Main Ideas About Secondary Transactions
As my man Kenny Rogers sang…
You’ve acquired 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
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 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 among 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 chance/reward related to VC. I’m not going to cowl causes to promote that I’d think about ‘taking part in protection’ — principally exogenous elements which contain LP stress for liquidity on non-optimal timelines, dissolution of funds as a result of partnership points, and so forth. These are all uncommon, however actual, and happily not something we’ve handled in our agency.
So for essentially the most half a enterprise investor holds their fairness till the corporate exits through an acquisition, IPO, or some form 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 progress and crossover buyers got here into the startup ecosystem they had been usually keen to place capital to work and completely happy to consolidate their positions with frequent or most well-liked shares from early workers, founders and former buyers. The excess of capital additionally meant that new funding rounds usually 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 at last, a extra strong (however nonetheless considerably opaque) secondary market emerged for transacting fairness amongst events.
As an early stage fund, usually shopping for 10–15% of an organization throughout its seed financing, this meant we had been usually 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 determine 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 trip 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; 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 apply and (b) friends may have the identical targets however take totally different paths to get there. And so subsequent we codified our personal ruleset. It sounds principally like this:
- Each time a portfolio raises a brand new spherical we ought to be ‘patrons’ or ‘sellers’ — that’s to not say that we purchase or promote into each spherical, however objectively we should always need to be on one facet 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 ought to be patrons or sellers as a concentrated early stage fund, not making an attempt to say “properly, if we had been a progress fund what can be do.”
- We should always try to execute choices which are each in one of the best curiosity of the corporate -AND- in one of the best curiosity of Homebrew. I’ll caveat this under however we need 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 convey buyers on to the cap desk through a secondary transaction which are 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 lately reminded, markets go down, not simply up. Simply concentrate on the incentives, feelings, and different elements at play. It’s okay to behave a method earlier than you hit your DPI goal and one other approach after, however perceive how these elements produce higher or worse attainable outcomes. That is additionally true close to recycling. If we will 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 one of the 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 are 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 one of the best model of what we will to deal with the corporate pretty but additionally do our fiduciary pursuits for our LPs. What’s an instance of a scenario which may begin fracturing the cap desk? Think about the CEO is sitting with two funding affords. One is a clear termsheet, no construction. The opposite has a ton of construction (preferences for the brand new investor) but additionally affords 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 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 frequent shareholders. Once more hardly ever however for those who do enterprise lengthy sufficient you see no less than considered one of all the things. At moments like this, in the event that they happen (and I can say we haven’t skilled something this grievous to one of the best of my information), abruptly we’re not rowing in the identical path.
A lot of success in enterprise is figuring out what (and when) to purchase. When you do this properly it’s very tough to mess it up. Conversely, for those who’re not a great 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++++) is usually a well-timed resolution to show unrealized features into partially realized.
