In the evolving landscape of venture capital, especially at the seed stage, the traditional “buy and hold” strategy is undergoing a significant transformation. Hunter Walk, in his insightful blog post titled “Praise Our Lord for Secondary Markets, Because Selling Shares Is Now an Essential Part of (Seed) Venture Capital,” delves into the reasons behind this shift and the growing importance of secondary markets for early-stage investors.
The Changing Dynamics of Startup Exits
Historically, startups aimed for exits—either through IPOs or acquisitions—within 7 to 10 years. However, the current trend sees companies staying private for 10 to 12 years or more. This extended timeline is influenced by factors such as founders’ preferences to remain private, higher bars for going public, and the availability of substantial private capital to support growth.
For seed-stage investors, this delay in liquidity poses challenges. Limited Partners (LPs) who manage to an Internal Rate of Return (IRR) find their returns delayed, affecting the reinvestment cycle into venture capital and other asset classes. Consequently, the traditional 10-year fund cycles are stretching closer to 15 years, prompting LPs to reassess their calculations about the asset class.
Misalignment Among Investors
In earlier times, there was a structural alignment across the venture sector, with most investors underwriting to similar outcome goals. However, the rise of multibillion-dollar Asset Under Management (AUM) holders has introduced a shift. These large funds often prioritize deploying significant capital, sometimes preferring a 5x return on a $300 million investment over a 10x return on a $30 million investment.
This divergence means that alignment gaps among investors can start as early as the Series A round. Early-stage investors, including angels and seed investors, may find their interests misaligned with later-stage investors, especially when substantial capital has been raised. In such scenarios, early investors might be better off considering themselves akin to common shareholders with a 1x preference.
Evolving Valuation Practices
The process of pricing investment rounds has transformed from being determined within a relatively small community to resembling a global auction. This auction includes investors with diverse objectives, experiences, and return goals. While higher valuations are not inherently negative, they often reflect optimistic projections, granting companies credit for future execution.
For seed investors, this environment increases performance risk, especially when they lack the capital to support or recapitalize companies during downturns. Therefore, selling early in secondary markets becomes a strategic move to mitigate potential risks associated with overvalued startups.
General Partner Incentives and Fund Returns
In the realm of megafunds, General Partners (GPs) can achieve significant wealth through management fees, which might influence incentives to maintain high private valuations (Total Value to Paid-In, or TVPI) while raising new funds. Conversely, for modestly sized pre-seed and seed funds, returns are the primary avenue for substantial gains. Thus, Distributions to Paid-In (DPI) become crucial, necessitating earlier liquidity events to demonstrate success and attract future investments.
Maturation of Secondary Markets
Previously, secondary markets were perceived as opaque and fraught with risks. Today, several large market makers, along with experienced investor and company counsel, have established standard and trusted processes that reduce risks for all parties involved in secondary transactions. While caution is still advised to avoid unscrupulous parties, the infrastructure supporting secondary markets has matured significantly.
Reframing the Perception of Secondary Sales
Traditionally, any VC selling shares was viewed as a warning sign, suggesting potential issues within the startup. However, in the current landscape, early-stage investors selling shares in secondary markets is increasingly seen as a strategic decision. It allows investors to manage risk, align with fund timelines, and capitalize on early successes, rather than being interpreted as a lack of confidence in the startup’s future.
Conclusion
The venture capital ecosystem is undergoing a paradigm shift, especially at the seed stage. Extended timelines to exit, misaligned investor incentives, evolving valuation practices, and the maturation of secondary markets are compelling early-stage investors to reconsider traditional strategies. Embracing secondary markets for early liquidity is no longer a sign of doubt but a strategic move to manage risk and ensure the sustainability of venture capital funds.
Also published on Medium.