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Creating an Efficient Secondary Market

Aug 9, 2022

Halle Kaplan-Allen

While secondary sales present the greatest opportunity for liquidity in the private markets, they come with quite a bit of baggage. Understanding the regulatory nuances of secondary transactions can help create more opportunity for elegant transactions, and subsequently more opportunities for early liquidity.

Considerations for secondary investors

Despite their many benefits, some VCs chose not to participate in secondary transactions given the implications around reporting, tax, and SEC registration. In venture capital, secondaries are considered “non-qualifying” investments, and fund managers are currently limited to 20% non-qualifying investments per fund or SPV. VCs who surpass this 20% threshold in any single fund or SPV, and who manage $150M+ in investments overall (based on fair-market value), may no longer benefit from certain VC exemptions. These managers 1) may have to register as an investment advisor with the SEC, which is a burdensome process that comes with additional reporting and financial audit requirements, and 2) they can only raise money from “qualified clients,” defined as individuals who have a net worth over $2.2 million.

Opportunities to build an effective secondary market

Previous attempts at creating an efficient secondary market have been thwarted given the absence of four factors: 1) homogenous assets, 2) sufficient supply and demand, 3) limited gatekeepers, and 4) reasonable transaction costs.

Venture capital assets are generally homogeneous (common or preferred stock in Delaware corporations) and demand for secondaries is plentiful given the associated benefits. While volume may be sufficient for a functioning marketplace, access is fractured and gatekeepers abound. A transfer of shares in a secondary transaction typically requires consent from a number of stakeholders, including the company’s board. The board may choose to reject the transaction simply because they don’t have the adequate time to evaluate whether it’s in the company’s best interest. Most companies also have a “right of first refusal” which allows the company and often some of the company’s shareholders to block a secondary transaction. They may choose to do so because of the implications such a transaction could have on valuation. Secondary share prices are typically determined by the buying and selling parties without the company’s direct input. If the price becomes public knowledge, it could impact the company’s future efforts to fundraise at a substantially higher valuation. In a similar vein, secondary prices can impact a company’s employee incentive plans, thereby making it difficult to offer a reasonable strike price for future employees.

Private companies are not obligated to share detailed information on stock price or valuation with all investors. This lack of transparency has made it difficult to establish an efficient secondary market. Because of the implications on valuation, many companies will specifically decline to share information if they sense that a stockholder plans to use the info to solicit secondary interest. This results in information asymmetry between buyers and sellers, and means that subjective factors such as industry news or product trends may impact pricing in a secondary transaction.

Using SPVs to build an effective secondary market

As noted above, a secondary transfer of shares directly on a company cap table typically requires board approval, review of transfer restrictions, and waiver of investor rights. However, a transfer of shares within an investment vehicle itself (such as an SPV) is generally free of these burdens — especially if the transfer involves a minority interest of the SPV and both the buyer and seller are accredited. Thus, there is a legitimate opportunity to create an efficient secondary market in which fund or SPV investors transfer their ownership of a vehicle rather than transacting directly on a company’s cap table.

These intra-vehicle transfers require that accurate and up-to-date information on the underlying investment is shared with the buyer, so the lack of price transparency still presents a challenge. SPV investors do not typically receive regular updates about portfolio company valuation events (i.e. follow-on rounds), partially due to their lack of information rights. Given that the rise of SPVs via syndicates is still relatively recent, there have not yet been efficient communication and information sharing channels built between portfolio companies and SPV investors. SPV investors typically do not have full transparency into the value of their (indirect) stake in a company and, on the other side of the table, companies don’t have efficient channels to leverage the support of their full network of investors.

If investment vehicles are created and maintained in a standardized way, with data stored in a structured manner, it would be easier to share valuation and other portfolio company updates with SPV members. This would give each SPV investor transparency into their specific interest in a company, and make it easier for them to entertain secondary opportunities. In many ways, a standardized approach to creating and maintaining investment vehicles is a significant first step towards an efficient secondary market with reduced regulatory burdens.

While secondary sales present the greatest opportunity for liquidity in the private markets, they come with quite a bit of baggage. Understanding the regulatory nuances of secondary transactions can help create more opportunity for elegant transactions, and subsequently more opportunities for early liquidity.

Considerations for secondary investors

Despite their many benefits, some VCs chose not to participate in secondary transactions given the implications around reporting, tax, and SEC registration. In venture capital, secondaries are considered “non-qualifying” investments, and fund managers are currently limited to 20% non-qualifying investments per fund or SPV. VCs who surpass this 20% threshold in any single fund or SPV, and who manage $150M+ in investments overall (based on fair-market value), may no longer benefit from certain VC exemptions. These managers 1) may have to register as an investment advisor with the SEC, which is a burdensome process that comes with additional reporting and financial audit requirements, and 2) they can only raise money from “qualified clients,” defined as individuals who have a net worth over $2.2 million.

Opportunities to build an effective secondary market

Previous attempts at creating an efficient secondary market have been thwarted given the absence of four factors: 1) homogenous assets, 2) sufficient supply and demand, 3) limited gatekeepers, and 4) reasonable transaction costs.

Venture capital assets are generally homogeneous (common or preferred stock in Delaware corporations) and demand for secondaries is plentiful given the associated benefits. While volume may be sufficient for a functioning marketplace, access is fractured and gatekeepers abound. A transfer of shares in a secondary transaction typically requires consent from a number of stakeholders, including the company’s board. The board may choose to reject the transaction simply because they don’t have the adequate time to evaluate whether it’s in the company’s best interest. Most companies also have a “right of first refusal” which allows the company and often some of the company’s shareholders to block a secondary transaction. They may choose to do so because of the implications such a transaction could have on valuation. Secondary share prices are typically determined by the buying and selling parties without the company’s direct input. If the price becomes public knowledge, it could impact the company’s future efforts to fundraise at a substantially higher valuation. In a similar vein, secondary prices can impact a company’s employee incentive plans, thereby making it difficult to offer a reasonable strike price for future employees.

Private companies are not obligated to share detailed information on stock price or valuation with all investors. This lack of transparency has made it difficult to establish an efficient secondary market. Because of the implications on valuation, many companies will specifically decline to share information if they sense that a stockholder plans to use the info to solicit secondary interest. This results in information asymmetry between buyers and sellers, and means that subjective factors such as industry news or product trends may impact pricing in a secondary transaction.

Using SPVs to build an effective secondary market

As noted above, a secondary transfer of shares directly on a company cap table typically requires board approval, review of transfer restrictions, and waiver of investor rights. However, a transfer of shares within an investment vehicle itself (such as an SPV) is generally free of these burdens — especially if the transfer involves a minority interest of the SPV and both the buyer and seller are accredited. Thus, there is a legitimate opportunity to create an efficient secondary market in which fund or SPV investors transfer their ownership of a vehicle rather than transacting directly on a company’s cap table.

These intra-vehicle transfers require that accurate and up-to-date information on the underlying investment is shared with the buyer, so the lack of price transparency still presents a challenge. SPV investors do not typically receive regular updates about portfolio company valuation events (i.e. follow-on rounds), partially due to their lack of information rights. Given that the rise of SPVs via syndicates is still relatively recent, there have not yet been efficient communication and information sharing channels built between portfolio companies and SPV investors. SPV investors typically do not have full transparency into the value of their (indirect) stake in a company and, on the other side of the table, companies don’t have efficient channels to leverage the support of their full network of investors.

If investment vehicles are created and maintained in a standardized way, with data stored in a structured manner, it would be easier to share valuation and other portfolio company updates with SPV members. This would give each SPV investor transparency into their specific interest in a company, and make it easier for them to entertain secondary opportunities. In many ways, a standardized approach to creating and maintaining investment vehicles is a significant first step towards an efficient secondary market with reduced regulatory burdens.

While secondary sales present the greatest opportunity for liquidity in the private markets, they come with quite a bit of baggage. Understanding the regulatory nuances of secondary transactions can help create more opportunity for elegant transactions, and subsequently more opportunities for early liquidity.

Considerations for secondary investors

Despite their many benefits, some VCs chose not to participate in secondary transactions given the implications around reporting, tax, and SEC registration. In venture capital, secondaries are considered “non-qualifying” investments, and fund managers are currently limited to 20% non-qualifying investments per fund or SPV. VCs who surpass this 20% threshold in any single fund or SPV, and who manage $150M+ in investments overall (based on fair-market value), may no longer benefit from certain VC exemptions. These managers 1) may have to register as an investment advisor with the SEC, which is a burdensome process that comes with additional reporting and financial audit requirements, and 2) they can only raise money from “qualified clients,” defined as individuals who have a net worth over $2.2 million.

Opportunities to build an effective secondary market

Previous attempts at creating an efficient secondary market have been thwarted given the absence of four factors: 1) homogenous assets, 2) sufficient supply and demand, 3) limited gatekeepers, and 4) reasonable transaction costs.

Venture capital assets are generally homogeneous (common or preferred stock in Delaware corporations) and demand for secondaries is plentiful given the associated benefits. While volume may be sufficient for a functioning marketplace, access is fractured and gatekeepers abound. A transfer of shares in a secondary transaction typically requires consent from a number of stakeholders, including the company’s board. The board may choose to reject the transaction simply because they don’t have the adequate time to evaluate whether it’s in the company’s best interest. Most companies also have a “right of first refusal” which allows the company and often some of the company’s shareholders to block a secondary transaction. They may choose to do so because of the implications such a transaction could have on valuation. Secondary share prices are typically determined by the buying and selling parties without the company’s direct input. If the price becomes public knowledge, it could impact the company’s future efforts to fundraise at a substantially higher valuation. In a similar vein, secondary prices can impact a company’s employee incentive plans, thereby making it difficult to offer a reasonable strike price for future employees.

Private companies are not obligated to share detailed information on stock price or valuation with all investors. This lack of transparency has made it difficult to establish an efficient secondary market. Because of the implications on valuation, many companies will specifically decline to share information if they sense that a stockholder plans to use the info to solicit secondary interest. This results in information asymmetry between buyers and sellers, and means that subjective factors such as industry news or product trends may impact pricing in a secondary transaction.

Using SPVs to build an effective secondary market

As noted above, a secondary transfer of shares directly on a company cap table typically requires board approval, review of transfer restrictions, and waiver of investor rights. However, a transfer of shares within an investment vehicle itself (such as an SPV) is generally free of these burdens — especially if the transfer involves a minority interest of the SPV and both the buyer and seller are accredited. Thus, there is a legitimate opportunity to create an efficient secondary market in which fund or SPV investors transfer their ownership of a vehicle rather than transacting directly on a company’s cap table.

These intra-vehicle transfers require that accurate and up-to-date information on the underlying investment is shared with the buyer, so the lack of price transparency still presents a challenge. SPV investors do not typically receive regular updates about portfolio company valuation events (i.e. follow-on rounds), partially due to their lack of information rights. Given that the rise of SPVs via syndicates is still relatively recent, there have not yet been efficient communication and information sharing channels built between portfolio companies and SPV investors. SPV investors typically do not have full transparency into the value of their (indirect) stake in a company and, on the other side of the table, companies don’t have efficient channels to leverage the support of their full network of investors.

If investment vehicles are created and maintained in a standardized way, with data stored in a structured manner, it would be easier to share valuation and other portfolio company updates with SPV members. This would give each SPV investor transparency into their specific interest in a company, and make it easier for them to entertain secondary opportunities. In many ways, a standardized approach to creating and maintaining investment vehicles is a significant first step towards an efficient secondary market with reduced regulatory burdens.