One of the hottest topics for venture funds in 2011 has been sales of shares held by founders, early employees and angel investors in pre-IPO technology companies.
As a manager of funds focused on venture secondaries and buyout secondaries, we have seen countless proposals for sales in some of the best-known tech companies, including Facebook, Twitter, eHarmony, and Groupon. In order to capitalize on this trend, marketplaces such as SharesPost and SecondMarket have emerged to match buyers and sellers. There was even a congressional panel convened in May of this year to discuss the implications of the secondary market.
Although some venture funds have discouraged secondary market transactions, many have embraced the market as a valuable portfolio management tool. In February 2011, Fred Wilson of
Secondary transactions have had a much cooler reaction among buyout funds for several reasons. First, unlike venture funds, buyout funds may have the option of a dividend recap to return money to their investors. This mitigates the reliance on a secondary sale to generate realizations. Secondly, the structure of a typical buyout deal is less conducive to a secondary sale. Minority and angel investors, frequent secondary sellers, are more common in venture-backed companies that rely on syndicated equity financings. Finally, many buyout funds that I speak with are apprehensive about creating management distraction and conflicts of interest by introducing new investors. These concerns are real and were also shared by venture funds who were early participants in the secondary market.
While there are trade-offs with any capital transaction, we have found that the secondary market can be a very useful tool for buyout funds, especially for small and mid-market funds. Here are some of the lessons that buyout funds can learn from the evolution of the secondaries market for venture-backed companies.
1. Buying Employee Shares Keeps Management Focused
One of the key goals for any buyout fund is to keep management focused on the operations of the business. We have found that sometimes, especially in fast-growing but marginally profitable companies, management can become overly focused on personal finances despite the substantial value of their equity holdings. For example, in one case, we purchased shares from a sales manager in a company who was concerned about paying for his son’s college tuition. By selling a relatively small number of shares, the employee was able to continue to focus on the growth of the business without feeling compelled to find a job with higher cash compensation. Buyout funds should encourage their portfolio companies to balance employee sales with the need to keep employees focused on the ultimate exit. Should employees sell too many shares, they will have little incentive to facilitate a sale or an IPO. In venture secondaries, funds have addressed this issue by limiting the amount of shares that each employee can sell to a small percentage of their holdings or creating windows for employee sales. Finally, some companies have limited employee share sales to non-current employees. All of these steps can help to preserve the alignment between employees and other equity holders.
2. Older Shareholders Can Be A Nuisance
In the venture secondaries market, the most common secondary sellers are angels and other early investors. While such investors are rare in buyout-backed companies, other shareholders can exhibit similar dynamics. In the course of pursuing a roll-up strategy, a buyout-backed company may be left with shareholders from integrated businesses. Such shareholders can sometimes become a nuisance by trying to influence the direction of the company or requesting unnecessary information. For example, we acquired the shares of two doctors in a Healthcare IT services company that needed cash for a future venture. The sellers were no longer involved in the operations of the company and their continued ownership was bothersome to the company. We replaced the doctors and became a passive and friendly investor.
In other cases, a company may have granted equity to a partner in connection with a business transaction. A lender might have invested in equity or received warrants in the course of providing debt capital. If the lender liquidates its debt holdings, it may no longer have a desire to hold an equity position. The most pressing strategic example of removing a minority investor is when a former strategic co-investor becomes a competitor. A secondary sale can eliminate such conflicts of interest.
3. Partial Realizations Can Be A Powerful Fundraising Tool
In a period of limited IPO and M&A activity, venture funds have used the secondary market to generate realizations and distributions to their LPs. According the Groupon S-1 filing, entities affiliated with
4. Dedicated Secondary Funds Can Help Fill Capital Gaps
In some venture secondary transactions, existing venture investors have been active buyers. According to the Pandora IPO prospectus, existing investors in the company initiated a tender offer for employee shares in August 2010. Existing buyout investors should also consider leading secondary transactions, especially when a selling shareholder is an employee or other minority shareholder. If the fund is exceedingly bullish on the company, this can be an ideal opportunity to increase its ownership position and consolidate its ownership position across multiple classes of stock. Alternatively, a buyout fund can invest directly in a company and buy back shares from its investors.
Nevertheless, an outside secondary investor can be extremely valuable when a fund is managing limited capital resources. Secondary opportunities often arise in companies that have been in a portfolio for an extended period of time. Such companies may be in older investment vehicles that are beyond their investment period. Even if a fund has the ability to make follow-on investments, it may prefer to avoid calling capital in order to preserve investor relations. Explaining an investment in a ten-year-old fund can sometimes be trying. Bringing in a new secondary investor can provide a new source of capital that is generally a passive participant in the company’s growth.
5. Secondary Investors May Have Different Investment Objectives
In the venture market, secondary buyers are typically targeting lower but more predictable returns on investment. The same is likely to be true for secondary investors in a buyout-backed company. If a fund is already showing a substantial unrealized gain on its equity investment, purchasing additional shares at close to its carrying value would imply a lower return expectation for the incremental investment. A secondary investor may be targeting lower returns than its buyout backers and be willing to pay closer to the carrying value. The NEA transaction mentioned earlier was executed through series of offerings by Groupon through January 2011. These sales raised $1.1 billion with over 85 percent of the proceeds used to redeem stock from existing investors. Buyout funds can use sales to other funds with lower investment hurdles to increase their own rates of return.
Conclusion
The key take away from the market for secondaries in venture-backed companies is that such transactions can be a valuable portfolio management tool. Secondary sales can increase employee satisfaction or replace difficult shareholders. They can also generate realizations to help funds with their future fund raising efforts. The particular circumstances will dictate whether a buyout fund would be best served by being a secondary buyer, secondary seller or merely a facilitator of a transaction. By paying close attention to lessons from the venture secondaries market, buyout funds can also take advantage of the growing market for liquidity in private companies.
David Tom, CFA, is Director of Business Development at VCFA Group, which is managing a $250 million buyout secondaries fund and a $250 million venture secondaries fund. Reach him at dtom@vcfa.com.
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