Softbank may turn out to be a price maker, just not the market we all thought

If you’ve missed the headlines, Softbank has a war chest of money and is actively deploying a record volume of capital into seemingly every large, private company. There has been active debate about whether Softbank can actually generate a return on a $100b fund, whether this activity will cause a bubble, and which companies they will target. There is not much to say that hasn’t already been said on those topics, but I do think there is one thing that isn’t getting enough attention in this situation: secondaries.

For those who aren’t familiar, secondary purchases are when an investor buys existing shares in a company. No new shares are created, existing investors are not diluted, and the cash goes to the seller, not the company. These transactions typically happen at a discount to the most recent round of financing. This is very different from a financing round, also known as a primary purchase, where the investor buys newly created shares and the capital goes towards growing the company.

The secondary market has become far more active recently, as companies stay private longer. So why would anyone want to sell their shares in a high-flying company, especially at a discount? Usually for liquidity. Early employees, who took a smaller salary for a larger payoff down the road may want to cash out part of their holding so they can finally afford to buy a house, pay off some debt, or start saving for their kid’s college tuition. Early investors, who have lots of paper gains but have yet to actually distribute cash back to their LPs, may want to show tangible returns before they go out to raise their next fund. Or perhaps their current fund is nearing the end of its life and they need to liquidate their positions.

The other thing to note, and this is important with regards to Softbank, is the market is still the wild west — pricing is opaque and transactions require extensive negotiation. There is no standard discount, (though they tend to range from 10–30%), terms vary widely, and are often done behind the scenes with little press coverage. Some companies allow board sanctioned secondary sales periodically, while others like Uber, have historically done everything they could to prevent these transactions.

Ok, so what does this have to do with Softbank?

A large part of Softbank’s strategy is not only to lead the next round of financing, but also to participate in secondary offerings as well. In fact, many times their investment into a company is contingent on the ability to purchase secondary shares at the same time. This is very unique strategy that we haven’t really seen anyone implement on a large scale before. Remember when public market investors (Fidelity, T Rowe Price, and others) were investing in large growth rounds and minting unicorns every week? They were acting like, or at least attempting to act like, traditional growth investors, leading new rounds. They weren’t buying secondaries as part of that strategy (at least not to my knowledge).

Why would Softbank do this? To lower their effective purchase price and still let the company maintain its lofty valuation. Let’s take their most recent rumored investment, Uber, as an example. According to reports, Softbank is investing $1b into Uber at its current valuation but as part of the transaction Softbank also is insisting on buying $9b of secondary shares at a lower valuation which, not surprisingly, seems to be the biggest sticking point in the negotiations.

So, let’s play this out. If Softbank does invest $1b into Uber at a $70b valuation and $9b into secondaries at a $50b valuation (rumored price) then their effective purchase price is actually around $52b valuation. However, because that $1b was effectively the latest round, Uber can still claim their $70b valuation, gets $1b in new working capital, and Softbank has an immediate markup on all those secondary shares they just bought.

Why hasn’t anyone pursued this strategy before? Well mainly because it takes a shitload of capital (that’s the technical term by the way) to pull it off. Companies need enough incentive (such as $1b in new capital at their current or higher valuation) to allow a fund to purchase secondary shares. And this really is only viable at a later stage company, so the numbers have to be fairly large.

So what? Good for Softbank for figuring out a way to deploy large amount of capital and not have to pay full price. Why does that matter to the rest of the ecosystem?

Well, remember how I said this was traditionally a very opaque market with little press coverage? This is the first time I can remember (granted I’ve worked in venture a relatively short period of time and would love to hear viewpoints from more seasoned VCs) that secondary purchases and their price points have been publicly reported.

We now, for the first time, have a price maker in the secondary market.

Whatever price Softbank pays for secondaries in any company is likely to become the baseline for negotiations of all other secondary shares in that company, especially if the price is publicly reported. I know a lot of investors and employees are anxiously awaiting what price Softbank ultimately pays for Uber’s secondary shares. Even for companies in which Softbank has not invested, secondary investors are likely to use the discounts Softbank received as comps for their own transactions. Because of the visibility and the amount of capital Softbank is putting to work, they could become the de-facto secondary price maker.

This of course, assumes that the press coverage of Softbank’s secondary purchase of Uber shares isn’t a one off. There is intense interest from the industry based on the size of the fund, and the press is likely to continue following Softbank’s moves. Therefore, it’s very likely that other secondary transactions will be publicized as well. If not, then this argument becomes moot as the secondary market goes back to operating behind the scenes.

So long as companies continue to stay private longer — and there are no signs of that changing anytime soon — this could be a welcomed, if unintended, consequence of Softbank’s strategy. Regardless of whether you agree with Softbank’s strategy or believe they can actually execute it, employees and investors do need liquidity at some point. Anything that moves this market to a more open, transparent, standardized, and more common transaction is a good thing in my opinion.