The founder of a later stage company recently asked me if a liquidity transaction was a fire sale or if he would get the actual value for his stock. I can see that many folks still have not understood the transformational culture shift in the Valley and around the world with founders taking some early liquidity; so I am summarizing my points to him here:
So to answer your question – no, this is not a fire sale. This is not selling at a discount to the true value of your stock or the value of the company. These types of deals are evidence of the world changing from the dot-com days where I was personally worth over $100m on paper based on a $50m private equity financing leading into an IPO with Morgan Stanley for my company. The IPO got pulled with the crash of the dot-com melt down and my stock crashed.
Today when a seasoned entrepreneur sees the value of his personal stock reach $100m, for many mature guys it makes sense to sell 10% of that for $10m and leave the remaining $90m of stock for the definitive liquidity event of the company. As the mantra in the Valley “Stay Private Longer!” becomes more pervasive, some founders complete an annual liquidity financing round. So the founders and big shareholders may want to take 10 to 20% of their chips off the table every year. This keeps all the earnings of the company going into growth, no dividends and the investors of the company mature to include not just venture capitalists and angel investors but a broader set of investors like Fidelity that want to invest in a pre-IPO later stage company and benefit from “investing private and selling public” strategy.
From the perspective of the investors in these liquidity and later stage primary rounds, they are thinking that if they invest in a mature company at a pre-money valuation of $200m or $500m it is unlikely they will sell at less than 1x or 0.8x of the valuation they invested in. Remember these companies are often growing revenues at 40% to 200% per annum. So downside risk protection is 1x or loosing 20% of their position on that single investment, but there is still potential for substantial growth in that stock. These investments are attractive, because they are all typically 1 to 3 years from an exit and some could even be acquired within the next 12 months. They invest in a few deals per year so they have portfolio diversification dynamics at play and are making a lot of money with good IRRs on short time delays to exit. This is an attractive asset class, but requires investors and bankers that know how to source the deals, not get ROFR’d (Right of First Refusal) by the existing investors (so position themselves as high value-added investors) and make sure the valuations are valid.
For a founder that is going into an IPO this is the last final chance to get some cash liquidity for a long time and it can be very painful to liquidate shares after the IPO with so many conflicting interests pressuring the founders to go long after the IPO to not affect the price of the stock. I remember Morgan Stanley and my own internal general counsel talking me into an 18-month lockup with my IPO. Looking back at that now, those dudes did not have my back. The new world we are in now is much more sensible than the late 1990’s. If I knew then what I know now.
The rest of this blog post really answers questions I was asked by a founder considering doing a secondary liquidity transaction. Most readers may wish to drop off here ☺
There are two sides of this to consider: 1) the seller (could be founders, hired CEO & senior management, early employees and seed stage investors or struggling VC that wants to return some LP dollars and put some points on the board ahead of raising a new fund for his VC firm) and 2) the buyer investing cash to buy part of this next financing transaction. Buyers could be a syndicate of VCs, family offices, hedge funds, all investing directly into the company or very well connected HNWI successful entrepreneurs investing smaller amounts via an SPV (special purpose vehicle, typically an LLC).
The financing transaction can be 1) 100% secondary. That means that 100% of the cash capital in the financing round goes to buy shares from sellers where the cash goes into the personal accounts of the sellers not the company. Sellers are selling some stock now, because they like this valuation to liquidate some or all of their stock position in the company and want some liquidity. 2) 100% primary, which means that all the cash goes into the growth of the company paying salaries, product development, marketing, international expansion, other growth of the business. No money goes into the pockets of the seller, but into the accounts of the company. 3) A mix of primary and liquidity. As the later stage company seeks to raise more funding and a valuation point is set for the company some of the existing shareholders sell some stock to the syndicate that is investing in the primary round or a different set of investors chose to participate in the primary only or the secondary only.
In most cases common / ordinary founder stock is priced lower than preferred investor shares, because of the liquidation preference and other rights associated with the investor’s preferred shares. That is not however always the case. Sometimes we value common the same as preferred if our analysis arrives at that conclusion.
For example if a company has raised $100m of funding and has a liquidation preference of 1x (typically participating preferred) then at the time of the liquidation, the first $100m of the consideration of the exit goes to the investors and once they are made whole and get all their investment dollars back the profits are split pari passu / pro rata according to who owns what percentage of the cap table.
So if the company has a pre-money valuation of $500m and the liquidation stack is $100m then we as buyers might consider the common founder stock to trade with a discount of 20% compared to the preferred. Every deal is different and we examine the value of the founder stock compared to the preferred stock.