Secondaries – Creating opportunities and unlocking value

When a fund invests in a company, new shares are created and given to the investor. This Is called a primary transaction.

Later on, as a company matures shareholders may like to sell some or all of their shares in a business and will look to sell their shares to a willing investor. This is called a secondary transaction.

Secondary transactions can also occur in fund investments. If an LP invests into a fund at the inception of the fund, this is the primary transaction. This money is then tied up until the fund investments start to exit and the fund pays out distributions to investors. The fund investor can, however, look to sell their LP position to a different investor during the lifetime of the fund. This is also a secondary transaction.

Why are secondaries interesting for both sides of the transaction?

For founders & early investors:

Founders often  take a significant pay cut at the early stages, or work for a salary below their market rate. The upside comes largely on the value of their shares.

As the business grows, investors may purchase a proportion of management’s shares (potentially as part of a wider funding round) which could ease financial stress, and improve quality of life for management & their families, whilst not giving enough that it should lead to apathy. 

Some investors believe this frees up management to go for the home run, or the “fund returner”.

Counterintuitively, for angel investors, the better the investment, the longer they will have to wait for an exit – this could be up to 10 years in some cases. Often, investors will look to take advantage of an early cash out, via a secondary transaction.

For venture capital funds:

Secondary transactions enable investors to invest at any time, rather than just when a formal fundraise is taking place. This may mean they can get into a “hot” company where otherwise they could have.

On purchasing shares, a new investor may start receiving information about the company (e.g. monthly board updates or annual meetings), giving insight in advance of potentially investing a larger stake through further transactions. This extra knowledge may enable them to make a more informed decision.

In other situations, a company may have a significant number of investors on their cap table from an early stage, meaning that they have too many voices at the table. In some transactions, funds like to “clean up” the cap table, and consolidate the number of investors.

Importantly, in the majority of cases, secondary transactions are undertaken at a discount (usually c.20%) to market value, or the primary round. This is because the new investor is offering existing investors early liquidity. However, these early shares are often “ordinary” shares, meaning that they don’t come with the preference that many later investors structure into their investment, and therefore come with more risk attached for the investor.

If secondaries are so interesting, and investors get a discount, why are they not more frequently used?

There are different reasons why investors don’t all invest in secondaries, including some which are geography-specific:

  • In the UK, the tax efficient funds (such as EIS and VCT funds) are not allowed to partake in secondary transactions. They are only allowed to make primary investments.
  • In the US, there are also regulatory restrictions on different types of funds. The SEC requires extra regulatory approval for any fund to deploy more than 20% of their fund on secondary transactions. This approval is challenging to receive and as such, many funds stick to primary transactions.
  • Additionally, not all investors are keen to invest in secondary transactions:
    • some investors believe that offering management an element of “cash out” may lead to a loss of incentive if they’re financially comfortable;
    • if early investors are selling their shares, new investors may see this as a signaling issue – if the company is a star, why would they want to exit now? 
    • the investor may not have the expertise to price the secondary shares correctly. For example, if the company has raised capital and added in a new level (or multiple levels) of different share classes (such as preference shares), if the person who is looking to sell had originally received ordinary shares, the pricing of the fair value of the shares may be complex and an incomplete science.

Stay tuned for more news in the coming months, as we build on our introduction to the world of secondaries.

The opinions expressed in this article are that of the author. This article does not purport to reflect the opinions or views of Sprout. Nothing contained in this article constitutes investment advice. It is not intended to be relied on to make investment decisions.