The Future Of The Secondary Market For Venture Capital Assets
By Dan Burstein and Sam Schwerin, Managing Partners, Millennium Technology Value Partners LP
We are witnessing the exploration of a new region in the cartography of private
equity’s secondary marketplace – the market for buying and selling
direct interests in venture capital-backed private companies
.Over the last decade, the secondary market for limited partnership interests
in well-established PE and VC funds grew into a multi-billion dollar annual industry – as
much as $6 billion in 2006, according to some reports. It is a market that is
also increasingly efficient in its operations. Indeed, the secondary market for
LP interests has evolved from its early 1990s status as a mar-ginal market with
sellers motivated largely by distress to today’s reality of a robust, mainstream
market with buyers and sellers coming together for diverse reasons.
When it comes to direct VC assets, however, the secondary market remains comparatively
underdeveloped.Yet with a reported $270 billion of assets under VC management
today – a historic high, by all accounts – it is only a matter of
time before this market gains some of the sophistication and maturity of other
secondary market sectors. Indeed, we believe that over the next few years, the
market for direct secondary VC assets will come to approximate the market for
LP interests in total size, driven fundamentally by objective need for liquidity,
but amplified by an increase in the creativity and sophistication of both buyers
and sellers.
By direct VC assets we mean the continuum of investments that venture capitalists
and entrepreneurs typically make or own – from founder’s stock and
employee options to debt and preferred stock securities. Since 2002, the funds
we manage have been involved in over 100 secondary transactions involving the
securities of privately held VC-backed technology companies. From these experiences,
we have chosen to highlight a few salient trends that may have important impacts
on the development of the secondary market for venture assets in the years to
come.
A multiplicity of investors need liquidity for their VC assets for a multiplicity
of reasons. While distress still accounts for some venture asset sales – our
funds have purchased venture assets out of large bankruptcies, such as Enron
or Exodus, for example – increasingly the parties involved in secondary
transactions are more varied and the motivations for selling more complex. The
medi-an hold period for a venture-backed private company (from time of investment
to time of exit) has trended up to more than six years – and that’s
for the handful of companies that succeed in achieving an IPO or M&A exit.
Six years with no liquidity is too long for many professional investors, and
certainly too long to incent founder and employee stock and option holders properly.
In those six intervening years, corporate investors find that their strategies
change, mutual funds and hedge funds find the need to rebalance portfolio allocations,
venture capitalists and lenders find investment prospects changing, and people
simply move on. Sometimes sec-ondary sales are driven by tax planning, sometimes
by regulatory, disclosure and compliance issues. In fact, we recently identified
more than 50 reasons why holders of venture assets seek liquidity for their investments.
Yet finding buyers of these hard-to-value, hard-to-transact, small private company
assets is not always easy. Although the demand for liquidity is strong and multifaceted,
the market is not yet sufficiently robust nor efficient enough to meet this growing
demand. An interesting insight into this dynamic is the way our small funds,
having established a reputation as efficient, creative, fair, discreet – and
active – buyers of secondary assets, have been able to become trusted liquidity
partners for a number of the most sophisticated financial and corporate sellers.
In fact, more than 80% of sellers who sell one position to our fund come back
at least a second time and often many more times to transact their positions.
The owners of venture capital assets are generally sophisticated sellers… and
they need sophisticated, customized liquidity and exit solutions. Cookie-cutter
solutions rarely work for the sophisticated owners of most VC assets. Because
the valuation assumptions about individual pri-vate companies vary widely, because
a variety of qualitative and quantitative reasons contributed to a past investment
thesis, and because corporate and financial owners of VC assets live in a public
disclosure fishbowl, each seller’s solution is inherently different. We
have found in cer-tain cases that sellers are interested in “shared upside” if
and when the investment is ultimately successful. But in other cases, shared
upside scenarios work against accelerating the tax benefits derived from losses.
In certain scenarios, a corporate seller may have lost interest in owning or
continuing to invest in the equity of a private technology company, but may still
wish to retain a strategic relationship with the company in terms of technology
development, designs, marketing or distribution. We hear increasingly from mutual
funds and hedge funds that they are spending too much of their internal administrative
time valuing and monitoring private company assets that are not likely to contribute
significantly to overall returns.
All of these situations create opportunities for innovative secondary market
buyers to customize liquidity and exit solutions for sellers. In our search to
meet seller needs, for example, we have established loan programs, written derivatives,
created synthetic options, designed asset swaps and exchange funds, funded the
exercise of options, and more. As we have brought these innovations to the attention
of potential sellers, we have generally received a warm welcome. If holders previously
believed there was no market for their assets and no solution to their problem
of being stuck in private, illiquid investments that no longer met their needs,
then they would have no reason to try to bring these assets to the secondary
market. Our experience suggests that when we demonstrate that we understand seller
needs and can offer creative, customized solutions to sellers’ challenges,
the supply of secondary assets for sale increases. In short, if there is no market,
there tends to be little supply. If we can demonstrate that there is a market,
the pent-up supply immediately manifests itself.
The secondary market is also becoming an important tool for venture-backed
private companies to create liquidity for key constituents and solve challenges
in the capital structure. We have found that smart management teams are increasingly
viewing the secondary market as providing a new set of arrows in their corporate
quiver with which to address certain types of issues. These may range from employee
motivation to resolution of litigation and severance situations. In recent transactions
we have found ourselves building a synthetic severance program designed to facilitate
a management transition or negotiating to remove litigious founders or employees.
In all these situations, our solutions have been funded by the secondary purchase
of shares and options, rather than through use of valuable cash on hand.
Secondary liquidity programs offered to senior management and employees also
serve to reduce the need for inflation in compensation programs, while increasing
the team’s motivation by converting a small portion of options to cash
in the bank. Furthermore, in an environment where regulators have increasingly
targeted even private technology companies with option pricing scrutiny, we have
found ourselves serving as a sophisticated “reference market” for
private company valuations and 409A option pricing (with the added benefit of
helping employees to realize the value of option awards). We have also worked
with the boards of private companies to help employees monetize the “option
value” in employee options, much the same way that Google has done. In
other cases, we have designed ways to streamline capital structures prior to
an IPO by buying the interests of smaller or obstructive shareholders. Secondary
market endorse-ment by management teams has reduced the friction of otherwise
complex secondary transactions and is beginning to drive a meaningful increase
in secondary volume.
Venture assets are among the rare financial investments that can become worthless,
even in the absence of a bankruptcy, and even when the underlying company ends
up with a successful outcome. At one point in the history of venture capital,
the earliest investors reaped the biggest rewards. But in recent years, that
principle has almost been inverted. Additional rounds of financings, cramdowns,
pay-to-plays, conversion of investors’ senior preferred stock to junior
common stock – these are all part of the daily reality of venture investing.
From angels who never imagined they would have to backstop their investments
with additional cash to corporates whose investment allocations have changed,
certain investors have been forced to sit by and watch their investments devalued,
not through malevolence or malfeasance, but by the dilution of additional fund-raising
rounds they can’t, won’t or don’t participate in. We have been
able to show some of the investors facing this impending dilemma that there is
a way to recover some value. By selling to secondary market buyers before the
cram down or the pay-to-play takes place, the buyer can sometimes ascribe a higher
price to the asset, because the buyer is able to “play” the shares
in the next financing, where as the seller was not going to be able to do so.
Breaking out of the “Hotel California.” Even when venture
investments don’t become radically diluted or devalued, they are often
too similar to the situation described in the famous Eagles’ song “Hotel
California,” where you can check in but you can never leave. By offering
liquidity strategies to investors, we can show them how they can adjust risk
and return, achieve partial liquidity on some of their investments in advance
of actual realization events, and otherwise create better management of the capital
allocated to venture assets in a portfolio. These steps help “fix” a
major challenge inherent in traditional venture investing – the binary
nature of most outcomes. By offering a market price and exit transaction at any
stage (e.g., especially when the risk-return equation changes unexpectedly),
the secondary market can help promote allocation to venture in the first place.
In other words, if there is a mechanism to correct for assumptions that have
proven to be flawed or for unexpected outcomes, without simply having to watch
and wait until the asset becomes worthless, the basic underlying venture marketplace
should benefit as well. We believe that as investors come to understand that
they can create their own custom solutions for liquidity, rebalance risk/returnratios
and benefit from new ways to create optionality, they will become increasingly
active participants in the direct secondary market.
It’s not about the “bubble.” It’s about sophisticationin
the VC investing community and maturity of the secondary market. We began raising
our current value-centric PE fund, Millennium Technology Value Partners LP,
three years ago. We found at that time that certain investors would listen intently
to some of our case studies about earning high returns through secondary market
investments. But they were also skeptical, arguing that our success was unsustainable
and that it was derived from a one-time and historically aberrant frenzy to divest
VC assets that followed the bursting of the late’90s technology bubble.
We argued then – and believe so even more firmly now – that the growth
of the secondary market has little to do with the bubble and much to do with
ongoing conditions in the investor equation. Corporate investors will always
change strategy and focus to serve the needs of the larger company business plan.
Departing founders will always need liquidity to start their next venture. Large-scale
M&A events will always lead to pruning, rationalizing and selling off non-core
assets. Unfortunately, bankruptcies will continue to occur. Certain investors
will always discover too late that they had underestimated the follow-on capital
needs or that they had misunderstood the technology or the business model. Like
any other nearly $300 billion asset class, it should come as no surprise that
2% or 3% of the dollars under management in venture would want to reallocate,
restructure, get liquidity or simply get out.
The secondary market offers holders of direct venture assets unprecedented new
opportunities to achieve better, more efficient, and more productive management
of their capital, new kinds of flexibility and targeted risk-reward ratios, and
most of all, an opportunity to solve problems, correct assumptions and recalibrate
the outcomes of their portfolios. Thus, the secondary market for direct venture
investments will become more systematic and comprehensive, just as the market
for LP interests did, and in fact, in much the same way today’s public
debt and equity markets have become ever-more efficient and systematic. For these
reasons, and all we have argued above, we fully expect the secondary market for
direct venture assets to continue to grow and thrive.
About the Authors
Dan Burstein and Sam Schwerin are managing partners of Millennium Technology
Value Partners LP. Burstein was senior adviser at The Blackstone Group for 12
years and has been making venture capital investments since 1983. He is also
a bestselling author, having published 10 books on global economics, new technology,
and popular culture. Schwerin has an extensive track record in large scale finance,
private equity and M&A at world-class financial firms including Salomon Brothers
and The Blackstone Group. He has also helped found and manage several successful
emerging growth companies in the last 10 years.
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