Secondaries via Venture Capital

FAST agreement

The rise of secondaries in startup funding


In recent years, keen observers to the startup growth funding landscape will have noticed a change in VC dynamics. Some would call it a maturing of venture capital perhaps.

Looking to the past, a key objective of VCs has always been to fund development and growth of promising tech startups. These funds were given directly to the company in order to finance their operations, i.e. via a primary investment. We see this trend stretching all the way back to the first check cut out to silicon valley’s semiconductor behemoths. 

Today, however, as we see venture capital funding of startups in later and later stages, another type of investment has become more prevalent - and those are secondaries. This effectively means that VCs are buying more and more secondary shares from founders and other shareholders instead of purchasing newly issued primary shares. The respective capital raised from a secondary offering will subsequently not fund the business or appear in the finances of the company but rather go directly into the pockets of the shareholders that part with their shares (find a more thorough explanation here).


Why venture capital firms are leveraging secondaries


There are two reasons for why secondaries have become more popular in VC financing lately. The first is that technology startups stay private longer. This trend is well-documented, but one of the often overlooked consequences of that fact is that early investors need to exit within their fund’s lifecycle. Hence, if a fund invests in the seed round of a startup and lasts ten years, but this startup only goes public after 15 years, the seed investor will require another means of exiting the business. Here, later stage venture capital firms are happy to pick up these seed investors’ shares, usually at a discount. 

The second reason is that allocation matters. When a VC invests into a promising tech business via a primary, they might not be happy with the share of the company they got to acquire. Secondaries are a means of gaining more ownership and control over a business, which can pay off and return huge capital gains once the business IPOs or gets acquired.


Why founders are selling their shares


Founders are not restricted by the fund lifecycles of their seed investors but they do have another problem. Profitable or not, their entire personal wealth is often tied up in the business they are running. With the aforementioned trend of technology companies going public later and later, prudent founders will want to de-risk their ownership by allocating a few eggs out of the basket by taking some cash home. 

Selling bits of their ownership may result in less control in their business but can help the founder realize a return on what they have built before the long-awaited exit. Given the finite lifespan of humans, taking some money off the table can be well-worth it to upgrade lifestyle and improve sleep from decreased concerns about what the future holds. Knowing they have something to fall back on in case the business does not work out as planned. Long-time founders will be familiar with the personal net worth limbo between all or nothing.

To founders of profitable businesses, taking chips off the table can be radically life-changing. So it was for Basecamp’s founder, David Heinemeier Hansson, who after he sold a minority, no-control stake to a HNWI for a few millions described the feeling of never having to work again as “there is an enduring and very real satisfaction and comfort in never having to look at the price of a meal in a restaurant again…”. In addition to good food, he also spent a slice of his partial buyout earnings on buying his childhood dream car, a yellow Lamborghini. He later accredits the deal to have given him the confidence he and his co-founder needed to take their SaaS business all the way. That decision gave them security of having hedged their bet to grow Basecamp to 3.5 million users fully bootstrapped.

million dollar payout

What to consider when onboarding VCs


Founders, especially of bootstrapped tech businesses, will, given any success, find themselves in the predicament that they have built a great company but are unsure of how to realize a return on it. An internet venture is, at the end of the day, a rather illiquid asset. So, a top-of-mind list of suboptimal options presents itself. Of course, the first one is to sell the entire company. This option, however, more often than not comes with the bittersweet pleasure of watching from the sidelines as the business grows to new heights at the hands of a new owner. 

An option for founders of profitable businesses is to withdraw cash from the company. Doing so too much can come at the cost of potentially hamstringing operations and future growth. Instead many choose to raise growth capital thinking that will solve their liquidity problems, both professionally and personally. But what most founders don’t realise is that a primary offering is different to a secondary.

A partial exit via a secondary is a favorable outcome for many founders who want to stay invested in their business and grow it further. To do so, onboarding a venture capital firm can be an option by having them invest growth capital into the business (via a primary), which also opens the door to buying equity directly from the founder (via a secondary).

But wait, there’s more. Founders should be weary of the invisible strings attached to checks from venture capitalists. With these transactions comes big growth expectations, as VCs will not invest simply to see a steady stream of dividends from shared earnings. Instead, founders of profitable internet businesses will have to change their approach to running their company and move into full growth mode, ready to risk it all.

One example for a business that ran profitably for a long time and then opted to raise venture capital is Unity Technologies. After founding the company in 2004, the founders bootstrapped the business into a profitable venture until 2008 before taking on investors. With the first investment, Unity’s path was altered drastically. The company would raise a total of 11 rounds of funding until its public offering in 2020. As a side note, Unity has yet to reach profitability again. Their priority for growth resulted in a public listing but at the cost of 12 years of fundraising and little time for anything else thanks to the internal pressures from taking outside growth capital.



What’s the alternative to onboarding a VC


When opting to onboard outside investors as a means of taking money off the table, founders should be aware of all their options. If their thinking is in line with the growth expectations of venture capital firms, this is likely a great path to take. However, if the founder wishes to continue to run their business like they have before, other investors might be a good alternative to consider. 

For founders running a more “calm” business, i.e. companies that run profitably with little ambition to IPO one day, Micro Private Equity funds or high-networth individuals are by far the superior option. These types of investors are oftentimes happy with obtaining a share of the business’ earnings and their incentives align in wanting the founders to succeed in the long-run instead of relying on a “grow or die” mindset like VCs do.

Platforms like BitsForDigits aim to put internet business founders in touch with like-minded investors who are looking for “calm”, dividend yielding opportunities, rather than the next Google. 

Further resources: The Rise Of Secondaries In Tech, ​​The Mess at Meetup, The Day I Became A Millionaire