Venture Capital: All You Need to Know About Secondary Market Transactions

The venture capital (VC) market has evolved and developed significantly over the last ten years. Until recently, primarily seen as a more emerging private markets asset class, VC is starting to mature, with secondary transactions being a significant catalyst.

The exponential growth of privately held companies and the deep pool of VC driving them has led to a thriving secondary venture capital market. Investors have realized that investing in a VC fund does not have to be a 15-year commitment because secondary transactions can give investors flexibility and a way to exit other than through the conventional initial public offering (IPO) or mergers and acquisitions route.

Due to these transformations, venture capital is now seen differently and is more readily available to a larger spectrum of investors. Let’s take a closer look.

What is a secondary venture capital market?

In venture capital, a secondary market transaction occurs when shareholders in a privately financed company sell their shares to an investor. Shareholders in private companies can sell some or all of their shares through secondary transactions.

Since startups often remain private for long, VC funds are also locked up for the same period.

Nowadays, it is increasingly becoming common for startups to remain private for longer periods, implying that venture capital funds are also locked up longer.

In this scenario, the secondary market allows VC funds and other early-stage investors to reclaim their investments before a prospective IPO. Therefore, the secondary VC market enables new investors to tap the significant potential offered by startups that have already attained some maturity maturation and scale.

Also, it must be noted that traditional venture rounds often have a size limit, so secondaries might be an attractive second opportunity for investors who missed out or did not receive their preferred allocation in a previous capital round.

Why are venture capital firms leveraging secondaries?

Several factors are relevant in convincing venture capital firms to choose secondaries as a viable option., for example:

1. Startups can remain private for a longer time

Secondaries have increased in popularity in recent years due to two factors. The first is that startups are more likely to remain private. This pattern has been well-documented, but one of its often-overlooked implications is that

Although startups remain private for long, their early investors must exit during the fund’s lifecycle.

Secondary transactions enable have evolved as a mechanism for venture-backed firms to provide liquidity to early investors and employees while remaining private as the timeframe for a public exit gets longer.

Allocation matters, which is the second justification. Also, wWhile making a major investment in a promising startup, venture capitalists can be dissatisfied with the share of the firm they acquired.

Secondaries are a way to increase ownership and control over a business, which may pay off and result in significant monetary gains if the company goes public or is acquired.

2. Offering a way for existing investors to realize their returns before the IPO

Early venture capital investors may be capable of maximizing their gains and exiting more quickly than they may if they wait for a prospective IPO or acquisition.  The VC money can frequently be locked up for extended periods since firms tend to remain private longer, which may not meet their liquidity needs.

A healthy secondary market allows venture capital funds to obtain capital before a formal exit. It offers meaningful opportunities for new investors to participate in the activity while there is still room for significant company growth.

3. Additional opportunity for investors

Although venture capital secondaries are no longer a niche market, they represent a domain where few investors have deep knowledge or proven track records and have historically done well in uncertain and volatile markets.

Investors are interested in diversifying their portfolios and accessing venture rewards with a shorter holding period, quicker drawdowns, a mitigated J-curve, and vintage-year diversification since it combines an underserved market with favorable market conditions.

These qualities make secondaries more appealing to riskier investors.

4. Opportunity for meaningful returns before an IPO

To exit a position, VC investors use the secondary market. At that moment, they realize their return on the growth of their investment.

This does not imply, though, that the company won’t keep growing as it approaches its IPO. initial public offering. Some investors may profit from exposure to a high-growth firm further along in its lifecycle since the risk may be considerably reduced.

At this stage, the company is often more than just a concept. Investors who join at this point through the secondary market might take comfort in knowing that failure is considerably less likely due to a proven track record.

Different forms of venture capital secondaries

There are several different forms of venture secondaries. But Nonetheless, they may be divided into two main categories:

1. Structured liquidity programs

A company typically initiates structured liquidity events. There are two types: auctions and tender offers.

(a) Tender offers

A tender offer enables multiple sellers (often employees and early investors) to sell their shares at a predetermined price to a group of investors, or back to the company, over the course of 20 business days.

(b) Auction

A secondary transaction’s price and volume are determined through an auction using supply and demand dynamics. A secondary platform usually organizes and conducts auctions on behalf of the company.

2. Direct secondary sales

When an investor sells directly to another investor shares of a firm in a transaction that isn’t initiated or sponsored by the company, the transaction is referred to as a private secondary sale, also known as a bilateral trade. This may present issues for companies that want more control over their cap table.

These transactions have no set disclosures, and companies occasionally give prospective buyers and sellers absolutely no information. Instead of being decided by the business, as in a tender offer, the buyer and seller negotiate the price. This can lead to different implied valuations across different transactions.

‍The bottom line

The secondary venture capital market allows early investors to realize their returns and exit sooner than they might if they wait for a potential IPO/acquisition. Since companies remain private longer, VC funds can often be locked up for longer durations, which may not suit their liquidity needs.

The venture capital secondary market is expanding in significance and acceptance due to the abundance of available capital and an increasing timeframe to exit.

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