Major Ideas About Secondary Transactions
As my man Kenny Rogers sang…
You’ve obtained 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
Once you’re sittin’ on the desk
There’ll be time sufficient for countin’
When the dealin’s carried out
Beginning a enterprise capital weblog put up with Seventies nation music lyrics is fairly unusual, however so is writing about when and why an investor may select to promote fairness earlier than the corporate exits. Beneath I’ll share a few of the rules 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 great steward of LP capital and the danger/reward related to VC. I’m not going to cowl causes to promote that I’d take into account ‘taking part in protection’ — largely exogenous elements which contain LP stress for liquidity on non-optimal timelines, dissolution of funds attributable to partnership points, and so forth. These are all uncommon, however actual, and luckily not something we’ve handled in our agency.
So for essentially the most half a enterprise investor holds their fairness till the corporate exits by way of an acquisition, IPO, or some form of different liquidity occasion (administration buyout, no matter). However particularly over the past decade, the alternatives to promote forward of an end result for the corporate multiplied dramatically. As extra progress 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 introduced alternative to promote parts of fairness to present buyers who in any other case had been seeing their professional rata allocations in the reduction of. And eventually, a extra strong (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 needed to promote parts of our stakes to different permitted 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 velocity 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 determine what to do with their very own holdings. Then we mixed this with noticed knowledge from the conduct 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’ll be able to” and others who had *very* particular formulation for after they promote (when it hits X valuation, take Y p.c 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 objectives however take totally different paths to get there. And so subsequent we codified our personal ruleset. It sounds mainly like this:
- Each time a portfolio raises a brand new spherical we must be ‘consumers’ or ‘sellers’ — that’s to not say that we purchase or promote into each spherical, however objectively we should always wish to be on one aspect 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 must be consumers or sellers as a concentrated early stage fund, not making an attempt to say “effectively, if we had been a progress fund what can be do.”
- We must always try to execute choices which might be each in the very best curiosity of the corporate -AND- in the very best curiosity of Homebrew. I’ll caveat this under however we wish 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 might be going to be problematic. And so forth.
- Pigs get fats however hogs get slaughtered. Even when we imagine an organization has large longterm upside, it’s not inappropriate to take some cash off the desk with a view to handle that danger. As we’re not too long ago reminded, markets go down, not simply up. Simply pay attention to the incentives, feelings, and different elements at play. It’s alright to behave a technique earlier than you hit your DPI goal and one other method after, however perceive how these elements produce higher or worse potential outcomes. That is additionally true almost about recycling. If we are able to 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 the very 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 choices which might be according to that? Nice. In these instances 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 considerations first after which doing the very best model of what we are able to to deal with the corporate pretty but additionally do our fiduciary pursuits for our LPs. What’s an instance of a state of affairs that may begin fracturing the cap desk? Think about the CEO is sitting with two funding presents. One is a clear termsheet, no construction. The opposite has a ton of construction (preferences for the brand new investor) but additionally presents an fairness refresh to the exec staff, or has a handshake with the CEO that they’ll purchase $30 million of fairness from them after shut. You may 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 hardly ever however should you do enterprise lengthy sufficient you see not less than one among the whole lot. At moments like this, in the event that they happen (and I can say we haven’t skilled something this grievous to the very best of my information), swiftly we’re not rowing in the identical course.
A lot of success in enterprise is figuring out what (and when) to purchase. Should you try this effectively it’s very troublesome to mess it up. Conversely, should you’re not a great picker, it’s troublesome to beat that, even should you had good timing on secondary gross sales. However typically the distinction between B+ and A- (or between A and A++++) generally is a well-timed resolution to show unrealized positive aspects into partially realized.