EGD News #180 — My thoughts on secondary rounds
Let me explain what secondaries are.
The secondary provides liquidity to existing shareholders looking to sell some of their shares. Secondaries usually happen at the Series A stage and later. During a secondary round, investors purchase shares directly from existing shareholders, such as employees, early investors, and, most often, from founders.
The terms and structure of a secondary round can vary widely depending on the prospects and needs of the company and the motivations of the investors and existing shareholders.
Note that secondaries are usually a component of a fundraising round, like a Series A, where the investors are also investing in the company: money goes into the company’s bank account.
In a secondary, the founder who sells, gets the money.
In the past, and still to this day, some VCs view secondary rounds as a negative signal about the company’s growth prospects. If a founder is selling their shares, it can be perceived as a lack of confidence in the company’s future potential. But there are positives for both founders and investors, and many VCs have become more willing to conduct secondaries.
When I was a founder, I never sold shares in a secondary round.
Is that good? I think not. I believe that selling part of my ownership later would have helped me over the bumps in the round, possibly avoiding a burn out in 2019. I can’t say for sure, but things might have been different with a secondary sale early on.
Why are secondaries good for founders?
When a secondary happens, founders get to remove some of the stress. Maybe they sell 200k worth of shares, which at Series A stage, shouldn’t be more than a few percent of their ownership.
After the secondary, the founder will feel elated: they’ve made it, at least somewhere. Growing a company has risks, and a new existential crisis could be looming around the corner. What if Apple changes the way you can market your game? What if a competitor comes in, and CPIs double overnight, or what if your game starts to flatline in growth and eventually approach zero? What if!
After the secondary, the founder’s outcome won’t be as binary as “going to zero” or “crazy success.” They won’t have all their eggs in one basket.
What would I do after a secondary, if I’d get to do a secondary as a founder?
If I got 200k, I would invest the cash into diverse assets like startups (small VC funds, or angel investing), index funds, real estate funds, etc. The result: I wouldn’t be “all in” with my startup, and I’m doing what a VC would do: diversify my investments; eggs in several baskets.
Why are secondaries good for investors?
By allowing founders to sell a portion of their equity, VCs can ensure that the founder’s interests remain aligned with the company’s. If a founder is financially stressed or has significant personal obligations, their decision-making may be influenced by personal financial considerations rather than the company’s best interests.
The secondaries are an excellent tool for investors to motivate the founders. An exit opportunity might appear out of nowhere, but with an insignificant price. This price could be financially transformational for the founders but a low return for the investors. If the company is posed to become a billion-dollar company in the long term, but the founders are stressed out with the risks of losing it all, they might sell.
My point is that a secondary round could delay the exit aspirations of the founders. At the same time, the round can be structured so that there’s also a cash injection into the company, which takes the company to the next stage. An early exit, which could have been fine for the founders, but catastrophic for the investors, was avoided.
New investors can also use the secondary to become owners in the company, with less dilution to existing shareholders and a discount for themselves — a win-win-win for existing investors, old employees with stock, and new investors.
One of the most famous win-win-win secondary rounds happened in 2009 when Yuri Milner’s DST bought a 1.96% stake in Facebook for $200 million. Out of the 200 million, a portion was used to purchase secondary shares from employees. Here’s the story from the book Power Law:
"[Milner] would happily buy employee stock in addition to shares freshly issued by [Facebook]. What’s more, he proposed a clever twist: he would pay one price for the company-issued (or “primary”) stock and a different, lower price for the secondary stock sold by Facebook workers. Up to a point, it was obvious that the primary stock should be worth more: it was “preferred,” meaning that it came with some protections against losses. But Milner used the two-tier pricing to add a secret weapon to his negotiating arsenal. He could offer Zuckerberg a satisfying valuation for Facebook’s primary stock while lowering the acquisition cost by lowballing his offer to employees." — Power Law, by Sebastian Mallaby
The key was that the secondary shares purchased from Facebook employees were priced based on negotiations between DST and the individual sellers. These prices were based on a discount on the valuation of Facebook’s primary shares. The secondary shares carried more risk and uncertainty than the primary shares because they had different terms and information rights. But DST knew that a Facebook share with no voting power was worth a lot more, especially since an IPO loomed in the near future.
I’ll put my investor hat on for the final words. When things start working for a company, I’m OK with doing a secondary round, and once the company gets to yet another level, there should a discussion about doing another secondary round. I’m willing to let the founders take enough chips off the table to go make the company big without worry.
Here’s a great quote from Hunter Walk, the General Partner at Homebrew VC:
"We’ve had lots of conversations with founders about wanting to make sure that they were in a situation where they could focus entirely on their company. Sometimes that meant salary bumps. Sometimes that meant a little bit of early secondary. It didn’t mean that they’d be winning ahead of the business, or it didn’t mean taking advantage of hot markets to cash out ahead of your team or investors. It did mean if you just raised a $20m round, but you’re still living in a three-bedroom apartment because you’re student-loan heavy but cash poor. Let’s figure out how to solve that problem for you so you can move into a place That you can work out of home without worrying about whether your roommate is drunk and focus on your business." — 20VC: How to Talk to Founders About Money
For further reading, check out my piece on founder dilution.