typically distributed first to later investors than early investors then to the rest of the company. In other words series C > B > A > seed, which are all typically preferred shares, with seniority to common shares. If it is a great exit then everyone makes money and it doesn’t matter. But otherwise some investors will get more than others relative to their investment, and management and employees might make even less. Which means secondary buyers care immensely whether they are getting common versus preferred shares. And they will typically want the latter’s liq pref to be of the last round of financing. What Example: the company is at series C, a cofounder is selling 5% of their shares from the series A, the buyer will argue these shares pos-secondary to have the liq pref of series C.
Originally published on “Data Driven Investor,” am happy to syndicate on other platforms. I am the Managing Partner and Cofounder of Tau Ventures with 20 years in Silicon Valley across corporates, own startup, and VC funds. These are purposely short articles focused on practical insights (I call it gl;dr — good length; did read). Many of my writings are at https://www.linkedin.com/in/amgarg/detail/recent-activity/posts and I would be stoked if they get people interested enough in a topic to explore in further depth. If this article had useful insights for you comment away and/or give a like on the article and on the Tau Ventures’ LinkedIn page, with due thanks for supporting our work. All opinions expressed here are my own.
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