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Secondaries here, secondaries there, secondaries everywhere
I’ve had a similar conversation about 10 times in the last 3 months with various people in tech — ‘v tempting to just hire a sick web designer launch a next gen data tool to a limited waitlist then drop the bag on Coatue and take 5m off the table at the A’ — this is crazy and of the times talk. But for anyone with ‘the right background’ and a decent idea, raising a seed round right now is pretty straightforward. What a time to be alive.
Hire a few good people and close some pilots? Series A, ahoy! Actually start generating revenue? Well, this business may still be a dumpster fire but investors will happily let you take a few millie off the table to compensate you for the continued risk you take on building the company. This isn’t the sign of a healthy market, and while it’s possible, it’s all the wrong reasons to start a company.
My last post was about the amount of cash floating around and the challenge of allocating it to company building. Fortunately all that cash doesn’t necessarily have to go to company building. An increasingly large proportion of it can now go to founders, employees and early investors.
Why is this happening? Well it’s the same reason companies are raising bigger rounds at higher prices. More competition on the funding side means funds offering better terms. When the price can only go so high and the terms so founder-favourable, then putting the cherry on top of cash in the pocket isn’t a bad option.
As competition increases there’s just less room in the rounds. Once investors are happy a company is well capitalised, they don’t care if their money was in primary or secondary. They just want the ownership. It’s also often an easier option for the founders/boards that want to bring in another investor but don’t want to take on the dilution.
Up until just 3 or 4 years ago taking secondary pre-product market fit was considered insane. Now it’s not uncommon. At Series A, it was reserved for certain life circumstances where it helped the founders stay motivated. Now, it’s used more and more as a standard offering to sweeten a deal.
It’s also much more favourable than the past. Secondaries were usually in Common stock and investors applied a discount to the common against the price per share of the last rounds preferred. Now there’s often no discount (although sometimes investors will ask to reclassify the shares at the top of the preference stack for this) and in some particularly hot companies I’ve heard of secondaries going at a 50% premium to the last round. (This is in pre-revenue companies too 🤪)
What are the actual impacts of this? There are some who say that taking money off the table will take away motivation from the founders. There are others who say that it allows them to take on more risk to really shoot for the moon. Like all things in VC, it really depends on who you ask and what way the winds are blowing that day.
There are of course founders who will lose their minds with $5m go on a bender and lose focus. There are others who will use that money in the back pocket to bet the farm on a mad idea that could change the company’s trajectory for the better but also dial up the odds of total failure. It’s really dependent on the person and why they want to do it. One of the most well known secondary stories of the moment is Johnny from Hopin selling over $150m in shares over the last three rounds. I remember hearing cries of horror in the VC world when he took a pretty chunky amount off the table at the Series B but that doesn’t seem to have slowed him down 7x’ing the value of that company since then.
Investors should want founders to make every decision that optimizes for the biggest possible outcome and as a founder if you’ve never had money then putting some cash in your back pocket can allow you to take more risk or most importantly turn down early exit opportunities. (and they will come if you’re building something special) Being financially insecure is a state of mind and impacts decision making — secondaries can take that insecurity out of the picture.
At Frontline, we‘ve always taken a pretty chill approach to secondaries. In the companies that we are bullish on we will buy up as much of it as we can get our hands on. We also think that founders shouldn’t be worried about their personal financial situation. They should be focused on running the business. So we’ve done 200k secondaries at seed, supported 1m at the A and even supported a 5m+ at the B. It’s all about doing right by the company and the management team and appreciating that each case is different. Selling enough to keep taking the right risks? A great call. Selling enough to not care about the outcome anymore? Not what we’d support.
Across all our funds, we’ve used secondaries as an investment strategy to build positions in companies that are increasingly dilution sensitive in the primary. With the power balance in founders hands at the moment, aggressive lead investors are often squeezing down existing pro-rata allocations and it’s hard to get all the ownership you want in the main round. But often, especially with where prices are at right now, you can find someone willing to sell.
Being a founder no longer means having your life, your sense of self and your entire net worth tied up in your business. That can work for some people (the Peloton founder to this day claims never to have sold a single share — which is great marketing but he’s also probably not disclosing the loans he’s been able to get collateralized against his shareholding) — but it’s not for everyone. This is part of what people mean when they say it’s a great time to be a founder. When it comes to start-up financial success it’s no longer 0 or 1 — there’s a wide spectrum in between and thanks to investor appetite for your equity even if your company doesn’t work out you could still make a life changing amount of money.
If this lowers the risk threshold for some amazing people to make the jump out of secure jobs and actually start something new and innovative then that can be good for the ecosystem. But, and I’m not simping for Musk here, there’s a good quote about what words of encouragement Elon Musk would give someone starting a company, his response was, if you need words of encouragement then don’t start one. Similarly — if the reason you’re starting a company is to make a quick buck then trust me there are easier ways to do it — talk to the Cumrocket millionaires.