Primary Thoughts About Secondary Transactions

As my man Kenny Rogers sang…

You’ve got to know when to hold ‘em
Know when to fold ‘em
Know when to walk away
And know when to run
You never count your money
When you’re sittin’ at the table
There’ll be time enough for countin’
When the dealin’s done

Starting a venture capital blog post with 1970s country music lyrics is pretty uncommon, but so is writing about when and why an investor might choose to sell equity before the company exits. Below I’ll share some of the principles we use at Homebrew, knowing that there’s not really a single ‘right’ answer for a fund manager. Most of this discussion is about ‘playing offense’ — working towards being a good steward of LP capital and the risk/reward associated with VC. I’m not going to cover reasons to sell that I’d consider ‘playing defense’ — mostly exogenous factors which involve LP pressure for liquidity on non-optimal timelines, dissolution of funds due to partnership issues, and so on. These are all rare, but real, and fortunately not anything we’ve dealt with in our firm.

So for the most part a venture investor holds their equity until the company exits via an acquisition, IPO, or some sort of other liquidity event (management buyout, whatever). But especially over the last decade, the opportunities to sell ahead of an outcome for the company multiplied dramatically. As more growth and crossover investors came into the startup ecosystem they were often eager to put capital to work and happy to consolidate their positions with common or preferred shares from early employees, founders and previous investors. The surplus of capital also meant that new funding rounds often presented opportunity to sell portions of equity to current investors who otherwise were seeing their pro rata allocations cut back. And finally, a more robust (but still somewhat opaque) secondary market emerged for transacting equity among parties.

As an early stage fund, often buying 10–15% of a company during its seed financing, this meant we were often being asked if we wanted to sell portions of our stakes to other approved investors (let alone the random pings from market-makers unaffiliated with the company). As former product managers Satya and I lean towards having frameworks for these sorts of decisions, for both consistency and speed in internal operations. We started by asking our LPs (a relatively small number of institutional investors) and other experienced VCs what they’ve seen play out and how, if applicable, they decide what to do with their own holdings. Then we combined this with observed data from the behavior by coinvestors in our own portfolio.

Not surprisingly there was no specific consensus. There were examples of great investors who said “never sell early — you ride your winners as long as you can” and others who had *very* specific formulas for when they sell (when it hits X valuation, take Y percent off the table each subsequent round; always sell until you hit a certain return multiple for the fund, then hold after; and so on). This was helpful because it let us know that (a) there wasn’t a universal best practice and (b) peers could have the same goals but take different paths to get there. And so next we codified our own ruleset. It sounds basically like this:

• Every time a portfolio raises a new round we should be ‘buyers’ or ‘sellers’ — that’s not to say that we buy or sell into every round, but objectively we should want to be on one side of the table or the other. We should have an opinion, although one that’s informed by our own fund strategy. That is, we should be buyers or sellers as a concentrated early stage fund, not trying to say “well, if we were a growth fund what would be do.”
• We should strive to execute decisions that are both in the best interest of the company -AND- in the best interest of Homebrew. I’ll caveat this below but we want to be protective of the longterm interests of the company, the CEO, and the coinvestors. You don’t try to reprice the company on your own. You don’t bring investors on to the cap table via a secondary transaction that are going to be problematic. And so on.
• Pigs get fat but hogs get slaughtered. Even if we believe a company has tremendous longterm upside, it’s not inappropriate to take some money off the table in order to manage that risk. As we’re recently reminded, markets go down, not just up. Just be aware of the incentives, emotions, and other factors at play. It’s ok to behave one way before you hit your DPI target and another way after, but understand how those factors produce better or worse possible outcomes. This is also true with regards to recycling. If we can sell partially out of a position and put those proceeds into one that we believe has more incremental upside, that’s accretive to our results.
• We’re aligned with the founders and the rest of the cap table until we aren’t. All the preferred stock is pari passu and behaving honorably in the best interest of the company? Great. The founders are taking some money off the table in secondary but still very much locked in on building and making funding decisions that are consistent with that? Great. In these cases there’s very little additional complication. But if this breaks, we need to reconsider how we think of our own positions. Not in darkness, but expressing concerns first and then doing the best version of what we can to treat the company fairly but also do our fiduciary interests for our LPs. What’s an example of a situation that might start fracturing the cap table? Imagine the CEO is sitting with two funding offers. One is a clean termsheet, no structure. The other has a ton of structure (preferences for the new investor) but also offers an equity refresh to the exec team, or has a handshake with the CEO that they’ll buy $30 million of equity from them after close. You might think, “Hunter! This doesn’t happen — a Board would stop it” (or whatever). And I’d say, it does even if it sucks for other investors and the employee common shareholders. Again rarely but if you do venture long enough you see at least one of everything. At moments like this, if they occur (and I can say we haven’t experienced anything this grievous to the best of my knowledge), all of a sudden we’re not rowing in the same direction.

Much of success in venture is knowing what (and when) to buy. If you do that well it’s very difficult to mess it up. Conversely, if you’re not a good picker, it’s difficult to overcome that, even if you had perfect timing on secondary sales. But sometimes the difference between B+ and A- (or between A and A++++) can be a well-timed decision to turn unrealized gains into partially realized.