The traditional model for venture capital is to invest in a company early in its life, hold for 7 to 10 years, and wait for a company to exit via an acquisition event (merger & acquisition or M&A) or an initial public offering (IPO). The model has been challenged by changes in the capital markets that both (a) allow companies to stay private longer and (b) dampen M&A activity.
As an alternative, many investors are increasingly looking at how to manage their investments and actively work to sell their investments prior to exits in order to generate cash-on-cash returns for their limited partners. Here's some background on the concept and details on how to model secondaries in a venture capital fund model, as well as how to do it in the Foresight models.
What are secondaries?
A secondary sale is when an existing shareholder in a private company sells their shares to another investor. This differs from a primary funding, where the company issues and sells shares to investors to bring capital into the business. A secondary sale may be done as part of a funding round, providing an opportunity for founders, employees, or earlier investors to get liquidity on their share holdings, or through targeted sales to investors, including special purpose vehicles (SPVs) that may be set up to provide access to groups of new investors.
Why secondaries are popular now
Several dynamics are driving more secondaries in venture capital:
- Longer exit timelines. IPO windows are narrow, M&A is slow, and the average time to exit for venture-backed companies has stretched past 10 years.
- Larger late-stage rounds. With more capital available from private investors and the public markets less accessible (or desired), companies can stay private longer by raising multiple rounds of late-stage capital, creating natural entry points for secondary buyers.
- Fund strategy and DPI pressure. LPs increasingly want to see distributions to paid-in capital (DPI) earlier in a fund's life. Selling secondaries gives GPs a way to return capital without waiting for IPOs or later M&A events.
- Risk management. By selling a portion of a concentrated position, a fund can lock in a return and de-risk its portfolio while still retaining upside.
- Growing secondary market. There is more dedicated capital for buying secondaries in the current environment from investors such as crossover funds, hedge funds, and secondary specialists.
For a deeper dive into the numbers and rationales behind secondaries for venture capitalists, check out the deep dive by Behind Genius Ventures, A Guide to Venture Capital Secondaries.
Who buys secondaries?
The buyers are typically:
- Crossover and growth funds that want exposure to late-stage companies but did not invest earlier.
- Dedicated secondary funds that specialize in buying existing stakes from early investors, giving opportunity to investors in invest in companies that they were unable to get primary allocation in.
- Large asset managers and hedge funds that want exposure to private companies close to IPO.
- Venture capital funds that want to increase ownership or establish a position in a breakout company.
How secondary transactions are structured
Secondary sales typically occur during or around a primary financing round:
- A late-stage round is announced.
- The company raises primary capital, but the round also includes a secondary component where existing shareholders can sell.
- The GP of an early-stage fund may choose to sell all or part of their stake, either directly to another investor or perhaps to continuation funds run by the GP, providing liquidity to fund investors and access to continution fund investors.
The pricing is typically based on the valuation of the new round, sometimes with a negotiated discount depending on supply/demand. Funds can also arrange direct secondary transactions outside of financing rounds, but those often require more negotiation and company approval.
How to model secondaries
In the Foresight venture capital models, I treat secondaries as a liquidity event like any other proceeds event.
- Models with manual portfolio construction approaches are straightforward, as there is no presupposition in the model what the proceed event represents. The existing way to model the liquidity event is to list the receipt of proceeds and the date on a line, and there is no limit to the number of secondary sales that you can model. This manual approach to portfolion construction is in the Venture Capital Model, Manual Portfolio Construction.
- Models without complicated portfolio construction approaches - ones where I specifically model each investment or I assume a distribution of exit multiples - do not actually make an assumption whether the proceeds come from a secondary sale or an IPO/M&A, so no structural changes are needed, just a change to the assumptions to reflect the multiples for that type of exit. It also may not be obvious, but you can also model partial secondary sales simply by assuming the percentage of invested capital that exits at each stage, the structure does not structurally assume that the percentages represent entire sales of positions.
- Models with detailed prebuilt portfolio construction approaches that model the cap tables of the average investment - meaning, the Venture Capital Model - are a bit more complicated, but still do not assume that an exit represents a secondary sale or an M&A/IPO event. Like the example above, you can set the percentage of capital that exits at each stage and the exit valuation, and your inputs should represent the valuation on your sale (not the valuation of the company).
Questions on how to model secondaries, ask anytime.