Secondaries: The New Best Route to Liquidity? (Views: 54)

Wed, 30 Jan 2019

The State of IPOs

Initial Public Offerings are no longer the logical next step for startups that have completed growth-stage funding rounds. In the United States, the passing of the JOBS act in 2012 “increased fourfold the maximum number of shareholders a company can have before it must disclose financial statements,” (McKinsey & Company) and with forced IPOs thus delayed, many companies are opting to remain private, avoiding SEC reporting and the scrutiny that comes with it. Exacerbating this situation was Facebook’s rocky IPO in 2012 (which some have used as explanation for other companies’ reticence to go public) and the US government shutdown.

Why Exits are Slow

As Alex Wilhelm of Crunchbase explained, a US government shutdown means SEC disruption, which in turn means IPO filing disruptions. If, between the filing and finalization of a delayed IPO, the stock market falls, large companies’ valuations could be discounted. Though this threat has been temporarily allayed, Uber, Lyft, Slack, Airbnb, and Pinterest were just some of the exit-ready giants who could have been hurt by last month’s shutdown.

Political uncertainty has also impacted markets outside of the States. Dean Braunsteiner, PwC Canada’s national IPO leader, noted that uncertainty surrounding NAFTA and trade in general likely contributed to the halving of the Canadian IPO market between 2017 to 2018. This wariness, when combined with Canada’s limited number of viable acquirers and consequent reliance on foreign buyer markets, has meant less liquidity for founders, early employees, and anyone else with stock in growing companies.

More Investments, Less Liquidity

Despite a decline in startup IPOs, however, venture capital investments have only increased. According to PitchBook, in 2018, the venture industry invested a record-breaking $130.9B in US-based startups. Canada experience a similar--though comparatively small--rise, from $1.42 invested in 2017 to $1.4B invested in 2018. While this influx of cash is arguably a positive thing, the deceleration of IPOs has meant fewer venture-backed exits, and, consequently, increased demand for alternative liquidity options.

Why Secondaries

Because of these converging circumstances, the North American private equity secondary market has blossomed. More and more often, shareholders are selling existing assets to achieve otherwise elusive liquidity. The proof is in the numbers; unlike the diminishing IPO market, the total volume of US secondary market transactions in 2018 increased by 31.3% over the previous year.

As Elad Gil broke down here, a few reasons for funders to sell shares include:

  • Optimizing taxes

  • Exercising stock options when leaving a company

  • Diversifying a portfolio

  • Achieving fast liquidity

On the flip-side (and as Hans Swilden of Industry Ventures LLC detailed here), investors purchasing stock in the secondary market may be attempting to:

  • Comply with current regulations

  • Generate tax gains and losses

  • Wind down older vintage funds and refocus time and energy on newer vintage partnerships and investment areas

  • Remove or reduce leverage on funds

  • Exit non-performing or strong-performing investments to optimize losses or gains

The Limits of Secondary Sales

Founders can also use the secondary market to lock in gains or salvage what they can from loses, however, as Riz Virk, executive director of MIT’s Play Labs, said, early shareholders looking to sell should be conscious of the class of their stock as well as the rights of the company whose stock they own. Common stock will likely be less valuable to purchasing investors, especially if there is no IPO in sight. This is firstly because preferred stockholders are compensated before common shareholders in a liquidity event and secondly because common stock tends only to acquire worthwhile value in the long-term. Other potential drawbacks to the secondary market include companies’ right of first refusal, which gives a company the right to purchase stock back from you before you sell it to someone else, right of co-sale, which gives investors the right to sell a portion of their shares as part of deals that you broker, and company cooperation--or lack thereof--which refers to the degree to which a company is willing to supply information about themselves in the interest of forwarding a secondary sale.

The Benefits of Secondary Sales

Given these limitations, how common is a sizeable secondary sale? According to secondary asset marketplace Palico, despite falling stock prices, pricing in the secondary market is the highest it’s been since they began tracking transactions in early 2017. The largest secondary fund sale in the States belonged to Sun Capital Partners VI, whose pricing was 126% of their net asset value (NAV). Palico further noted that, “funds selling at a premium have an average age of 5.1 years versus 8.5 years for funds selling at discount.” Of course, these companies and figures are specific to the States. According to Crunchbase, the latest disclosed and sizeable secondary market deal to take place in Canada occured in Q2 of 2017, when cloud software company Resolver closed a $20M deal with Klass Capital.

What Secondaries Mean for Canada

This disparity between the US and Canada seems to support the feelings of TandemLaunch CEO Helge Seetzen’s, who claimed in a Globe and Mail thought piece that Canada needs to develop a stronger secondary market. Though we’re underperforming at the moment, he says, “Canada has a chance to use secondaries as a stimulus of our growing startup economy.” If you’re an early stage founder or employee looking to achieve liquidity, and you want help augment Canada’s burgeoning economy, consider putting a price tag on your shares.

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