I've been rewatching Silicon Valley lately (if you haven't seen it yet, massive spoilers below, and, more importantly, what are you doing in life?).
Above all, it's a riotously funny, Emmy-nominated comedy (a parody of Silicon Valley has a lot of material to work with). That said, the writers do a great job of accurately portraying the themes they cover over the six-season run.
Elon Musk said of the show's accuracy:
It starts to get very accurate around episode 4...so it took a few episodes to kinda get grounded. The first episodes struck me as Hollywood making fun of Hollywood's idea of Silicon Valley...which is not on point. But by about the 4th or 5th episode of Season 1 it starts to get good, and by Season 2, it's amazing.
One of the topics covered was secondary stock sales (season 3, episode 8).
As owner of the incubator where the protagonists founded their startup, Erlich Bachmann owns 10% of Pied Piper, a potentially multi-billion dollar company. He's been there from the very beginning, right through from getting sucker-punched to negging VCs in the most outrageous ways. Naturally, having been through so much with the company, he wants to stay there right to the end, realising the lucrative upside that awaits him.
Anyway, after some characteristically profligate decisions, Erlich finds himself effectively bankrupt with a lot of debt. All the signs suggest that his only way out is to cash in on his most valuable asset: his stake in Pied Piper.
Erlich takes the proposition to the company's largest investor, Raviga, after a board meeting. That's that. The bottom line is that Erlich has sold his shares in a secondary transaction to Raviga, who increased their ownership in the company.
Maybe in 1999, if you started a venture-backed business, your odds of success were 1 in 10. Today they might be 1 in 50.
There’s a lot more companies. We’re going after hugely winner-take-all markets. The new entrants keep coming up, the platforms keep shifting faster and faster, the half-life of the winners is shorter. It’s becoming a much more competitive atmosphere.
The other secular shift is that of companies staying private longer - the median age of venture capital backed technology companies at the time of IPO has risen to 10.9 years in 2018 from 7.9 years in 2006. In a world starved of yield, allocation to VC and PE funds will only increase, further reinforcing the case for staying private longer and postponing the scrutiny and reporting requirements of being a public company.
In tandem, what are the consequences of these shifts? What was already an infinitesimal chance of success (defined as an exit of the scale that makes all parties happy, including your investors who can block exits that aren't favourable to them) is only getting smaller. To top it off, founders and employees have to wait longer and longer to realise any appreciation in their wealth, when they're already making the trade-off of working on reduced salaries to capture upside from their shares.
Let's dissect this. When a founder or employee sells shares, it is ostensibly a signal that things aren't going well - in the fleeting world of early-stage companies, optics and reality can become one and the same in a vicious cycle. This was exactly the concern of Pied Piper CEO Richard Hendricks, who then confronts Erlich as he's finishing off a photo shoot for the company in a scene that is amusing even without the context.
As a prospective or existing investor in the business, you would naturally want to minimise the risk of signalling that things are awry. The signal is transmitted to a wide range of stakeholders, from everyone inside the company to all the suppliers, customers and future employees (as Richard learned in the case of the latter).
A more direct objection is that founders and employees will be less motivated if they have less of their compensation tied to the success of the company - I don't think this requires much elaboration.
Having made the case against secondaries, let's explore the arguments for them.
As we noted above, founders are taking huge risks when they start companies. This risk is far more acute for founders coming from working-class or lower middle-class backgrounds, who struggle to get their company off the ground to begin with.
Let's say that after working in a corporate job for a a few years you've managed to save up enough to sacrifice your salary. You're single, have few dependents and are able to take the plunge. Over time, your circumstances inevitably change as you start a family, buy a house, pay for the kids' education, take care of unforeseen medical bills, and so forth. Not all of these happen to everyone, but most people will incur mounting financial obligations or a change in their personal circumstances over time. Eventually it can become untenable to meet your new obligations when all of your newfound wealth is illiquid and you're cash-poor. Early employees are in the same boat, owning even less equity (far less usually).
Austen Allred, founder and CEO of Lambda School, appeared on The Twenty Minute VC a few weeks ago and talked about how financial insecurity affected his risk-taking mindset as a founder:
I think that's one of the things people underestimate about being poor, or not, is how your mindset can change.
When you are poor, or your salary or income is low, you have to think really, really hard about downside risk, because any little thing that goes wrong, totally flips you upside down.
Austen goes on to give the example of when he used to live in his car and how having it impounded basically left him without a place to sleep.
Laura Connell, Principal at Balderton Capital, noted this second-order effect of financial insecurity in her own writing:
Loss aversion refers to the fact that most people prefer to avoid losses than acquire equivalent gains, i.e. better not to lose $100 than to find $100. As startups grow and more of a founder and management’s wealth is tied up in equity, with less certainty about their gains than potential losses, this can paradoxically lead them to minimise risk taking, i.e. risk appetites are not static and evolve as the size of the potential loss grows.
Investors benefit too - early investors may want to cash out to return money to their LPs so they can raise their next fund. Conversely, later-stage VCs want ownership in the best companies - whether that's in common or preferred shares. Transferwise is one example, but I encourage you to read this thread on DST's investment into Facebook through secondaries as well.
Liquidity for founders and employees is a good thing. Signalling risk and motivation should be managed. There's a lot of nuance in there, but those are the headlines.
Elad Gil is a veteran of the Valley and one of its most respected advisors. Secondaries get a whole chapter in his invaluable book, High Growth Handbook, as there are a lot of practicalities to consider. I'm going to list out a few of the most important suggestions, but I strongly encourage you to read the chapter in full. I'm also going to add Laura Connell's suggestions from her brilliant article on the European venture liquidity gap.
EG: A $500 million to $1 billion valuation is usually where founders and/or employees might start to consider selling stock
LC: Well past achieving product-market-fit, likely at Series C or beyond and are firmly in the scaling stage with reasonable revenue visibility.
EG: As an active founder, you may want to sell up to 10% of your holdings (or up to $5 to $10 million, whichever is lower)
LC: The standard in our experience is usually 10%. Many businesses take a hybrid approach here such that they set the sale limit at the lesser of % or $ amount.
Different types of secondary sales
EG: In general, the company has an incentive to push the stock seller to a buyer it already knows well. In general, one-off sales can backfire on a company as new, non-savvy, or potentially badly-behaved investors come on board. It is beneficial to the long-term health and stability of the company to establish a set of “preferred buyers” early to soak up secondary sales and demand for selling stock.In parallel, the company should start to institute programs detailing how much employees or early investors can sell, and under what circumstances.
LC: This is primarily the kind of situation Balderton focuses on. In this instance, due diligence and the subsequent offer to the seller are made with management buy-in.
EG: Most financing rounds for late-stage breakout companies tend to be oversubscribed. The extra demand for company stock means that an investor who could not get a full primary allocation may be willing to take in a blend of preferred (as part of the round) and common stock (acquired from an employee or founder), or early-stage preferred stock (from an early investor).
Usually no more than 20% of the funding round will take place as secondary. There are also regulatory limits on the percentage a venture capital fund can invest in secondary versus primary stock.
LC: This can be efficient from a management perspective as materials will already have been prepared for the primary round and any additional primary demand can potentially be funnelled into secondary liquidity.
EG: A tender is basically a large coordinated event in which one or more buyers buy secondary stock in your company at a preset price. Typically, buyers in a tender are large institutional buyers from the hedge fund, private equity, or late-stage VC worlds, such as BlackRock, Goldman Sachs, DST, Fidelity, and others. Tender offers may range from the tens of millions into the hundreds of millions or billions of dollars in size.
LC: We have seen situations, particularly involving employee liquidity, in which we complete due diligence and agree a term sheet with management to invest up to a given amount. Management then shares this information with eligible employees who can choose to opt in or out, usually with a % maximum sale amount per employee as outlined above.
EG: Most investors tend to discount common stock 20% to 30% relative to the preferred stock price.
LC: Most secondary investors take a market-based approach to valuation.
There's a lot more to consider like preferred buyers, ROFRs, information rights, etc. - read the respective sources in full to discover the pertinent advice on each.
The Key Players
The biggest firm specialising in secondaries is TempoCap - their Managing Partner Olav Ostin did a far better job of articulating the case for secondaries than I ever could. TempoCap invest in growth-stage technology companies across Europe, both through primaries and secondaries.
MMC Ventures unveiled a Scale Up fund in November 2019 that offers liquidity to early MMC and third-party investors in MMC portfolio companies.
That's it, as far as I know. Whether that is enough is hard to say, as PE funds are definitely doing secondaries. Ultimately, as Nicolas Colin has argued, Europe needs an alternate ecosystem of secondary investments to compete with the US and spur the sort of recycling of capital that sustains ecosystems.
If I missed out any, please reach out. Initially I wanted to make an open-source list, but quickly discovered it wouldn't take long!
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“The fact that an opinion has been widely held is no evidence whatever that it is not utterly absurd; indeed in view of the silliness of the majority of mankind, a widely spread belief is more likely to be foolish than sensible" - Bertrand Russell