Major 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 depend your cash
Once you’re sittin’ on the desk
There’ll be time sufficient for countin’
When the dealin’s accomplished
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 may select to promote fairness earlier than the corporate exits. Under I’ll share a few of the ideas we use at Homebrew, figuring out that there’s not likely a single ‘proper’ reply for a fund supervisor. Most of this dialogue is about ‘taking part in offense’ — working in the 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 think about ‘taking part in protection’ — principally exogenous components which contain LP strain for liquidity on non-optimal timelines, dissolution of funds on account 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 kind 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 have been typically keen to place capital to work and comfortable to consolidate their positions with widespread or most well-liked 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 have 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 have 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 the 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 determine what to do with their very own holdings. Then we mixed this with noticed information from the conduct by coinvestors in our personal portfolio.
Not surprisingly there was no particular consensus. There have been examples of nice buyers who stated “by no means promote early — you experience 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 p.c off the desk every subsequent spherical; all the time 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 may 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 should 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 “properly, if we have been a progress fund what can be do.”
- We should always attempt to execute selections which can be each in the very best curiosity of the corporate -AND- in the very best curiosity of Homebrew. I’ll caveat this beneath 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 can be going to be problematic. And so forth.
- Pigs get fats however hogs get slaughtered. Even when we consider an organization has great longterm upside, it’s not inappropriate to take some cash off the desk so as 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 okay to behave a method earlier than you hit your DPI goal and one other means after, however perceive how these components produce higher or worse potential outcomes. That is additionally true as regards to recycling. If we are able to promote partially out of a place and put these proceeds into one which we consider 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 selections which can be in step 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 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 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 crew, 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 not often however for those who do enterprise lengthy sufficient you see at the least one among 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), swiftly 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 do this properly it’s very tough to mess it up. Conversely, for those who’re not a superb picker, it’s tough to beat that, even for those who had good timing on secondary gross sales. However generally the distinction between B+ and A- (or between A and A++++) generally is a well-timed determination to show unrealized positive aspects into partially realized.
