Under the radar operators – why secondary investments are enjoying increased popularity

When founders of technology companies or venture capitalists talk about exiting a business, most people think of a big banner initial public offering. As many in the industry know, the reality is that far more companies exit through other routes, such as M&A[1]. The reality is also that in order to achieve an optimal exit outcome, founders and investors need not only to be well aligned in their exit objectives and timing, but also to do a great deal of planning and preparation – all without neglecting the usual running and continued growth of the business in the process.

However, there is another way of bringing new investors into a business and facilitating exits – secondary transactions. It’s an approach that may have slipped under the radar for some, but is now enjoying significant growth.

Secondary transactions take place when one investor acquires another’s shares in a company – whether the seller is a founder, employee, business angels, VC, corporate or another kind of investor. Secondaries can be bought and sold in a single company – but deals can also be struck across a whole portfolio of companies. Globally, secondary market deals (including venture capital secondary) totalled $42.1 billion in the first half of 2019, up a third on the same period in 2018.

It’s something we’ve done a lot over the last couple of years at TempoCap, such as our investment in leading human capital management software business Talentsoft or our portfolio acquisition from Entrepreneur Venture Gestion.

Venture capital secondary is definitely a booming trend, and we expect the number of secondary transactions in European technology companies will continue to increase, but what’s driving this growth?

We think it’s a combination of a few things, including continued macro uncertainty and the two rules of nine.

Those rules of nine represent two important data points that we have uncovered at TempoCap. First that technology investors in Europe have typically made nine more investments than exits – a consistent phenomenon over the last 10 years. The second rule of nine is that technology investors have, on average, had to wait nine years from a company’s initial funding round until getting to a full company exit. That’s a long wait for investors, angels and founders alike, making investing in early stage technology companies not only a financial commitment, but a significant time commitment too. Your investments could easily be locked up for a decade or more.

While many investors are prepared for that wait, situations change, relationships evolve, and what made sense at the beginning may, through no one’s direct fault, not be in the best interests of all parties a few years later.

Then there’s a consistent level of macro uncertainty, whether through challenges in Europe or further overseas that can drive a change in investment strategy or in investors’ priorities.

It all means that investors and entrepreneurs may look for liquidity at a point in time that they had not necessarily foreseen. So, what are their options? IPOs need buoyant markets to achieve a good outcome and can be very difficult to time well. They also require a huge amount of preparation and cost, and the reality is that going public is not the right answer for all businesses. Similarly, a trade sale might force all investors out at the same time, when only some might be looking for liquidity. In any exit route, the investors that invested in a company earlier often want to exit earlier too – but forcing a full company exit could result in a sub-optimal return for everyone.

This is where secondary investments come in, providing liquidity and offering attractive options to everyone involved. For the buyer, there’s security from investing in a known, proven business that still has significant potential. For the seller, they achieve liquidity faster than they otherwise might have done, while for the company itself, there’s new support, fresh ideas and enthusiasm for their work.

As European venture capital has grown rapidly as an asset class over the last decade, to over €20 billion worth of company funding rounds in 2018, it is natural for the secondaries market to increase too in tandem. Having an array of options to exit and achieve liquidity is vital for any environment to support a vibrant ecosystem. That is why the growth of secondary investments is so positive. It gives both investors and founders multiple opportunities to realise a decent return, restart or reinvest in newer businesses, and ultimately contribute to keep the ecosystem active, well-resourced and dynamic.

[1] CB Insights 2016 report showed IPOs made up just 3% of all tech exits during the year.