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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