Major Ideas About Secondary Transactions
As my man Kenny Rogers sang…
You’ve acquired to know when to carry ‘em
Know when to fold ‘em
Know when to stroll away
And know when to run
You by no means rely your cash
While you’re sittin’ on the desk
There’ll be time sufficient for countin’
When the dealin’s performed
Beginning a enterprise capital weblog publish with Seventies nation music lyrics is fairly unusual, however so is writing about when and why an investor would possibly select to promote fairness earlier than the corporate exits. Beneath I’ll share a number of the ideas we use at Homebrew, figuring out that there’s probably not a single ‘proper’ reply for a fund supervisor. Most of this dialogue is about ‘taking part in offense’ — working in direction of being a superb steward of LP capital and the danger/reward related to VC. I’m not going to cowl causes to promote that I’d contemplate ‘taking part in protection’ — principally exogenous components which contain LP strain for liquidity on non-optimal timelines, dissolution of funds because of partnership points, and so forth. These are all uncommon, however actual, and fortuitously not something we’ve handled in our agency.
So for probably the most half a enterprise investor holds their fairness till the corporate exits by way of an acquisition, IPO, or some type of different liquidity occasion (administration buyout, no matter). However particularly during the last decade, the alternatives to promote forward of an consequence for the corporate multiplied dramatically. As extra development and crossover buyers got here into the startup ecosystem they had been typically keen to place capital to work and joyful to consolidate their positions with widespread or most popular shares from early staff, founders and former buyers. The excess of capital additionally meant that new funding rounds typically offered alternative to promote parts of fairness to present buyers who in any other case had been seeing their professional rata allocations reduce. And at last, a extra sturdy (however nonetheless considerably opaque) secondary market emerged for transacting fairness amongst events.
As an early stage fund, typically shopping for 10–15% of an organization throughout its seed financing, this meant we had been typically being requested if we wished to promote parts of our stakes to different authorized buyers (not to mention the random pings from market-makers unaffiliated with the corporate). As former product managers Satya and I lean in direction of having frameworks for these kinds of choices, for each consistency and pace in inside operations. We began by asking our LPs (a comparatively small variety of institutional buyers) and different skilled VCs what they’ve seen play out and the way, if relevant, they resolve what to do with their very own holdings. Then we mixed this with noticed knowledge from the habits by coinvestors in our personal portfolio.
Not surprisingly there was no particular consensus. There have been examples of nice buyers who mentioned “by no means promote early — you trip your winners so long as you may” and others who had *very* particular formulation for once they promote (when it hits X valuation, take Y % off the desk every subsequent spherical; at all times promote till you hit a sure return a number of for the fund, then maintain after; and so forth). This was useful as a result of it tell us that (a) there wasn’t a common finest observe and (b) friends might have the identical targets however take totally different paths to get there. And so subsequent we codified our personal ruleset. It sounds principally like this:
- Each time a portfolio raises a brand new spherical we needs to be ‘patrons’ or ‘sellers’ — that’s to not say that we purchase or promote into each spherical, however objectively we should always need to be on one facet of the desk or the opposite. We must always have an opinion, though one which’s knowledgeable by our personal fund technique. That’s, we needs to be patrons or sellers as a concentrated early stage fund, not attempting to say “nicely, if we had been a development fund what can be do.”
- We must always attempt to execute selections which are each in one of the best curiosity of the corporate -AND- in one of the best curiosity of Homebrew. I’ll caveat this under however we need to be protecting of the longterm pursuits of the corporate, the CEO, and the coinvestors. You don’t attempt to reprice the corporate by yourself. You don’t carry buyers on to the cap desk by way of a secondary transaction which are going to be problematic. And so forth.
- Pigs get fats however hogs get slaughtered. Even when we imagine an organization has super longterm upside, it’s not inappropriate to take some cash off the desk as a way to handle that threat. As we’re not too long ago reminded, markets go down, not simply up. Simply concentrate on the incentives, feelings, and different components at play. It’s alright to behave a technique earlier than you hit your DPI goal and one other manner after, however perceive how these components produce higher or worse attainable outcomes. That is additionally true almost about recycling. If we will promote partially out of a place and put these proceeds into one which we imagine has extra incremental upside, that’s accretive to our outcomes.
- We’re aligned with the founders and the remainder of the cap desk till we aren’t. All the popular inventory is pari passu and behaving honorably in one of the best curiosity of the corporate? Nice. The founders are taking some cash off the desk in secondary however nonetheless very a lot locked in on constructing and making funding selections which are in line with that? Nice. In these circumstances there’s little or no further complication. But when this breaks, we have to rethink how we consider our personal positions. Not in darkness, however expressing issues first after which doing one of the best model of what we will to deal with the corporate pretty but additionally do our fiduciary pursuits for our LPs. What’s an instance of a scenario that may begin fracturing the cap desk? Think about the CEO is sitting with two funding affords. One is a clear termsheet, no construction. The opposite has a ton of construction (preferences for the brand new investor) but additionally affords an fairness refresh to the exec workforce, or has a handshake with the CEO that they’ll purchase $30 million of fairness from them after shut. You would possibly suppose, “Hunter! This doesn’t occur — a Board would cease it” (or no matter). And I’d say, it does even when it sucks for different buyers and the worker widespread shareholders. Once more not often however in the event you do enterprise lengthy sufficient you see at the very least one among every part. At moments like this, in the event that they happen (and I can say we haven’t skilled something this grievous to one of the best of my data), unexpectedly we’re not rowing in the identical route.
A lot of success in enterprise is figuring out what (and when) to purchase. If you happen to try this nicely it’s very tough to mess it up. Conversely, in the event you’re not a superb picker, it’s tough to beat that, even in the event you had excellent timing on secondary gross sales. However generally the distinction between B+ and A- (or between A and A++++) generally is a well-timed choice to show unrealized positive factors into partially realized.
