A secondary market transaction in venture capital (VC) is when shareholders in a private VC-backed company sell their stock to an investor.
Secondary transactions give shareholders in private companies an opportunity to liquidate some or all of their shares. Liquidity allows early investors to secure a return on their investments and gives employee shareholders the chance to cash in their equity compensation prior to an exit transaction, such as an initial public offering (IPO) or an acquisition.
Secondary transactions in venture capital have given rise to their own market. To understand the function of the VC secondary market and how your company can benefit from secondary liquidity, we’ll cover:
- What is a secondary market?
- Types of secondary markets
- The growth of the VC secondary market
- Varieties of VC secondary transactions
What is a secondary market?
A secondary market is any market in which investors buy and sell securities (such as stocks or bonds) that have already been issued by a company.1 It’s “secondary” to a primary market, where securities are issued and sold directly from the company. In other words, when the initial purchaser of a stock sells that security to another investor, the security moves in a secondary market.
Primary vs. secondary markets
The most common primary markets for public companies include the IPO market and the market for newly issued corporate bonds. Many types of investors participate in these markets, including institutional investors—such as mutual funds, investment banks, sovereign wealth funds, and hedge funds—and high-net-worth individuals.
For private companies, a prominent primary market is the venture capital market, in which VC firms purchase newly issued equity from startups that are raising money. Another is the private equity market, in which investors buy equity stakes in private companies, including some that have never before raised outside investment.
There are many types of secondary markets. Mortgage-backed securities are a secondary market for home loans, for example. Most of what we refer to as “the stock market” is a secondary market for public equities. That secondary market operates through public exchanges, such as the New York Stock Exchange (NYSE) and the Nasdaq. These exchanges are secondary marketplaces where shares in public companies are bought and sold by retail and institutional investors.
Public vs. private secondary markets
Public exchanges in the U.S. are transparent, which means the purchase price per share is visible to other market participants. Public companies must also disclose information about their earnings and finances. And public stock exchanges are more accessible: Just about anyone can open a brokerage account and start buying shares in public companies.
Stock in a public company might trade hundreds of times each day, making it easy for investors to discover an accurate market price and to sell their holdings for cash. Highly liquid markets allow buyers and sellers to trade on their own preferred timelines.
Private secondary markets tend to be more opaque, less accessible, and less liquid. Historically, they have lacked the centralized infrastructure of an exchange like the NYSE, making it difficult for sellers to know who is interested in buying and for buyers to know who is interested in selling. Trades occur less frequently, and the lack of a centralized marketplace and public disclosures makes price discovery more difficult. And while public exchanges are accessible to all investors, the same isn’t true for private markets, which may be restricted to accredited investors who meet certain wealth or investment sophistication requirements. Having fewer participants in a non-centralized secondary market makes it more difficult to match supply and demand.
In spite of these difficulties, the secondary market in venture capital has grown significantly over the past decade.
A boom in venture secondaries
Between 2012 and 2021, the global market for venture secondary deals grew from $13 billion to $60 billion. This growth happened in part because the primary market for venture capital also grew: Over the same span, annual global venture investment rose from just over $50 billion to well north of $600 billion. This growth culminated in a record-setting 2021.
Although venture funding returned to Earth in 2022, deal activity still remained well above other recent years. And venture capitalists and other private market investors are sitting on record amounts of dry powder.
The surge in primary VC fundraising has allowed companies to stay private for longer, because they can still raise ample cash without the full extent of the regulatory oversight and reporting requirements of the public market. As the timeline to a public exit stretches out, secondary transactions have emerged as a way for venture-backed companies to offer liquidity to early investors and employees while remaining private.
The VC secondaries landscape
Venture secondaries take many different forms. But they can be broken down into two major groups: structured liquidity programs and direct secondary sales.
Structured liquidity programs
Structured liquidity events are typically initiated by a company. There are two types: tender offers and auctions.
Tender offers
A tender offer allows multiple sellers (usually employees and early investors) to sell their shares to a group of investors or back to the company at a predetermined price over a 20-business day period. Companies running tender offers have control over which buyers and sellers may participate, and they also control the price of the transaction. Tender offers come with stricter SEC regulations than other types of secondaries. There’s no firm legal definition of a tender offer; rather, lawyers and regulators weigh eight different factors when determining whether a sale qualifies as one.
Auctions
An auction uses supply and demand dynamics to decide the price and volume for a secondary transaction. Instead of using a predetermined price, potential buyers and sellers enter bids and offers for prices at which they would transact, and a market operator determines a price that will best match supply and demand. Auctions are typically organized by the company and conducted by a secondary platform.
Direct secondary sales
A private secondary sale, also called a bilateral trade, is when one investor sells shares in a company directly to another investor in a deal that isn’t initiated or sponsored by the company. This can create problems for companies that would like more control over their cap table. There are no standard disclosures for these transactions, and sometimes companies provide no information at all to potential buyers and sellers. The price is negotiated between the buyer and seller rather than being determined by the company, as in a tender offer. This can lead to different implied valuations across different transactions. Because secondary transactions have historically had an impact on a company’s 409A valuation, companies sometimes try to prevent bilateral trades.
To retain as much control as they can, companies and existing investors often have a right of first refusal (ROFR) in place. This gives them the option to buy back stock before a shareholder is allowed to initiate a direct sale to an outside investor. Companies also sometimes place transfer restrictions on issued stock that allow them to block direct sales.
Timing of secondary transactions
Companies can conduct venture secondary transactions at any time, but they typically happen within 90 days after a primary funding round. There’s usually a cap on the size of traditional venture rounds, and secondaries can be an attractive second chance for investors who were left out of or did not get their desired allocation in a recent capital raise.
Other private-market secondaries
There are several other secondary markets across the broader private market landscape. Each offers one of the various participants in the private market ecosystem a path to liquidity. These include:
Fund secondaries
A fund secondary deal involves one limited partner (LP) selling its stake in a private fund to another investor, usually because the first LP wants liquidity before the fund is able to provide it.
Secondary buyout
In a secondary buyout, one private equity firm sells its majority stake in a company to another firm. These deals have become increasingly common as the private equity industry expands and matures.
GP-led secondaries
In a GP-led secondary, one investment fund manager (also called a general partner) sells a stake in a company from one fund to a newer fund. Sometimes, the GP owns the second fund as well, in which case the transaction allows the GP to maintain control of high-performing assets while still providing liquidity to LPs that invested in the older fund. The market for GP-led secondaries has grown rapidly, expanding from $7 billion in 2015 to $62 billion in 2021.
A new approach to venture secondaries
Carta has a suite of customizable liquidity solutions that range from structured company-sponsored transactions to one-off direct secondary sales.2
If you already use Carta to manage your cap table, you can easily integrate that cap table data into a secondary deal— speeding up the time to settlement and reducing your legal costs.
To learn more, request a demo of Carta Liquidity.
1. Some secondary markets trade in securities issued by entities other than companies, as in the case of mortgage-backed securities.
2. Private company brokerage products and services offered by Carta Capital Markets, LLC (“CCMX”). CCMX is an SEC registered broker-dealer and member of FINRA/SIPC, and is the operator of an Alternative Trading System (ATS) – CartaX.
DISCLOSURE: This publication contains general information only and eShares, Inc. dba Carta, Inc. (“Carta”), and its affiliates, are not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests. Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein. This report includes aggregate statistics of transactions on Carta, Inc. and CartaX. All product names, logos, and brands are property of their respective owners in the U.S. and other countries, and are used for identification purposes only. Use of these names, logos, and brands does not imply affiliation or endorsement. © 2022 eShares, Inc., dba Carta, Inc. (“Carta”). Carta Capital Markets, LLC, member FINRA/SIPC. All rights reserved.
