4 Things Late Seed Companies Should Know About The Secondary Market


By Sean Adler, CEO of GZI and an expert advisor at Founder Institute, GLG, Guidepoint, and AlphaSights.

Corporate politics don’t need to be a nightmare when modifying the playing field can generate positive-sum outcomes. There are ways to manage the unicorn that is your startup and utilize the “dark side” of equity markets. Based on my experience as a founder and expert in public and private equity markets, there are four things you need to know about dark pool trading and the secondary market in the land of structured finance.

1. Unicorn poaching is common on the secondary market.

From what I see in the industry, private equity investors often invest at inflated valuations that tend to drop. A primary investment is when equity is purchased directly for the use of funds. A secondary investment is when the primary equity is resold to another party or an executive sells a block of their own equity to someone—often at a slight discount. Private company valuations are half-real since the valuation exists on paper, but the equity can’t really be turned into cash unless executives sell on the secondary market, go public or exit for all cash (which, in my experience, is very rare). You can technically have hundreds of millions in company equity on paper and still might not have the ability to turn hundreds of millions into actual cash without secondary liquidity or an exit.

And while I don’t generally advocate for slicing up and eating an endangered species, the genetics of a unicorn aren’t exactly scientific and the composition of a unicorn varies across countries. The key is knowing how to slice up your company (a.k.a. the unicorn) in the right place at the right time.

Secondary offerings can be like having executives eat filet mignon while the board eats flank steak—not everyone wants to eat dinner together at the same time. Investment banks, brokerages and recruiters all get paid a commission so how they interact with your company varies. While nobody likes hurting a mythical creature, there are times when all humans are forced to eat in order to survive.

2. You want to be careful about golden handcuffs.

Cliché as it may be, the saying “more money, more problems” is accurate in the startup world. It can reach a point where no amount of money will compensate you enough for managing a toxic environment. The dilemma for startup founders is that contracts may prevent you from leaving if it’s beneficial enough to shareholders, even if it’s at your own expense.

There is usually a clause stating that 100% of your professional efforts will go toward the company while you gradually accumulate shares if you sign a term sheet for preferred stock. Those contingencies will likely continue for the life of your company—exit outcomes and IPOs included.

Founders cash out last and various preferences change the earnings multiples for your investors. Most companies at late-seed or Series A are bound to a variety of vesting clauses that cause “lock-ups” with the potential to limit secondary liquidity for your company. Venture capitalists generally will not tell you there is potential to sell six-figure blocks of your company online via alternative trading systems, so working both ends is important.

3. Private company valuations are in the eye of the beholder.

Valuations are static on paper but change in the eye of the beholder. It’s not your valuation that matters, it’s how the valuation is broken down. A lower valuation with an all-cash exit may be superior to an earn-out at a higher valuation, depending on everyone’s interests. There are a variety of ways to bridge the gap between private and public markets once your company is valued at a minimum of seven figures, and seed companies need to be aware of this since transitioning from a struggling startup founder to an executive discussing estate planning is as isolating as it is life-changing. I find that this is not something widely understood, and it is hard to describe, especially when starting a company in your 20s. As it happens, the biggest success of your life can make you the most miserable.

4. Alternative trading systems can be a bridge between two worlds.

In business, you have the mythical land of private equity and the harsh reality of the public market. Crowdfunding platforms are like using a boat to cross the river—you can die while rowing or kick back in a yacht, but the people operating the vehicle have the potential to sink everyone before you reach the other side. Private companies are often safe when a hurricane hits the public market, but selling VC-backed pixie dust to an investment bank is difficult when the weather has flipped the world upside down. Dark pool trading via an alternative trading system is like a black hole executives can jump through as you walk from the eye of the storm to Neverland. There is a lot of uncertainty about where things end up after being sucked through a black hole, but it can be much faster than crossing by foot since the length of the bridge varies and there is a small chance the underlying construction supporting the bridge will collapse as you cross—executives can walk or run to the other side.

The money you’ve raised and the quality of the board seat in your preferred term sheet will have a dramatic impact on your experience with the secondary market. Working with an alternative trading system is like having Tinkerbell sprinkling a little SEC-compliant seasoning into your VC-backed pixie dust—private equity investors may be neutral to the taste, but investment bankers are more likely to appreciate the texture that compliance brings to the table.

The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.


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