Secondary Q&A

  1. What are secondary investments?

Secondary investments are in essence any transactions involving “pre-owned” (more elegant name for what people used to call “second hand”) assets. In financial markets this involves buying and selling already existing financial instruments (shares, debt, partnership stakes, etc.) relating to a given entity (company, fund, etc.) whereby the proceeds go to the sellers rather than the entity whose instruments are being sold. This is in contrast to primary investments where new instruments are being issued and proceeds go to the entity issuing them.

Typical example of a market for secondary transactions is a stock exchange where people buy and sell listed equities. Yet secondary transactions can also happen with shares of privately held companies. Such transactions where new investors buy shares directly from the private company shareholders (and whom the new investors replace on the company cap table) are often referred to as “direct secondary”. Direct secondary transactions can involve instruments of companies in any stage of development, from early start-ups to “pre-IPO”, although in general the more mature the company is the more prevalent secondary transactions become.

Flashpoint approach: Flashpoint set up a fund dedicated to secondary investments, Flashpoint Secondary Fund, which focuses on direct secondary transactions in shares of private growth stage tech companies. We look to purchase minority stakes with good information rights and also aim to deploy more capital into selected companies over time in follow-on transactions (hence the focus on the information rights). Although we are a secondary fund, we can contribute primary capital to the companies as well. 

  1. Are secondary transactions common?

Secondary market for privately held companies exists for a long time. Historically most of the secondary transactions were involving shares of mature, cash flow positive companies; these could be minority stakes or also majority (take-overs eg by private equity companies). Secondary transactions for minority stakes in high growth tech companies have developed more recently as the venture capital ecosystem grew extensively in the past decades. Secondary transactions are therefore a natural development of a maturing investment ecosystem.

The growth of secondary transactions for tech start-ups (or scale-ups as some might want to correct) goes also hand-in-hand with the growing average time span that companies spend as private. As investment horizons of investors tend to be more fixed (eg linked to life times of investment funds) this creates a mismatch which can be solved by direct secondary market.

Flashpoint approach: We focus on companies with founders originating from CEE and Israel. The venture capital markets are in different stage of development in these regions. Israel’s tech boom has been fuelled by emergence of early stage funds more than two decades ago and now the country has a deep and diverse ecosystem with a number of secondary players. CEE follows a similar pattern but about a decade later, so while very active, the ecosystem is still developing and we are one the pioneers of secondary investments in the region. 

  1. Who are the sellers in direct secondary transactions?

In short – anyone.

Sellers can be any shareholders of the company regardless of how they acquired their shares –investors, founders or employees. Often times secondary transactions involve sellers who are no longer closely associated with the company, such as former employees or (ex)founders who have in the meantime moved on to a different venture. Early investors who have supported the company in the beginning may also look to sell their shares to either de-risk their positions (expression used for partial sales) or fully realise returns on their investment.

Flashpoint approach: We are open to consider purchasing shares from any shareholders or types of sellers. That means that we are also open to purchase any types of shares, preferred or common, and for that matter also options from company ESOPs, although all under an appropriate structure (on structures a bit later). Nevertheless, when the sellers are company insiders (founders, management) we do focus on ensuring that the people who drive the business remain incentivised by the future success of the company even after the transaction.

  1. Doesn’t the fact that there are people who want to sell shares signal that there is something wrong with the company?

Uff, a bit of a loaded question. Any expression of an intention of a party to get involved in a transaction of any kind can and does send some signal. This is true in life as in business. It is definitely also true for both primary and secondary investments. As companies raise primary capital for different reasons (growth, M&A, rescue, etc.), so can their shareholders sell shares for various reasons. These reasons can be either related to the health of the company, eg that the company is not doing well and investors are looking to cut their losses, or it can be for unrelated reasons, eg personal situations of founders/employees, concentration limits for investors, end of lifetime of funds, etc. What kind of signal a transaction sends is therefore closely related to the motivations of the sellers to engage in a secondary transaction.

Flashpoint approach: We place a lot of emphasis on understanding the intentions of the sellers. We look for situations where the motivation to sell is unrelated to the health of the company. We invest in high growth companies, not in distressed situations involving companies in trouble. In other words, we look for situations where the sellers still believe in the company, but there are specific reasons why they need liquidity.

  1. Are there any benefits of secondary transactions for the company itself and not just the sellers? 

There is a saying that founders/managers can change anything in a company but the shareholders. Well, with secondary transactions they can now do that as well. 

Indeed, companies can use secondary transactions to manage their cap tables. This can be reducing the size of “dead equity” (a part of cap table occupied by people no longer involved in the business, like former employees), rationalising the number of shareholders (as large cap tables can be inefficient and cumbersome), restructuring shareholder base for a more institutional profile (particularly relevant for companies that grew with “friends & family” money but are looking to establish themselves in institutional investor community), alleviating shareholder pressure for liquidity (which might otherwise restrict further company development or lead to premature exit), or even “recycling” investors that have in the meantime become inactive or disengaged from the company.

Additionally, secondary transactions can be used for eg financing M&A (whereby secondary investors buy-out certain shareholders of the target company) or even as a tool to incentivise and retain talent (share buy-back programmes that give real palpable value to private company ESOPs). In short, secondary transactions should be a natural part of the toolbox of company managers to be used for specific situations.

Flashpoint approach: We aim to be a constructive shareholder, looking to assist the founders/management in the future success of the company. This can involve leveraging our experience and network, but also our secondary investment mind set. We believe that having a secondary focused investor on a cap table is beneficial for a company as the secondary toolbox is more readily available for them. Moreover, at investment we want to be a “welcome” party to the cap table. We have no intention of becoming a shareholder without the company knowing (that would not be the best start of a collaboration). In fact, most of our engagements are directly with the company founders/management and only indirectly (or at later stage) with the sellers. Even when the initial contact comes from a selling shareholder, involvement of the company in the process is essential for us.

  1. Who are the buyers in direct secondary transactions?

Again in short – anyone.

A lot of secondary transactions are done by existing shareholders of the company, so within the insider circle (or as the fathers in law say: “circle of trust”). This is because of specific shareholders rights that are usually in place – namely rights of first refusal (so called ROFRs). ROFR is the right of an existing shareholder to buy company shares that other shareholders are selling at the same terms as a third party buyer is offering to the selling shareholder (more on that later). The buyers therefore may end up being also investors who are not “natural born” secondary investors. Such internal deals may be a preference for the company as well as they may be quicker (if that is the goal) since existing shareholders usually do not have to do (the same level of) due diligence as outside investors.

Another situation where broader set of investors may participate in a secondary transaction is when secondary shares are offered at the same time as a primary raise of a company. In those cases both of the transactions can be sometime bulked together as essentially two parts of an overall investment.

Nevertheless there are specialist players on the market with an investment strategy focused on secondary transactions – secondary funds. These can be exclusively secondary, meaning that their investment mandate does not allow them to invest primary capital at all, or their mandate can be flexible with a strategy geared towards secondary, but with a flexibility to participate in primary as well.

Therefore, in theory any investor can be a buyer of secondary shares. Yet such transactions may be hard to do for certain players whose “DNA” is in primary transactions and have internal barriers, either hard in their set-up/mandate or soft in their investment process/preference, to participate in secondary deals. It is therefore advisable for a company to have a diverse balance of shareholders, including secondary funds, to keep the overall flexibility in their investor base to cover various types of transactions. 

Flashpoint approach: Flashpoint Secondary Fund has a flexible mandate – our key focus is secondary investments, but we can invest primary capital as well (eg as one of anchor investors in future capital raises of our investee companies). We have concluded, based on our experience with secondary investments, that having some flexibility is the right approach. We also think that it is important for the companies to have a shareholder that can support them on an ongoing basis also with new capital. In fact, this is one of the key motivations why companies would look for potential secondary investors – to replace shareholders who have become disengaged and are no longer willing or able to support the company in the future.

  1. How are secondary transactions different to primary from investors’ perspective?

Yet another short answer – they are not.

From the point of view of investors secondary transactions are no different to primary ones – it is still deployment of capital into shares of a company with a view that the price of those shares will grow (ie positive investment returns). Access to company information to do a proper analysis is therefore usually high on the agenda for secondary investors as for deals which are originated by the sellers (as opposed to by companies themselves) this may be a sticking point.

Then again, there is quite an active secondary market for “pre-IPO” companies, so companies which are planning to become listed in the near future. Such secondary deals may sometimes happen on minimal information available. Yet these are usually relatively small stakes (relative to the overall valuation of the company) for businesses which are already “household names” among the investor (or wider) community. Some investors may therefore get comfortable with very limited information and due diligence at the time of the transaction simply because they are already well familiar with the company and the expected time horizon until the transaction becomes liquid (publicly traded) is relatively short and sometimes with an established valuation guideline for the IPO.

Flashpoint approach: Our key focus is on growth stage companies that still have several years to go until they start seriously thinking about an exit/IPO. These are usually pre-unicorn companies (ie not yet household names) that may sometimes also have less investment history (eg because they grew bootstrapped). Thorough commercial review and formulating investment thesis are an integral part of our investment process for such situations. We therefore require good access to information both before the deal (to perform due diligence) and after the deal (because of our focus on follow-on investments). 

  1. Is the process of secondary transactions different to primary for the company?

There can be a lot of similarities, of course with the negligible difference that at the end of the secondary process the company does not get the funds, the sellers do.

As the thought process that investors go through while deciding on secondary transactions is similar to a primary investment, the level of information disclosure they would want from the company may also be similar.

This brings the question whether companies or sellers should run wide competitive processes for secondary transactions the same way as they are common for primary deals. The opinions may differ. Basic wisdom would say that a wider process yields better price discovery (ie can maximise the price). This nevertheless ironically may not be true as a wide process with many parties can be a drag on company’s resources while no new money is coming to the business – not all companies are prepared to undergo that. This then limits the level of due diligence secondary investors can do which in turn may put off a lot of potential investors and prices offered may have “risk buffer” embedded in them (ie to account for possible risks that the investor simply wasn’t able to diligence). Therefore it may be ironically more efficient to run bilateral discussions (or very limited processes) which is in fact what we see most of the times.

The investment execution process itself then looks like a lighter version of a primary investment particularly on the legal side as big part of legal documentation is normally related to representations and warranties which tend to be much more limited for secondary deals. Also, even if company is involved in the whole process the ultimate transaction documents (the share purchase agreements) are not between the investors and the company as in primary but between the sellers and buyers directly.

Important, and specific, part of secondary processes is dealing with rights of first refusal of existing shareholders (or ROFRs, as mentioned above). These rights, from the perspective of secondary investors, represent a non-negligible risk that investors may dedicate a lot of time and resources on a transaction only to be ultimately “ROFR-ed” by an existing shareholder. Stringent ROFRs therefore work as a deterrent for secondary investors (and thus also secondary transactions as such). Secondary investors therefore tend to spend time analysing the particularities of the ROFR clauses in companies and usually request ROFR waivers from existing shareholders as early as possible in the process.

Flashpoint approach:  As mentioned above, good access to information is key for us when making investment decisions; therefore we consider involvement of the company founders/management in the process as crucial to ensure this. Majority of the secondary processes we are involved in are bilateral. The important aspect in those processes is therefore efficiency and with good access to information we aim to get to get to indications of interest and commercial terms quickly (am cautious not to mention time frames as they really depend on info availability). Post outline of commercial terms we then require clearance/waivers on ROFRs before embarking on a confirmatory due diligence.

  1. How are secondary transactions priced?

Good question (which usually means though to answer). Generally speaking secondary investors are “value investors” and they do look for an attractive entry price, ie they do look for a discount. Again though one may ask discount to what? The general answer would be a discount to a benchmark. If the company had a recent primary raise then any secondary price would be considered relative to the last price per share of that round. On the other hand, when the last raise of the company was already some time ago (and the company has developed in the meantime) then establishing the value of the company at the time of the secondary transaction is very similar to a primary process.

The size of the discount may differ widely from deal to deal (ie company to company, or situation to situation) and generally has two sources: 1) price of liquidity for what is ultimately an illiquid instrument (a share in a private company), and 2) structural subordination of the sold instrument. The price of liquidity derives its core principles from financial markets theory, but ultimately it is an interplay between supply and demand for shares of that particular company. Structural subordination is another way of describing the positioning of a particular instrument on a liquidation preference waterfall. On company cap tables “newer capital” usually has preferential position to “older capital” in case of an exit/liquidation event – ie is more senior. In a downside scenario this provides a protection to such senior investors, which in turn increases the risks to junior (earlier) investors. In effect the senior instruments create leverage in the structure. To reflect that, secondary investors will price shares differently based on their positioning in the liquidation preference stack.

Flashpoint approach:  As a secondary investor focused on growth stage tech companies we are ultimately value investors and do look for attractive entry prices (no point in hiding or denying that). At every investment we nevertheless perform our own analysis and come up with our own view on the valuation of the company and pricing of the specific instrument offered. The analysis of cap tables, past funding rounds, liquidity preference terms of different instruments and the amount of “liq pref stack on top of us” plays a crucial role in that analysis.

  1. Are secondary transactions structures any different from primary?

This is actually (finally!) an area where primary and secondary transactions can be quite different. Primary transactions tend to be quite standardised – new rounds of preferred shares with similar terms as the previous ones, just with differing issue prices (ideally always increasing) which are positioned either senior or pari passu (fancy latin term meaning ranking equally) to the previous round of preferred shares. To a degree, the more standard they are the better, as standard terms of rounds are a sign of “normal”/healthy development with a company issuing those instruments to fund their growth (organic or M&A) and not because of other reasons.

Nevertheless instruments sold in secondary transactions can differ widely as well as can the situations why people sell the shares; therefore the structures to acquire them can also be quite different. The major differences will lie in whether the instruments acquired stay as they are even post acquisition or whether their rights or positioning changes. One of the relatively common features is a conversion of the acquired shares to more senior (or most senior) preferred shares on the cap table. This is to solve for the issues of structural subordination (as discussed above). Such conversions, though while possibly endorsed by the sellers (as they may get potentially higher price), 

would need consent from the company, Board and/or shareholders.

And this is the other difference between primary and secondary transactions. In primary transactions there is a relatively simple relationship between an investor and the company. Existing company shareholders do have pre-emptive rights for future share issues, but these are usually clarified at the start of the process (as usually companies go to their existing shareholders first for support in the next funding round). Secondary transactions include interactions between investors, sellers, company and other existing shareholders. There are simply more parties around the table to think about which is reflected both in the process (eg clearance of ROFRs), but also can have an impact on the structure (eg agreements needed in place with different parties).

Flashpoint approach: We split our approach to investments in two parts – one is the rigour (the analysis) that we go through to evaluate an investment and the other is the structure of the investment itself. We keep the former one within a fixed framework to ensure systematic approach to analysis and repeatability of the thought process. Yet on the structures we employ a more tailored approach and are open to various structures fitting the specificities of the situation. As mentioned above, we are open to buying preferred or common shares and also share options, but all these should be under suitable structures. As no two situations are the same the structures can sometimes be even relatively creative requiring quite some corporate finance (and legal) skillset which we do have in-house.

  1. Should companies make it easier for secondary transactions to happen?

Absolutely!

The answer may depend on whether companies want to enable secondary transactions or restrict them. We (unsurprisingly) think that companies should be open to them and in fact be their enablers. The easiness with which secondary transactions can be done is increasing the ability of the shareholders to actively manage their portfolios (eg investment horizon terms) which in turn increases the pool of potential investors that could invest in the company in the first place (which is never a bad thing). The flip side is that with no rules at all the company may lose control (or even transparency) as to who are their shareholders. But then – this is the reality for listed companies, so something that companies (especially those with IPO ambitions) should be getting used to. But then again, shareholders that supported the company in the past deserve to have a say (a ROFR) in such transactions so it should not be fully free. But then yet again, companies can control the flow of information to pick their secondary investors, so there is a natural order in the system. etc etc …as you can see there can be multiple arguments one way or another and, even though we are naturally biased, we do recognise that it may not be an easy decision.

If nevertheless the inclination is to be open to secondary (which we would recommend), then there are things the companies can do to make them easier. These include clauses in their legal docs enabling share transfers for (any types of) shareholders without Board approval, not having look-through change of control clauses for holders of shares, enabling free price discovery in the process (ie no approvals of the company or Board on the price at which shares are sold), having an easy to understand one-step ROFR process (ie not having to go to multiple parties in stages), having clear and reasonable time frames (ie not too long) ROFR periods, limit the number of parties that have the ROFR right, consider defining that transaction with certain characteristics (eg transaction amounts per time or per shareholder) are not subject to any ROFR, etc etc. And then of course, once secondary process is ongoing, be open with information disclosure and dedicate resources for the process to enable investors to property evaluate the transaction. Certainly it is better for the company itself to have new shareholders who have invested based rational analysis around an investment thesis than shareholders that made the decision on a whim or under wrong assumptions because they didn’t have the proper information.

Flashpoint approach: We, quite obviously from our biased point of view, think that companies should be open to secondary transactions and have legal documents that make it easy to execute them. Also, as mentioned multiple times, for us access to information and company management is key in the investment process, so we would encourage companies to embrace the secondary processes to get a well-informed constructive shareholder.

  1. When should the companies and/or shareholders think about secondary transactions?

Always.

Flashpoint approach: Always.