A Guide to Secondary Sales

The illiquid nature of venture capital investment is debatably one of its biggest downsides. To date, secondary sales have presented the greatest opportunity (as well as the greatest challenges) for bringing more liquidity to venture as an asset class.

What is a secondary sale?

In venture capital, a secondary sale is any sale of ownership in a startup (typically common or preferred stock) where the seller is anyone other than the company itself. For instance, an investor may purchase Series Seed stock and then resell it to another investor several years down the line prior to the company going public or getting acquired (known as “exiting”). Since the seller in the second transaction is the investor rather than the company, this is called a “Secondary” transaction (as opposed to a “Primary” transaction).

A brief history of secondaries

Secondaries have a long history in the private markets. In private equity, secondary transactions typically occur in the form of a “leveraged buyout,” when a third party purchases shares of a struggling company using loaned funds. The first leveraged buyout on record was in the 1950s, shortly after the emergence of venture capital as an asset class. Secondaries were not initially used in VC, since venture investors are primarily focused on funding the research and development of new products. But, as the venture asset class has expanded and more folks have gotten involved, the illiquid nature of venture investments has created an increased appetite for secondaries.

The benefits of secondaries

The primary function of a secondary transaction is to create liquidity (otherwise known as cold, hard cash) for the initial purchaser. This is especially relevant in VC, where investments are typically “illiquid,” meaning that investors won’t receive a return for five, ten, or more years. Secondaries give VCs an opportunity to return funds to their LPs without having to wait for a portfolio company to exit. This can be appealing to VCs because returning capital to investors improves fund metrics such as IRR, which may make it easier for them to raise subsequent funds.

Alternatively, secondary sales can give VCs an opportunity to recycle capital back into a fund. Rather than return funds to LPs immediately, the money that a fund receives from an exit (or secondary sale) is used to invest in additional companies. If LPs are not particularly concerned with early liquidity, recycling proceeds can create higher long-term returns because more capital is deployed into companies overall. In addition to increasing total LP returns, recycling boost fund metrics like IRR and TVPI, which may impact a fund manager’s ability to raise future funds. This fantastic post by Sapphire Ventures provides a great, in-depth example of how recycling can impact fund return multiples.

On the buyer side, secondary transactions are all about deal access. Secondaries provide a viable opportunity for newer investors, including angels and micro-fund managers, to buy ownership in companies that they wouldn’t have an opportunity to invest in directly. These are almost always later-stage companies, where there’s more demand for equity given that the companies are more established and have demonstrated success. Newer investors may see this as an appealing way to diversify their portfolio and participate in value creation of a company soon before an IPO.

Because of these benefits, and because of the increased interest in private markets as a whole, there has been a demonstrated increase in secondary activity over the past several years. Secondaries are particularly appealing to stakeholders such as family offices, high-net-worth individuals, and fund-of-funds that are newer to venture investing and therefore may not have access to primary investment opportunities.