Stacking the Odds: Direct Secondaries

14 min readSep 28, 2023

Introduction

The private equity secondaries market has recently garnered considerable attention from media and investors. However, amidst the spotlight on GP-led and LP-led solutions, direct secondaries have remained relatively overlooked. In this post, I’m going to talk about direct secondaries, specifically focusing on the intricate dynamics of pricing and deal structuring within complex capitalization tables of venture-backed companies.

The evolution of the venture ecosystem in recent years has given rise to a wide variety of opportunities for secondaries buyers. They have an expanding and broad range of counterparties seeking various avenues for liquidity, including employees, founders, angel investors, corporate investors, non-traditional investors such as pensions, and traditional venture managers. However, as noted by Bill Gurley on a recent “All In” podcast (Discussion on complex cap tables is ~50m mark), the venture ecosystem has seen a proliferation of companies that boast complex capitalization tables and liquidation stacks.

For this reason, it’s important that the direct secondaries professional knows their way around a complex cap table. The direct secondaries professional often has the option to acquire common shares, early round shares, or even shares from the most recent fundraising round. Since multiple securities are often available for sale, secondaries investors can purchase a blend of the available securities. Additionally, sophisticated secondaries investors can employ instruments like debt, preferred equity, or equity to create highly customized liquidity solutions.

For comparison purposes to enhance understanding, I want to highlight how secondaries investing is different from other commonly seen private markets investing strategies. Buying shares within a complex cap table is a frequent scenario for secondaries investors but less so for buyout and growth investors. Buyout investors typically assume full control of a company, while growth investors inject new capital in the latest financing round. As a result, buyout and growth investors are typically less concerned about the specifics of earlier preferred financing round terms and outcomes, while secondaries investors are almost exclusively concerned about the specifics of earlier financing rounds.

Here’s what I’ll go over in the post:

I. How we arrived at the complex cap table
II. Implications of complex cap tables for secondary investors
III. Valuing the complex cap table
IV. A complex cap table from a secondary investor’s perspective example

I. How We Arrived at the Complex Cap Table

Stepping back, let’s examine how we arrived at the complexity of these cap tables. The proliferation of venture capital (VC) over recent decades has sparked a surge in VC assets under management (AUM). According to PitchBook’s Q1 2023 Global Private Market Fundraising Report, VC AUM stood at approximately $500 billion in 2013, rising to over $3 trillion by 2022 — a sixfold increase.

This growth can be attributed, in part, to astute investors who recognized large valuation gaps between typical funding rounds. These investors could enter between rounds (including the private to public round), capitalizing on large valuation step ups. An analysis of the valuation gap between the final funding round and the IPO revealed (at the time) a compelling proposition that enticed many investors to participate in late stage venture deals.

Another factor contributing to the rise in the number of funding rounds stems from the ambitious business orientation embraced by many venture managers. This approach is grounded in the aspiration to secure more assets under management to increase fees. However, if a manager substantially increases their fund size, it becomes difficult to deploy at the same check size they did in their previous fund. Practically speaking, it’s not viable for the growing venture manager to allocate funds across 100 separate $10 million deals for a $1 billion fund. Instead, a more optimal strategy, which will bolster the venture managers’ margins as it would not necessarily entail hiring more investment professionals, involves directing $50 million into a smaller set of twenty deals (which still equals $1 billion in deployed capital). Hence, rounds are getting larger, and companies have the option to stay private for longer.

Furthermore, the evolution of this landscape has been amplified by the emergence of new financial instruments and structures as well as the popularization of venture debt. This added layer of financing has contributed to the ongoing transformation of the venture ecosystem, reshaping how companies manage their growth trajectories and secondaries investors evaluate cap tables.

So now that we can see that complexity in cap tables is at least in part due to the increased funding, rounds, products, and innovative funding structures, let’s look at some examples of the terms found in the capital stack and cap table.

In direct secondaries, it is very possible you will encounter all of the following in one venture-backed company’s cap table:

Pari passu and/or waterfall structures on preferred shares
Participating, non-participating, and/or convertible preferred shares
Various share prices and conversion prices
A range of liquidation multiples. Some may have conversions while others won’t
PIK dividends that could possibly have terms tied to exits
Convertible debt
Warrants and options

In short, underwriting securities in complex cap tables is more complicated than the straightforward secondary deals from years past.

Side story: My favorite cap table I’ve seen was a company with negative cash flow, $30M in revenue, and < 30% YoY revenue growth. Through creative uses of liquidation preferences, waterfalls, and participating/convertible preferred shares, the company had close to a $1B headline valuation.
The sophisticated seller was offering a 50% discount to the last round share price for their Series A shares, and they honestly believed they were offering us a good deal.
So why wasn’t this a good deal? I’ll be generous and say the valuation was actually about $100M (or ~3x EV/revenue) for round numbers purposes. The Series A shares were worth close to $0 at the time because of the preferred shares stack ahead of the Series A in the liquidation pay out. If you calculated the payout of the Series A after looking at potential ranges of outcomes, it likely would’ve left me with a <0.2x multiple. I go over an example of how I determine these numbers later in the article.

II. Implications for Secondaries Investors

The first implication is that you need to know what you’re doing if you want to buy shares on a complex cap table. However, just because these cap tables are more intricate and the underwriting process demands more work, it doesn’t mean we should shy away from this area. Pursuing secondaries in venture-backed companies that have transitioned from the venture stage to growth-stage but either have fallen out of VC favor or haven’t reached unicorn status can make a lot of sense. It is an opportunity to acquire promising growth-stage companies at good prices. These companies exhibit strong financial growth, are on the brink of positive cash flow, hold product-market fit, and offer cost-effective entry to the growth space.

The second implication is that different types of shares have distinct features and risks, so the securities should price differently. Over the past few years, some pre-IPO secondaries investors haven’t paid attention to this hypothetical pricing differential. This is because when markets are strong or interest rates are low, some pre-IPO secondaries investors believe i) company valuations are constantly rising, so they expect to convert their preferred shares at later rounds of financing and ii) there will be an eventual conversion to common shares through an IPO. This is arguably a poor approach as I’ll show later in the article. Now that down rounds seem to be an actual possibility and public comps have declined in value, secondary investors need to be hyper aware of the vulnerability of shares lower in the capital stack and adjust their pricing strategy accordingly.

The third implication is that the proliferation of funding rounds caused a multiplier effect to the number and diversity of possible counterparties. Furthermore, the possible counterparties hold unique motivations for liquidity in an illiquid market. This often results in a range of securities available for sale at notably different prices. For example, a venture manager may not sell for more than a 10% discount to last round because their fund is still early in its life while an employee could sell for a 60% discount to the last round because they’re facing a liquidity crunch. Consequently, there are instances where share prices from earlier rounds could be either overpriced or under priced in comparison to later rounds, which secondaries investors can take advantage of.

III. Valuing the Complex Cap Table

After establishing a company’s fair value using standard valuation methods like discounted cash flow (DCF), comps, and precedents, an additional analysis is required. There are three common approaches to valuing a complex capitalization table, listed below:

Options Pricing Method (OPM): Calculate the breakpoints, which are generally the equity values at which each tranche of preferred shares converts, then use the Black-Scholes model (pictured below) or another variant of it to price each security. I’ll refer to why we use Black-Scholes later.

Probability Weighted Expected Return Method (PWERM). Determine the possible outcomes, assign probabilities to them, conduct a cap table liquidation analysis, then discount those values to present day.

Current Value Method (CVM): Calculate the price of each security if the company were to liquidate today. Note that this excludes prescribing the value from the option-like upside to each security, as captured by the Options Pricing Method.

I won’t provide a comprehensive guide on executing these methods at this moment (although I might consider it for a future post). For this post, I’ll reference current value for ease of discussion.

IV. A Complex Cap Table from a Secondary Investor’s Perspective Example

Let’s examine a complex cap table situation from the lens of a secondary investor.

There are multiple sellers in a venture-backed company
The shares for sale include Common, Preferred D-2, and Preferred F
All of the preferred shares are convertible
We’ve determined the company is worth an EV of $200M today through comps, precedents, and a DCF
The net debt is $5M, so the equity value is $195M
We believe this company will most likely exit at a value between $350M and $400M within 2.5 years, with an extreme downside case of $150M
The company is trading a discount to its last round valuation

Seller pricing requests are outlined in the table below. Keep in mind that sellers possess varying goals, leading to imperfect pricing.

Seller pricing:

Examining the seller table, we can gather the following:

Common shares are trading at a premium to the current value. As a reminder, this refers to the distributions an investor would expect if the company were to be liquidated today. In other words, if an investor paid $14, they’d receive $12.76, or 0.9x their investment if the company liquidated at its current value of $200M.
The Preferred D-2 and Preferred F are trading at a discount to their current values, meaning investors would receive ~1.2x ($20/$17) and ~1.1x ($37.50/$35), respectively, if the company liquidated at its current value of $200M.

When examining the seller pricing table in isolation, it might lead investors to believe that Preferred-F presents the most favorable opportunity. This is due to its position at the top of the capital stack and the discounted price.

Now, let’s broaden our perspective to encompass the entire capitalization table and explore the various payout scenarios in the case of a sale. This broader view provides a substantially different perspective:

Cap table (share classes for sale are highlighted):

Payout share prices based on exit EV for Common, Preferred D-2 and Preferred F shares:

If you’re familiar with options and the Black-Scholes model, you’ll observe that the preferred securities resemble distinct legs of options payouts. This is why valuation experts employ Black-Scholes to value complex cap tables.

For those unfamiliar with options payout charts, the interpretation is as follows: in the case of a $400M exit value, the exit share price for common and Preferred D-2 is approximately $30, while for Preferred F, it’s ~ $45.

Observations for each share class are as follows:

Preferred-F: This category seems to offer substantial downside protection for initial investors. The original shareholders in this class stand to gain 1.75x their initial investment, granted the company achieves an exit valuation above ~$40 million. Losses for investors begin only when the company’s value dips by ~ 80%. For incoming investors, it’s evident that the latest preferred round won’t yield significant upside unless the exit value greatly surpasses our projected figure, as the last funding round valuation considerably exceeds the current value.
Preferred D-2: Similarly, this category exhibits strong downside protection for initial investors. With the current value at $200 million, investors holding these shares can sustain around a 50% decrease before incurring losses. However, the potential for substantial upside also seems limited based on where the conversion values of the shares sit.
Common: Common shares move accordingly with valuation, but not in a 1:1 fashion because of the leverage effect of the preferred shares, as displayed in the picture below.

Looking at the above, we notice that a $50 million (or 25%) upswing in valuation translates to a 37% return for common shareholders from the current value. In contrast, an equivalent downward shift leads to a larger loss of 41%, and a valuation decrease of 50% results in a complete capital loss of 100%. This underscores the crucial need for cautious consideration when investing in common shares. I’ve included the Preferred D-2 shares in the comparison to highlight the valuation movements of shares higher up in the capital structure. As you’ll see, they remain largely flat with a +/-50% swing in valuation.

IPO scenario:

The above commentary only pertains to a sale exit case, so I’d like to quickly address the IPO exit case. Given the leverage effect in common shares we just looked at, one might be inclined to believe Preferred F shares as the most secure option. However, this assumption is not universally accurate. In many cases, venture companies structure their shares to convert to common shares upon an IPO. Let’s examine the impact on share price below in the IPO case.

In this context, we can observe a 65% decline in Preferred F shares if the company were to liquidate at $200M and a 30% decline in Preferred F shares in the event of an exit at our best-case valuation. Consequently, in the case of a secondary purchase, the case against buying the top of the capital stack preferred shares gets stronger.

In our scenario, it’s a minimal probability of this happening according to our diligence. However, it is something to keep in mind.

Shifting our focus from the IPO scenario, let’s proceed with an examination of the exit sale scenario, which remains the most probable outcome.

Secondaries investor sale

While considering the advantages of downside protection and upside potential from the primary shareholder’s perspective, it’s crucial to adopt the viewpoint of a secondary investor. To achieve this, we divide the price per share from the various securities’ exit values over the cost of the secondary shares for sale. This provides us with the secondary investors potential MoIC (Multiple on Invested Capital) for each exit enterprise value.

We can observe the following:

Preferred F offers a relatively secure return of approximately 1.4x, with robust downside protection but lacking significant upside potential. Given our anticipated exit value of over $350M, Preferred F might not align well with our desired return target. This diverges from the initial notion of favoring the latest discounted round as the top choice.
Preferred D-2 converts by the exit range of $350M+, providing a 1.5x+ MoIC. Moreover, it ensures a minimum multiple of approximately 1.2x even if the company exits at a downside case of around $80M enterprise value — a 60% decrease from the current value.
Common shares offer the highest return potential at roughly 2x the investment, but they come with the risk of a 25% decrease in company value resulting in a 50% loss of invested capital.

Since our extreme downside case is a $150M EV, and we don’t want to risk 50% of our capital, how do we address this challenge? The D-2 provides excessive security and leaves significant potential gains on the table, whereas the common shares carry an excessive level of risk. Remember, multiple share classes are available for purchase, allowing us to blend them and align with our risk tolerance.

Combining shares enables us to mitigate the potential 25% downside case, optimizing our reward relative to the level of risk we’re comfortable taking.

Blending shares:

By strategically combining the shares outlined in the provided combination table, we can still achieve a multiple close to 2x. This approach offers the advantage that even in the event of the company’s value declining by our extreme downside scenario of 25%, we’ll still return 1x of investor capital.

Furthermore, secondaries investors can also collateralize these shares through a loan or preferred equity structure to further engineer the risk/return profile they’re looking for. I’ll go over secondary preferred options in my next article.

Final Thoughts

The key takeaways:

It is important to undertake a comprehensive evaluation process with the whole cap table. A lack of insight into the terms and prices of earlier investment terms places investors at a significant disadvantage when assessing potential downsides.
Relying solely on the purchase of last-round shares, merely because they trade at a discount to their initial price, exposes us to the risk of minimal returns if the last round no longer aligns with the present value.
In order to engineer a desirable risk/reward balance, we possess the flexibility to selectively blend various share classes to suit our risk profile.
It’s important to recognize that each situation and capitalization table is unique and warrants thorough examination.

As the realm of venture capital continues its growth, companies that hold complex cap tables are on track to become even more common, providing attractive returns for those ready to put in the effort. The current undercapitalization within this field highlights substantial potential for future returns.

While the direct secondary market might be relatively small at present, its landscape is on the brink of a significant shift. This transformation is being driven by the emergence of innovative investment technology solutions and the entrance of more advanced institutional investors into the arena. With executive share sales becoming more prevalent and limited partners aiming for enhanced capital returns from venture capitalists, this trend is positioned to extend further. Recent events, such as Chamath Palihapitiya’s offer to sell 300+ of his startup stakes, validates this observation.

In the future, we’re likely to witness the continued development of quasi-public marketplaces for private companies, marked by simplified trading processes, lower barriers to execution, and higher acceptance among companies. Veteran secondaries investor Jeremy Coller even suggested that the secondary market could surpass the primary private market, just like it did in the public market.

I’ll break this up into smaller articles over the coming months but leave this up as the comprehensive overview.

Disclaimer: The information presented in this post is the sole opinion of the writer and does not reflect the view of any other person or entity. The information provided is believed to be from reliable sources but no liability is accepted for any inaccuracies. This is for information purposes and should not be construed as an investment recommendation.