This week on the startup to scaleup journey:

• Founders using 'secondaries' to unlock new investment
• What is my startup worth?

Founders using 'secondaries' to unlock new investment

In the aftermath of the venture funding bubble that burst in 2022, a rapidly growing market in secondaries is emerging. Venture secondaries involve the purchase of pre-existing investor commitments in startups or funds rather than direct, 'primary' funding. Given that they are transactions between investors, why are they of such increasing interest to startup boards? From discussions with founders over recent weeks it becomes clear: By employing innovative funding strategies, secondaries can open the door for founders to secure additional primary investment in their company. Using a 'twin-track' approach, founders that can identify investors that have the remit to undertake both primary AND secondary transactions, can fix 'broken' cap tables as well as fund the next stage of the startup journey.

Misaligned interests. A 'broken' cap table is one in which the interests of a major investor(s) and those of the founders have seriously diverged. This is usually because of market circumstances rather than any nefarious behaviour. For example, it could be that an exit might now seem much more distant than originally hoped - very common in the depressed exit environment we are currently experiencing. It could be that the amount of capital deployed into a company by a particular investor might have ballooned well beyond what they had originally planned. This could be due to multiple, unbudgeted bridge rounds to keep the company afloat when other options seemed elusive. Whatever the reason, the need for accelerated liquidity trumps all other interests. The current investor is highly motivated to sell part or the whole of their shareholding, even at a discounted price.

The backdrop. Secondary transactions have historically been associated with one investor offloading a distressed asset onto another. The buyer may believe they can foresee or even engineer a return to valuation growth. These were common following the Tech crash of 2000 and the Global Financial Crisis of 2008. But they now serve a much wider purpose. For example, VCs and other venture-stage investors are using secondaries as a powerful portfolio management tool. In particular, with startups staying private for longer, increasing amounts of capital are becoming locked up in private companies. An early exit via a secondary transaction can therefore be very useful in rebalancing an investor's portfolio. This can provide much needed returns for LPs or allow the GP to reinvest this capital in a higher-performing asset.

Multiple categories. Few founders are well versed in the dynamics of the secondary market. It is obscure and relatively unknown. There are 3 main deal categories: First, LP-led secondaries, which involve the purchase of an LP's stake in a venture fund. This is where the secondaries market started back in the 1980s. Then, there areGP-led secondaries, which are often highly customised transactions enabling GPs to restructure their fund and bring in new capital for 'continuation funds'. Finally, Direct secondaries, also known as private secondary sales or bilateral trades, where a new investor buys shares in a specific company from an existing shareholder. Direct company secondaries currently account for the majority of Europe’s venture secondaries deals. In devaluing markets, many are done at a discount to the last round as buyers seek compensation for providing early liquidity. But with pockets of valuation growth emerging over recent quarters, there is increasing motivation (by sellers) to resist discounting.

Collaboration essential. Secondary transactions that are initiated or sponsored by the company stand the greatest chance of success. Why? To retain as much control as they can, companies and existing investors often have a right of first refusal (ROFR) in place. This gives them the option to purchase the stock before a shareholder is permitted to enter into a direct sale to other investors. Companies also sometimes place transfer restrictions on issued stock that allows them to block direct sales, unless first approved by them. Shareholders should be motivated by the fact that a stronger, more aligned cap table is being created and new primary investment secured (in the case of a twin-track deal). If the process is undertaken collaboratively and with the agreement of shareholders to waive ROFR or restrictive rights, deals can be engineered.

Investor selection. If primary investment is being sought to enable a twin-track strategy, it is essential to approach only those investors that have the remit to invest both directly as well through a secondary. Such investors can be found right across the venture investing landscape. Once a niche within Private Equity (PE), now a wide selection of VCs, Growth funds, Corporates/CVCs, Family Offices and a host of other investor types are active. Some VCs even have dedicated secondary funds and these are on the increase. But secondary funds are marketed in more discrete ways than primary funds due to their target audience. This is because secondary deals are rarely good publicity for the seller, so transactions are usually kept quiet. And even though secondary buyers typically benefit from quick capital deployment routes, shorter-term holdings (before exit), and the potential to participate in otherwise inaccessible, lower risk/high-return opportunities, they are not always keen to broadcast this.

Valuation critical. Twin-track deals are obviously more complex to navigate than a secondary-only deal. Two sales cycles must be completed: One, to convince the new investor that the underlying asset (the company) is an exciting prospect, and two, to find convergence on secondary deal terms between the parties. Valuation quickly becomes a critical consideration, especially for the seller, as it is the key factor in delivering their liquidity objective. The earlier the stage the company, the fewer financial metrics there will be to go on, so modelling a valuation is usually a very imprecise game. This is where peer group comparators become important and usually act as a starting point in the negotiation (see more below). Comparators that reflect the company's sector and position in its lifecycle are of greatest relevance. Individual investors will of course assess every company against their own investment criteria before a final valuation/price is agreed.

No playbook. In sum, twin-track strategies can deliver powerful outcomes for all parties. For the startup, they are often interpreted as a strong signal of confidence in the company's future prospects. The incoming investor not only believes in the startup's growth potential but also sees value in the current state of the company. Importantly, the interests of the company and its investors should once more be aligned. In turn, current shareholders, possibly including both employees and founders, benefit from some 'early' liquidity. Unsurprisingly, however, such deals can be delicate and complex processes to manage, given that there are at least 3 parties involved. Every deal is thus bespoke and there is no simple playbook. But founders that are able to pull them off can not only fix broken cap tables but also unlock funding for future growth in one neat move.

What is my startup worth?

The latest research shows that 57% of VC-backed startups have <18 months of runway remaining and will need to raise again in 2024. Most will seek primary investments. Some will pursue 'twin track' (primary + secondary) transactions as we have outlined above.

As founders build their plans, one of the big unknowns is valuation. The turbulence in the venture market since the heights of 2021/22 has created much uncertainty. Some stages are down and some are up. Some sectors are still in the tank and some are once more on the increase.

Without a good sense of where valuations are now trending, it's hard for boards to 'green light' funding campaigns.

OFFER. To help address the valuation question, Duet is making available its extensive investment research capability to provide a free, no obligation, peer group valuation trend analysis for companies looking to raise capital at Seed or Series A in 2024.

Our aim is to provide founders with the very latest market data, customised for their specific sector and funding stage. This is the hard evidence that boards seek but is often so difficult to obtain.

Founders interested in receiving this customised market trend data should contact John Hall at john.hall@duetpartners.com.

(Offer open to the first 25 applicants, closes 31/12/23).

Happy reading!