Direct Secondaries: A New Escape Route From The Illiquidity Matrix

Published in
January 1, 2024

Published by Forbes Finance Council

“I don’t know the future. I didn’t come here to tell you how this is going to end. I came here to tell you how it’s going to begin.”—Neo, The Matrix

The key difference between public and private stocks is liquidity. There are volumes of literature on the illiquidity discount. It’s steepest the further you are from an IPO, with a startup being the starting coordinate. As IPOs are down 14% versus 2022, liquidity becomes especially concerning for founders, who need to take care of themselves and their employees.

The Illiquidity Barrier

Founders take enormous risks to create new businesses. They trade the security of their jobs for an option to score big if their startup becomes successful. Most of their value is locked up in the equity of their enterprise. Their only source of income is their current compensation, often below market or even zero, enabling the business to take off with less funding and allowing them to keep more “sweat” equity.

The source of the illiquidity discount comes from various factors:

Marketability Discount

In corporate finance theory, this is the discount between private and public companies measured by comparing pre- and post-IPO valuations. Shares of public companies are a standardized product with immediate liquidity, whereas private shares are akin to real estate with infinite variety and limited liquidity. Some rights can have a positive effect, such as preferred versus common or drag-along rights. However, in most cases, corporate governance, such as rights of first refusal and tag-along, creates obstacles to liquidity. Other considerations include the size of the business, long-term profitability and concentration in the value chain of the industry, length of time required to sell, alignment of shareholders for such a transaction and even access to information for potential buyers. All of these are non-issues for public companies.

Minority Discount

This can apply to both public and private companies and shows the difference between a controlling ownership and a minority stake. The underlying driver is that minorities have fewer shareholder rights, affecting the per-share value of their position.

Preferred Versus Common

One of the most important sources of discount comes from subordination. As companies raise capital, financial investors usually acquire shares with preferred rights that come in handy, especially in case of liquidation or liquidity. The lower down in the stack you are and the larger the overhang of preferred capital above you compared to the overall value of the business, the larger the discount.

Motivation Puzzle

One of the key challenges for founders as their business grows and becomes successful is keeping their own motivation and risk balanced. Their net worth is usually heavily skewed by the one illiquid stock that they hold —their stake in their own business. At one point, protecting what you already have can become more important than risking it to grow further, misaligning you with other shareholders. Secondaries help resolve this by allowing the founders to diversify their equity and become less risk-averse with their main asset, the company that they run. Seeing the fruits of their labor reflected in a better lifestyle for their families can also be motivational.

Another conundrum is the necessity to attract new and motivate existing employees. Employee stock option programs are specifically designed for this, but without liquidity, they remain pieces of paper that are often disregarded by employees in their decision-making processes. As the company matures, providing a regular liquidity opportunity for employees can address this issue.

The capability can also become a source of internal pressure as the investment horizon of the various participants may vary widely. Imagine a company with an active founder in for the long haul, a founder who moved on and would like a cash-out, some angels each with their own idiosyncratic situations, an early-stage fund at the end of its lifetime that needs to repay its investors soon and a larger fund that just invested in the last round. Secondaries can act as a relief valve allowing some people to depart, and as a result, increasing the alignment of shareholders on their exit timetable and general business strategy.

Secondary Toolbox

Secondaries have been developing steadily in the past few decades. Demand always generates supply resulting in a number of interesting solutions and tools appearing in the market. These include:

Dedicated Secondary Funds

The most obvious solution, which appeared originally about 15 years ago, is expanding rapidly in the current market environment. Some are independent players specializing in either direct or LP secondaries and sometimes both. However, most are offshoots launched by VC managers, including yours truly.

Primary Funds Doing Direct Secondaries

This is especially true for PE managers, who are going downmarket in software and looking to acquire smaller businesses, but growth funds have been dabbling with this as well.

Continuation Funds

This is a special branch of secondary activity coming from VC funds restructuring and recapping as their original funds are coming to the end of their lifetime and they are under pressure from some LPs to generate exits and distributions. They roll up their most successful investment around special purpose vehicles creating liquidity for those in need.

Secondaries Brokers And Marketplaces

These include companies such as Forge or Zanbato as well as capable management software companies offering their own solutions, such as Carta.

Helicopter View

All of this is happening with the backdrop of a convergence in public and private market investing. This is driven by several key factors: the abundance of data available on private businesses, the gradual removal of the regulatory obstacles for the securitization of smaller companies via tokenization and the strategic convergence of VC, PE and hedge fund managers in search of the ever-elusive alpha.

My free advice to successful founders out there—educate yourselves about the issues and challenges you face and the tools available to address these. As Neo rightly observed in The Matrix finale, it’s impossible to predict the future. However, it is possible to manage personal liquidity. Begin your escape by awakening now!

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