Several defining factors lie at the center of a developed startup and VC ecosystem, like a successful track record of innovation and company formation. A stable funding ecosystem with both experienced local and foreign investors, a continuous influx of great first-time entrepreneurs, and the presence of global players with growth capital to build out bigger companies are all other characteristics of such an ecosystem.
Another important but often overlooked characteristic of a mature and sophisticated market is an increased receptiveness to transactions involving company shares before a true “exit” event. These deals, known as secondaries, present opportunities to startups and other shareholders when executed correctly.
How Secondary Deals Advance Startups
Focus for Founders
Secondary deals built and timed properly can often present founders and company boards with an opportunity to deepen their aligned interests.
In the case of a founder seeking liquidity for example, it would allow them to pay down a mortgage while maintaining a significant stake in a company. This in-turn would allow a founder to be far more focused on building a company for the long-haul rather than seeking a short-term win. Of course, when doing so, company boards should strike the right balance, leaving founders yet with a very significant skin in the game.
In a highly competitive environment for talent, it helps to show new and early hires that they could still gain value from their shares, even if the much anticipated “exit” event is not near. Providing early or critical employees with liquidity for a portion of their holdings often helps relieve tension, and could prove very helpful in increasing loyalty in the face of competition for talent.
Furthermore, secondaries can create an opportunity to bring aboard institutional investors with deep resources and connections for a company. They offer an opportunity for a company to clean-up it’s cap-table without a new funding round.
Win-Win with Angels and Early Investors
Secondary transactions provide angel investors, often the earliest investors in a company, with a shorter wait to see returns. This is especially important because larger institutional investors will often invest later-on, diluting the initial stakes held by angels or early investors. In fact, angels waiting longer might end up seeing smaller returns than if they’d cash out earlier.
From the company’s perspective, a new alternative investor has been brought onboard, who can be more aligned with long-term value creation.
What are the key risks & considerations in gaining a partner through a secondary deal?
Like any financing transaction, secondary transactions could backfire if not executed properly. The transaction introduces a new shareholder to the company, and as any experienced CEO or VC can tell you, the company and other investors need to think carefully about choosing the right partner.
Do I trust this secondary firm with my information, and their ability to keep it confidential? Are they more interested in a PR announcing a deal with my company than in becoming a true partner? Will they be aligned with us the next time someone wants to sell shares in my firm?
These are all questions that the CEO of a company should ask, and that I ask as a direct investor into companies.
Deal timing or the seller’s relationship with the company could have long-term ramifications. For example, a CEO might not want to give the option to sell shares during a sensitive primary financing transaction, or in the case of an ex-employee that had acted in a manner harmful to the company, etc.
A firm doing secondary transactions with an eye towards the future needs to focus on the long run by looking at these things carefully and holistically. A secondary investor should conduct itself in a manner that completely meshes with the board of directors.
Commitment to Venture
Secondary investing represents a very specific and effective investment strategy. Choose a firm with a larger commitment to venture than just one investment strategy. Firms that cater to a broader set of investment strategies within venture have considerable advantages over firms that only do secondaries.
For example, if the secondary investor invests into other venture funds or has access to top VC funds, they may be able to introduce you to additional investors qualified to lead your next round. If the secondary fund VC also does direct investing, they could lead or join your next funding round. Depending on their pool of capital, they may be able to invest considerably more than the amount of the original secondary transaction.
Does the firm Add Value?
CEOs and investors should also consider the ability of the new shareholder to add value. After all, their goal should be to maximize the long-term value. A value-add shareholder can make introductions to new investors or qualified customers and join forces with management and existing investors to augment business development and recruiting efforts.
I hope this has given you a well-rounded summary of ways that managing shares can help a founder or investors. In an increasingly competitive venture landscape, secondary deals that are executed well could become a vital asset in a founder’s toolset, helping align everyone with a stake in a startup to build a great new company.