According to the founding principles of venture capital, investors and employee shareholders in startups receive the fruits of their labor either when the company goes public or when it is bought out. For many, these two paths are the underlying motivation for building a company.
Interestingly, the financial landscape has changed considerably in recent years. With M&A slowing down substantially and IPO volume slowing to a trickle, it's clear that the paradigm has shifted, forcing us to revisit the potential paths to liquidity for startup shareholders and employees.
Public markets at half mast
Over the past two years, we have seen a significant reduction in the number of IPOs and a major slowdown in mergers and acquisitions. This trend, due in part to economic and geopolitical factors, has had a major impact on the number and size of transactions, causing liquidity opportunities to be less attractive and more rare.
A widening gap between company and shareholder timelines
Early shareholders are more often forced to hold on to their investments for longer than originally planned. This can have significant repercussions on portfolio performance and even (in the case of early employees) the planning of personal finances.
Faced with this new constraint, they may be tempted to favor short-term value-creation scenarios, at odds with a longer-term strategy adopted by the company's board. This divergence is liable to create tensions that are detrimental to the company's good governance.
The secondary offering: an effective route for enabling liquidity
At a time when preferred solutions for an exit are few and far between, secondary offerings are increasingly becoming a complimentary (and often times necessary) strategy for companies to understand and implement.
Before considering a secondary offering, it's essential to understand its specific dynamics.
Unlike a traditional fundraising operation, the aim of a secondary offering is not to provide new financing for the company, but instead to provide liquidity to existing shareholders or employees. Often times this presents a wonderful opportunity to bring in a fresh investor who may be aligned to a greater extent with the long-term vision of the company.
Effectively, for the shareholders concerned this is an opportunity to realize their gains without having to wait for a possible IPO or acquisition of the company.
A well-executed secondary operation with the right stakeholders can make everyone happy and breathe new life into the long-term trajectory of the company.
For this to happen, we need to deconstruct the myths surrounding secondaries and understand the rules involved.
🙅♂️Secondary market myths and misconceptions:
1. Secondaries are a bad signal in an equity story
If the aim is to cash out the majority of your company's management and key employees from the capital, there's no doubt that this approach will send the wrong signal to the market. Importantly, this would also be the case during any primary financing round. It may imply that the company no longer enjoys the trust and support of its key internal players, which can cause concern and skepticism among potential investors.
However, in most situations (when handled diligently and reasonably), a secondary process can be an excellent signal. For example, when replacing investors who have already contributed everything they can - whether in terms of resources, knowledge or skills - with new shareholders who are capable of accompanying you on a long-term basis. In this case, a secondary process shows that the company is in a position to attract new investors and has the foresight to deeply consider the long-term sustainability of its cap table.
Similarly, secondaries can be an excellent way of rewarding your employees. By offering them cash, you give them the opportunity to benefit directly from the company's success. This can have a very positive impact on morale and contribute to a motivating and rewarding corporate culture. What's more, by showing that the company cares about its employees' financial well-being, this new trick will be perceived positively both internally and externally. This can reinforce your reputation as an employer of choice and help you attract and retain talent.
2. Secondary financing is easier to manage than primary financing
Contrary to popular belief, setting up a secondary financing round can be more complex than organizing a primary round, especially if approached the wrong way.
Several factors contribute to this dynamic:
Firstly, the number of investment funds focusing on secondary financing is significantly smaller than those investing in primary financing. This makes access to investors more difficult, as options are more limited. Startups therefore must be persistent and resourceful in identifying and attracting the right type of investor.
Additionally, in a secondary financing transaction, pre-emptive rights and share class hierarchies are carefully examined by potential investors. It is therefore necessary to carry out a differentiated valuation by share class. This step may require more in-depth financial skills and knowledge, adding another layer of complexity to the operation.
Finally, the legal complexity inherent in secondary financing transactions should not be overlooked. Between contracts, shareholder agreements and various regulations, there are a multitude of administrative details that must be taken into account. This often requires the assistance of legal experts, which can increase the cost and time required to complete the transaction.
In short, all these factors combine to make secondary financing more difficult to manage than primary financing. However, with the right preparation and a dedicated advisor, it is entirely possible to successfully navigate this complex process with very little cost and time spent.
3. Secondary financing inevitably happens at the last round valuation
In a secondary transaction, the shares offered for sale usually come from those who invested in the first rounds of financing, and are often classified as common shares. It is important to note that these common shares have different characteristics than any preferred shares that may have been issued in the most recent rounds of financing. The latter generally have greater protection and therefore offer investors a higher level of security.
📖 How do you plan a smooth secondary operation?
1. Educate shareholders
It's important to note that not everyone involved in a secondary operation is necessarily well-informed about the details of the shares and their conversion process, especially your company's employees. Indeed, the complexity of this information can sometimes make it difficult for them to understand (and is often very far removed from their day to day jobs). Therefore, it's a good idea to adopt a proactive education and communication strategy. For example, organizing an annual information session concerning the conditions of sale of BSPCEs, their exercise price and other relevant information, can be extremely beneficial. The main aim of this approach is to make employee share ownership as transparent and comprehensible as possible for all employees.
2. Actively plan your secondary processes (well in advance)
Generally speaking, a secondary transaction is initiated either by the investment fund holding shares in the company, or by the company itself. In either case, several preliminary steps are essential. First, the timing of the transaction must be well-projected, taking into account the company's financial situation and stakeholder preferences. Next, it's important to define a precise timetable for the operation, in order to organize the various stages as effectively as possible and avoid any unforseen delays.
3. Avoid aggressive preferential liquidation clauses
It is strongly recommended to avoid building preferential liquidation clauses into your cap table wherever possible, and especially any clause that deviates from the 1x participating standard. Such clauses, when particularly aggressive, can often be seen as a symptom of a company in a precarious or distressed situation. Within such a context, considering a secondary transaction is certainly not the best strategy, as investors frequently identify this type of "steep" cap table as a red flag.
🎯 A secondary round can be adapted to all stages of development:
Early-stage or pre-LBO: These companies, with valuations under €250 million, are generally in a growth phase. A secondary operation at this stage can enable early investors to realize gains.
Unicorn or Soonicorn: These companies, valued at between €250 million and €5 billion, have demonstrated substantial traction and are well established in their sector. A secondary transaction can enable them to provide liquidity to their employees and shareholders, while attracting new investors to support their continued expansion.
Decacorn: These companies, with a valuation of over €5 billion, are often market leaders with a strong international presence. A secondary transaction at this stage can enable these companies to provide significant liquidity to their shareholders, including employees, while reorganizing their ownership structure for the next phase of growth or an upcoming IPO.
If you're interested in learning more about this topic, don't hesitate to watch the replay of our recent webinar on the subject here!
