What are secondary investments?
Secondary investments are in essence any transactions involving “pre-owned” (more elegant name for what people used to call “second hand”) assets. In financial markets this involves buying and selling already existing financial instruments (shares, debt, partnership stakes, etc.) relating to a given entity (company, fund, etc.) whereby the proceeds go to the sellers rather than the entity whose instruments are being sold. This is in contrast to primary investments where new instruments are being issued and proceeds go to the entity issuing them.
Typical example of a market for secondary transactions is a stock exchange where people buy and sell listed equities. Yet secondary transactions can also happen with shares of privately held companies. Such transactions where new investors buy shares directly from the private company shareholders (and whom the new investors replace on the company cap table) are often referred to as “direct secondary”. Direct secondary transactions can involve instruments of companies in any stage of development, from early start-ups to “pre-IPO”, although in general the more mature the company is the more prevalent secondary transactions become.
Flashpoint approach: Flashpoint set up a fund dedicated to secondary investments, Flashpoint Secondary Fund, which focuses on direct secondary transactions in shares of private growth stage tech companies. We look to purchase minority stakes with good information rights and also aim to deploy more capital into selected companies over time in follow-on transactions (hence the focus on the information rights). Although we are a secondary fund, we can contribute primary capital to the companies as well.
Are secondary transactions common?
Secondary market for privately held companies exists for a long time. Historically most of the secondary transactions were involving shares of mature, cash flow positive companies; these could be minority stakes or also majority (take-overs eg by private equity companies). Secondary transactions for minority stakes in high growth tech companies have developed more recently as the venture capital ecosystem grew extensively in the past decades. Secondary transactions are therefore a natural development of a maturing investment ecosystem.
The growth of secondary transactions for tech start-ups (or scale-ups as some might want to correct) goes also hand-in-hand with the growing average time span that companies spend as private. As investment horizons of investors tend to be more fixed (eg linked to life times of investment funds) this creates a mismatch which can be solved by direct secondary market.
Flashpoint approach: We focus on companies with founders originating from CEE and Israel. The venture capital markets are in different stage of development in these regions. Israel’s tech boom has been fuelled by emergence of early stage funds more than two decades ago and now the country has a deep and diverse ecosystem with a number of secondary players. CEE follows a similar pattern but about a decade later, so while very active, the ecosystem is still developing and we are one the pioneers of secondary investments in the region.
Who are the sellers in direct secondary transactions?
In short – anyone.
Sellers can be any shareholders of the company regardless of how they acquired their shares –investors, founders or employees. Often times secondary transactions involve sellers who are no longer closely associated with the company, such as former employees or (ex)founders who have in the meantime moved on to a different venture. Early investors who have supported the company in the beginning may also look to sell their shares to either de-risk their positions (expression used for partial sales) or fully realise returns on their investment.
Flashpoint approach: We are open to consider purchasing shares from any shareholders or types of sellers. That means that we are also open to purchase any types of shares, preferred or common, and for that matter also options from company ESOPs, although all under an appropriate structure (on structures a bit later). Nevertheless, when the sellers are company insiders (founders, management) we do focus on ensuring that the people who drive the business remain incentivised by the future success of the company even after the transaction.
Doesn’t the fact that there are people who want to sell shares signal that there is something wrong with the company?
Uff, a bit of a loaded question. Any expression of an intention of a party to get involved in a transaction of any kind can and does send some signal. This is true in life as in business. It is definitely also true for both primary and secondary investments. As companies raise primary capital for different reasons (growth, M&A, rescue, etc.), so can their shareholders sell shares for various reasons. These reasons can be either related to the health of the company, eg that the company is not doing well and investors are looking to cut their losses, or it can be for unrelated reasons, eg personal situations of founders/employees, concentration limits for investors, end of lifetime of funds, etc. What kind of signal a transaction sends is therefore closely related to the motivations of the sellers to engage in a secondary transaction.
Flashpoint approach: We place a lot of emphasis on understanding the intentions of the sellers. We look for situations where the motivation to sell is unrelated to the health of the company. We invest in high growth companies, not in distressed situations involving companies in trouble. In other words, we look for situations where the sellers still believe in the company, but there are specific reasons why they need liquidity.
