Main Ideas About Secondary Transactions
As my man Kenny Rogers sang…
You’ve bought 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
Whenever you’re sittin’ on the desk
There’ll be time sufficient for countin’
When the dealin’s completed
Beginning a enterprise capital weblog submit with Nineteen 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. Under I’ll share among the ideas we use at Homebrew, realizing that there’s probably not a single ‘proper’ reply for a fund supervisor. Most of this dialogue is about ‘enjoying offense’ — working in direction of being an excellent steward of LP capital and the chance/reward related to VC. I’m not going to cowl causes to promote that I’d think about ‘enjoying protection’ — principally exogenous elements which contain LP strain for liquidity on non-optimal timelines, dissolution of funds as a consequence of partnership points, and so forth. These are all uncommon, however actual, and thankfully not something we’ve handled in our agency.
So for probably the most half a enterprise investor holds their fairness till the corporate exits through 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 end result 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 pleased to consolidate their positions with frequent or most popular shares from early workers, 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 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 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 types of selections, 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 information 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 experience your winners so long as you possibly can” 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 apply 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 needs to be ‘patrons’ or ‘sellers’ — that’s to not say that we purchase or promote into each spherical, however objectively we must always wish 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 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 through 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 super longterm upside, it’s not inappropriate to take some cash off the desk with the intention to handle that danger. As we’re just lately reminded, markets go down, not simply up. Simply pay attention to the incentives, feelings, and different elements at play. It’s okay 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 on the subject of 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 which may begin fracturing the cap desk? Think about the CEO is sitting with two funding gives. One is a clear termsheet, no construction. The opposite has a ton of construction (preferences for the brand new investor) but additionally gives 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 frequent shareholders. Once more hardly ever however if you happen to do enterprise lengthy sufficient you see at the least considered one of every little thing. 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 data), hastily we’re not rowing in the identical route.
A lot of success in enterprise is realizing what (and when) to purchase. Should you try this nicely it’s very tough to mess it up. Conversely, if you happen to’re not an excellent picker, it’s tough to beat that, even if you happen to had good timing on secondary gross sales. However generally the distinction between B+ and A- (or between A and A++++) is usually a well-timed choice to show unrealized beneficial properties into partially realized.
