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The thesis of secondaries – Seedrs Insights

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Venture Capital investment thesis’ vary, but the investing principles remain the same for primary investments. VC firms invest capital, guidance, and expertise into early stage entrepreneurs in order to help them grow. The risks are high, as with all private investing, but if explosive growth is achieved, outsized returns can also be achieved.

Venture capital secondaries have a different thesis. With an increased focus on the potential returns that can be achieved, secondaries allow investors to gain economic exposure to the growth potential of later stage startups. This is often at a discounted price to the last priced round.

So, why do individual investors choose to sell early? 

Individual investors end up as shareholders in a number of ways. Their reasons for selling vary, but the motivation is typically the same. Companies are remaining private for longer, and individuals have liquidity needs.

Employees

When startups are first founded, most management teams are on tight budgets. Yet, a company’s first hires are critical to setting up the company for long-term success. So, in order to recruit the best talent, companies use equity as an essential part of startup employees’ pay packages. If a startup then experiences considerable growth, the value of those shares will increase. This leads to early employees holding share options and equity worth lots of money. 

Great for them, right? Yes, but it comes with challenges.

These individuals are often ordinary early employees rather than professional investors. They may want to realise the value of their shareholding sooner than waiting to exit, which is often years in the future. This could be for one of life’s big events, like buying property, starting a company, or retiring. Early employees are able to leverage a secondary sale to divest some or all of their shareholding early and realise this wealth.

Angel Investors

Startups often raise their first rounds of investment from angel investors. Angels vary from family and friends who want to show support, to seasoned investors who are professionals in the space. In the same way as employee shares increase in value, angel investors can see the same growth.

Angel investors often want to cash out before a full exit. Some want to sell part of their holding to realise gains already made. Others want to sell all of their holding as the company has passed the stages that they want to invest in. All are able to exit early and unlock illiquid wealth through a secondary sale.

Founders

Founders will typically have large holdings of equity in their own companies. After years of long hours, high stress, and often a total lack of work/life balance, it’s unsurprising that founders often want to take some equity off the table and realise some paper wealth. Being a millionaire on paper doesn’t sound nearly as exciting as having that cash in the bank. 

Founder secondaries have historically been frowned upon by traditional VCs. A founder taking equity off the table can reduce their alignment to the success of the company. If they’ve already cashed out some of their holdings and made a load of money, will their focus and drive to grow the company still be the same? But over the last few years, that sentiment has changed as VC’s have adopted a more modern mindset.

Secondaries can enable founders to focus on their ambitions without the distractions and pressures of short- or medium- term financial issues. A secondary can keep a founder aiming for the greatest outcome, rather than settling for a mediocre one.

And why do institutional investors sell through secondaries?

Fund lifecycle

VC firms invest through funds that have limited lifecycles. Most funds are set up as 10-year vehicles with a five-year investment period. With fast-growth companies choosing to remain private for longer than ever, VCs will sometimes have to exit investments early in order to distribute returns to their Limited Partners (LPs) on the timelines that they’ve committed to. Secondaries allow VCs to access this liquidity.

Rebalancing portfolio

Institutional investors want to generate outsized returns, but also want to diversify their assets to mitigate risk. Investing in high growth companies can result in funds becoming overexposed to certain sectors, and institutions are able to turn to secondaries in order to reduce shareholdings and rebalance.

Some institutions that have seen particularly successful investments may want to de-risk entirely. Through secondary transactions they can exit for the value of their initial investment, whilst holding onto any additional shares, allowing them to retain exposure to the upside of any future valuation gains.

Now, why would investors want to invest in secondaries?

Investors in secondaries range from individuals to institutional investors, and their motivations are similar. Investors invest to increase their economic exposure to high growth companies that are already scaling fast.

Institutional investors

Existing investors and new investors are very common buyers in secondaries. Existing investors already know the company and have likely completed their due diligence. If the company is doing well, existing investors may want to buy as much of the company as possible.

Hot primary raises are often oversubscribed, and not all institutions that want to invest are able to. Investors that have been left out can either wait for the next primary raise and hope to invest then, which will likely be at a higher valuation if the company is doing well, or they can buy in through a secondary transaction. The latter is often preferable as it typically allows them to invest at a lower valuation than they may receive in future.

Certain investors, particularly growth-stage investors, are less interested in the very early stages of the startup lifecycle. The first rounds of investment present the best opportunity to make outsized returns if a company succeeds. However, investors in these rounds take on the most risk of the venture failing. Historically, a rule of thumb has been that 90% of startup businesses fail within 10 years. 

By the time a fast-growing company approaches hockey stick growth, it can be too late for certain investors to get into new primary funding rounds. Secondaries present an opportunity for investors to get in later, mitigating some of the risk of early stage private investing. In addition, it offers a potentially larger upside than waiting for a company to go public.

Many institutions that buy up secondaries are looking for a bargain. In the VC secondary market, shares are often offered at a discount to the most recent listed valuation. Although, this has changed over the past few years with more investors willing to pay premiums for the right deal. 

A few factors contribute to the pricing of secondaries:
  • Share class – secondaries typically offer common stock with limited voting and information rights, rather than preferred stock offered in primary raises. The increased risk of being at the bottom of the share tree if liquidation occurs is factored into the valuation of secondary shares. 
  • Finding a buyer – typically secondary shares appear in the market because a shareholder is actively seeking a buyer for the shares. Depending on how urgent the liquidity requirement, secondary buyers can act fast with low offers to take advantage of their position to deliver liquidity fast
  • Supply of shares – simple supply and demand economics. If shares are in short supply, the market price is going to be higher. If shares are widely available in the market and demand is low, the market price will be lower. 
  • Company perception – if the company is particularly exciting, e.g. operating in a big market with a unique idea, lots of room for growth and good defensibility from competitors, that is factored into pricing.

The pricing of secondaries on Seedrs are based on the same factors, and are negotiated by our secondaries team.

High net worth investors and SPVs

It’s possible for individuals to buy shares in later-stage startups that are doing well, aiming for the same upside as institutional investors. Previously, individual investors would have to be well-connected, high net worth individuals, willing to buy large share allocations and manage complex transaction processes. 

A group of investors can form an SPV (special purpose vehicle), in order to pool money to buy secondary allocations. This creates one entry on the issuing company’s cap table, but allows multiple investors to invest through the SPV structure.

Everyday investors

Due to substantial investment minimums and the complex legal issues associated with creation of SPVs, everyday investors have previously been excluded from investing in secondaries. Investors would have to wait for the IPO to invest, and watch the share price with crossed fingers. 

Whilst outsized returns can be generated after public listings (why didn’t our parents invest in Apple in 1983?) turbulent short-term market conditions can make for challenging investing – as we see high profile IPOs such as Robinhood, Coinbase and Marqueta, all of whom have dropped 60%+ since their 2021 IPOs (see also, Apple going public in 1983…).

The role of secondaries in building a portfolio

Ultimately, all investors – whether institutional, high-net-worth or everyday – should be focused on building a diversified portfolio that balances personal risk appetite with their long-term wealth building strategy. Secondaries offer a chance to further diversify a portfolio beyond just very early stage and public companies. 

With our industry leading nominee structure, we can help shareholders exit. We give everyday investors access to exciting pre-IPO companies for the first time, from as little as £10. 

Recently we’ve successfully provided eligible investors the opportunity to invest in Freetrade and Impossible Foods. Keep an eye our for some exciting names in the pipeline for the next few weeks by registering below. 

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