It’s not you. It’s me. I swear. I think your company is great. I think you’re great. I believe in what you’re building, and I think you will be wildly successful. But here’s the thing. We’ve been together for five years. I need to see other companies. We can still be friends.
But…well…I know this is awkward. But can I get my money back, with a bump in valuation, so that I can go raise another fund?
The request for secondary from an existing investor.
It is not an unusual situation, particularly for companies that are at least 5-7 years into their life as a venture-funded company. Why are they asking, and what should you do?
First, if you’re a founder that’s raised, or plans to raise, venture capital to fund the growth of your company, then you need to understand the business of venture capital.
Some basics for the purposes of this discussion.
As you know, a VC firm raises an investment fund from their LP’s to invest in early-stage companies, with the hope of delivering extraordinary returns sometime during the life of the fund.
The typical venture fund has a 10-year life, during which there is an expectation that the fund will deliver those returns. Most of the funds are invested in the first couple of years. Then it’s a waiting game for a few companies in the portfolio to exit at a valuation that returns the fund, and hopefully delivers those investment gains.
Another thing to keep in mind is that most VC firms will plan to raise multiple funds. As I noted above, most funds are fully invested within the first couple of years of its launch. What is the VC firm supposed to do if they have no more money to invest in new companies? If they don’t have fresh capital to invest, deal flow dries up quickly.
So they will have to go back to investors to raise a new fund. And an important part of the story to support raising a new fund is the investment returns of their earlier funds. Not just the unrealized returns from the markup of their portfolio. But real cash returns that they have returned to your investors.
You can see how either a fund getting close to its end of life, or a VC that needs to show some real cash returns in its portfolio to raise another fund, will result in a request to the founder to help find someone to buy their shares.
I’ve seen both of these dynamics play out in companies I’ve been involved with.
You can help an early investor get liquidity either through an upcoming fundraise process you already had planned, or you might be asked to spin up a separate process to help them find an investor that will buy their shares and give them liquidity.
This can get tricky really fast. You want to be helpful to early investors that supported you when you were raising that early round of funding. But you need to be very much aware of what your own funding needs are going to be in the future. You need to ensure that their desire for liquidity does not get in the way of funding your company.
If you’re a company that is still burning cash, between rounds of fundraising, and working hard to get to your next set of milestones to support that next round, you should not launch a process just to try to find a new investor to buy out your old investors. You’re going to be stuck trying to explain why your early investor wants to sell, while at the same time trying to convince a new investor of the tremendous upside and opportunity.
You’ll likely be in the market at a time when your KPI’s aren’t as strong as they should be, telling a less than
Additionally, fundraising is a time intensive process that always ends up distracting you from the day to day of
The alternative is to try to get that investor at least some liquidity during your next fundraise process. This is a path that I’ve navigated myself. You’re balancing a
First, the reason your early investor needs secondary is important. The optics here can be problematic, so be sure that you and the investor are aligned on why they want to get out, and how that will be presented to other investors. Particularly in situations where the early investor owns a large stake in the company, providing for some liquidity while having them hold on to some shares can help a lot with the story to new investors.
More importantly, you need strong enough investor interest in the company to be able to raise more than enough capital for your company in this round of funding. This sounds obvious, but every dollar you raise into secondary for your investor is capital that is diverted from the company.
You always need to do what’s best for the company and your team. Your first responsibility is to secure the funding you need to ensure the company has the cash it needs to continue to execute. You want to be as helpful as you can be to your investors. They are also trying to build their business, and their success is ultimately tied to yours.
But the last thing you want to do is to provide liquidity to an early investor, only to have your company run out of cash later on because you got distracted, or diverted essential early capital away from the company.
If in the end, you can’t provide that investor secondary when they ask for it, the best way to make it up to them is to build a hugely valuable company that delivers outsized returns to their fund sometime in the future. That’s when everyone wins.