Now that the secondary market has existed in both a stagnant and booming venture environment, we believe that it has long-term staying power as a strategy for maintaining liquidity and accessing venture capital.
Key points
Secondary markets allow investors to buy and sell securities such as stocks, bonds, and other financial instruments after their initial issuance. Shares are offered to investors during primary funding rounds, such as Series A and Series B, while secondaries refer to the purchase of shares from these initial investors. Typically, companies predetermine the number of shares, and each funding round receives an allocation based on the company’s valuation and the amount it aims to raise.
In this blog, we’ll zero in on how secondary transactions, including tender offers and direct secondary sales, provide stakeholders with liquidity and a way to realize returns in a muted exit landscape. As secondary sales and purchases are controlled by the Securities and Exchange Commission (SEC) and companies and startups, we’ll further delve into regulatory obstacles, issues with transparency, and the benefits of these investment vehicles.
Our Q3 2024 Analyst Note: Exit Alternatives for US VC, authored by Emily Zheng, senior analyst for venture capital at PitchBook, shows that 2024’s expectations for US VC-backed public listings are the lowest since 2016. Only 37 companies went public in H1 2024, generating $28.4 billion in value.
“Secondaries have evolved since the highs of the pandemic era when the market was used to gain access to oversubscribed rounds.”—Emily Zheng, Senior Analyst, PitchBook |
Oversubscriptions happen when companies have more investors and money (demand) than they want to funnel into a round (supply). Because investors don’t want to miss out, they use the secondary market to buy into a company.
However, two years into an IPO drought that started in 2022, VC firms are using secondary sales to generate liquidity for their investors and bridge the gap left by the lack of distributions.
Zheng’s Analyst Note highlights the rise of secondary funds through StepStone’s impressive $3.3 billion raise for the largest venture capital secondary fund to date. This trend indicates a strong demand from investors keen to explore this expanding market. Additionally, leading companies are actively getting involved, with four of the ten highest-valued startups in the U.S. planning to launch tender offers in the first half of 2025.
“The narrative has shifted recently because fundraising, dealmaking, and exit activity aren’t as robust as they were during the zero interest rate policy era. Now, the secondary market is a way for sellers to access much-needed liquidity. With current discounts, secondaries provide buyers with lower access points for investors who want to buy into a company and didn’t do so through a primary round, and existing investors who want to increase their allocation,” Zheng said.
Secondary sales and purchases encompass transactions between investors, including employees of venture-backed companies who receive equity compensation and limited partners (LPs) and general partners (GPs). Direct secondary markets facilitate transactions where shareholders buy and sell shares in a venture-backed company rather than purchasing or selling shares directly from the company itself, with the caveat of approval by the startup.
Below, we look at three of the most fundamental secondary transaction types.
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Tender offer |
A tender offer is a transaction initiated by a company that allows employees, early-stage investors, and other shareholders to sell their shares at a predetermined price while the company remains private. The stakeholders can sell their shares to the company or another investor through a platform such as Zanbato, which facilitates secondary transactions.
The shareholder will receive a notice from the company with a 20-business-day review period mandated by the Securities and Exchange Commission (SEC) to decide whether they will sell at the tender offer.
The company can restrict the number of shares sold, as well as determine who can participate and what types of shares are available. For instance, participation might be limited to stock options, excluding restricted stock units (RSUs). As a result, some former employees may not be eligible to participate.
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Direct secondary purchases |
Direct secondaries involve a fund or an investor who reaches out directly to a shareholder, either employees or early-stage investors willing to sell their shares. The company isn’t directly involved in this transaction but must approve it; instead, the fund will facilitate the sale based on the investor’s interest.
The buyer could be a secondary fund, an institutional investor, a family office, or a high-net-worth individual (HNWI) interested in acquiring company shares. A direct secondary sale provides liquidity to shareholders who wish to cash out before an exit event such as an IPO or acquisition.
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Secondary exchanges |
Secondary exchanges match a buyer and a seller, similar to a stock exchange. Forge and Zanbato are two leading platforms where shareholders of private companies can sell their stakes to potential buyers, ensuring access to liquidity. This process allows investors to access high-profile private companies that are not publicly traded.
The right of first refusal (ROFR) is triggered when a company receives a third-party offer for its shares. In a tender offer and direct secondary sale, ROFR is a provision that safeguards the interests of current investors.
This contract requires the company to offer the same terms proposed by the third party to the right of first refusal holder, typically the current investors. This allows investors to make an informed decision by matching the third-party offer or retaining their current stake.
Due to the potential impact of secondary transactions on a company’s valuation, many companies impose restrictions on these transfers. According to Zheng, this is often a necessary measure.
When an investor declines ROFR, it can negatively impact the perceived valuation of a company and future transactions with new investors. While the ROFR serves as a protective mechanism for current investors, it can also complicate share sales by creating the impression of high demand for shares or, if declined, raising concerns about valuations.
Due to the illiquid nature of private company shares, direct secondary markets serve as a mechanism to provide liquidity for those who own individual private company shares. These transactions allow investors to realize value and return capital without a full exit.
Secondary transactions can also help mitigate potential volatility when a company is first publicly listed. Shareholders who need liquidity get the opportunity to sell beforehand, which limits an early trading frenzy. Plus, a secondary sale can help gauge investor sentiment—essentially providing a sneak peek at the demand for a company’s shares—and determine a more accurate price.
Direct secondaries also allow investors to gain access to high-growth and emerging technology companies that they could not access in the primary markets.
As the secondary market helps to re-align the changing interests of companies and investors, one of its core advantages is the redistribution of ownership. For example, as companies remain private for longer, early-stage investors who wish to cash out sooner can benefit by selling their stakes and investing in later-stage companies or those preparing for acquisition. On the other hand, companies that intend to remain private benefit from the involvement of crossover investors who are not required to sell after an initial public offering (IPO).
Early investors may not have anticipated holding their investment for a long time; they prefer to exit. Therefore, it is in the company’s best interest to have investors who share a similar timeline and are not limited by their investment roles.
One of the most significant challenges is the need for transparency and more information on opportunities in the direct secondary markets. The market poses legal and regulatory obstacles due to the complexity of shareholder agreements and their impact on secondary transactions; opacity can make it challenging to conduct due diligence efficiently.
Overall, each company’s shares have unique characteristics and challenges that investors must consider. As when purchasing just one stock, a lot of unsystematic risk is involved in a direct secondary market transaction, depending on company-specific issues. Some investors have concerns regarding the potential for volatility due to limited supply and a generally illiquid market.
Similarly, Zheng added that because there is no centralized stock exchange for these transactions, there needs to be more transparency.
“Company policies around secondaries are not standardized and are not always included. There’s so much room for growth in secondaries because once more companies start being more transparent in their contracts, there will be more clarity and activity,” said Zheng.
REPORT
Evergreen funds are including secondaries as part of their investment strategies. Unlike closed-end structures, evergreen funds allow investors to exit and enter positions more flexibly.
Read our note, The Evergreen Evolution, to learn more.
The size and growth of the overall venture market suggest a bright future for the direct secondary market. One caveat is that uptake in direct secondary transactions may rely on conditions of the current exit environment. In a tepid exit environment, direct secondary transactions become even more meaningful to investors seeking liquidity—encouraging more activity. In a robust environment like the zero interest rate policy era, secondaries provide investors access to oversubscribed deals.
“Extended private company timelines mean that once the IPO market jump-starts, a robust backlog of eligible startups will be ready to sustain the exit momentum. In the meantime, the rise of specialized funds will support the increased adoption of venture secondaries,” said Zheng.
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Emily Zheng |
