23 November 2022 |

We Need To Talk About Secondaries


I spend a lot of time thinking about the venture ecosystem, especially thinking about what happened over the last few years. 

One massive trend that we don’t spend enough time talking about is secondaries—when founders and employees sell their shares in a company to a third party, usually to a venture fund but sometimes to a syndicate of investors. We’ve seen it in the news a bit more recently thanks to FTX—SBF took out $300 million in a secondary sale during FTX’s October 2021 fundraising round. The secondary sale accounted for over 70% of the entire round. 

There are a few problems with this. But before we dive into that, we should talk about why VC’s and investors even participate in these rounds. For those folks, secondaries are an opportunity to own larger percentages of companies without the company giving up more dilution. Companies often only want to give up a certain amount of the company in each fundraising round; if thats the case then its hard for investors who participate to get the amount of ownership they want. Secondaries are a solution to that. 

But, over the last few years it’s gotten bastardized. I’ve heard of some ridiculous stories of companies at seed, or Series A rounds, taking out secondaries. VC’s sometimes even encourage secondaries as a part of the deal to make the deal more attractive to founders. 

And, as an ex-founder, it can seem really attractive. Getting cash off the table can help you pay for personal expenses—this is especially true if you’re a founder with a family or thinking about one. 

But, again, things have skewed a bit too far. Founders are taking secondaries as a way to cash out early and live an extravagant lifestyle, getting $50k/month apartments in NYC and living like they’ve already created a ton of value and have exited. A lot of founders build companies and hype with the goal of getting a big secondary sale at an early round. 

The issue is misaligned incentives—almost every stakeholder wants founders to be incentivized to lead a company to an exit or ideally an IPO, whether you’re an investor or an employee. 

A part of this is the fact that founders don’t typically pay themselves a lot. A lot pay themselves very little. That’s something that needs to change—founders should pay themselves as much as they need to live a comfortable lifestyle and not worry about money, but not much more than that. 

If you’re a young founder at a Series A taking out $5 to $10 million in a secondary deal, your motivations change dramatically. A lot of founders don’t need much more than that to live a comfortable and happy lifestyle. But at a Series A, you’re still just in the beginning stages of your company’s lifecycle (in baseball terms, you’re really at the 3rd inning.) 

Another aspect is the human element—founders surround themselves with super wealthy people, that only becomes more exacerbated as your company grows. If you’re raising a ton of money and seeing your peers flaunt their wealth, you’re gonna want to participate too. Its hard to imagine raising $50m to $100m while only have a few thousand in your personal bank account. The simplest solution? Sell secondaries!

Who’s fault is it, the founder that accepts the secondary deal or the VC that offers it? In my opinion a lot of the blame falls with the VC’s. They need to be much more conscious of what they’re doing and the incentives they’re laying out. 

Now, I’m not saying all secondaries are a bad thing—at the late stage they might make a bit more sense. If you’re a Series D founder having your first kid, taking out secondaries to buy a home makes sense. But there needs to be way more checks and balances. For instance, founders shouldn’t be allowed to secondaries just for themselves; the same courtesy should be extended to employees as well. They shouldn’t account for over 50% of an entire funding round. We as an ecosystem, and especially journalists, need to push more on getting details on secondary sales. 

There have been a lot of secondary sales in early rounds in fintech, or secondary sales in fintech companies that go to the same people. Its one of the many reasons fintech deals have been so overinflated over the last few years. As an ecosystem, folks in fintech need to look in the mirror a bit more around secondaries, too. 

A lot of people could say that secondaries are a symptom of a zero interest rate environment and excess capital in the venture ecosystem. That is partially true but also not looking at things with nuance. No one is forcing VC’s to do secondary deals, often its the VC’s that come up with the idea themselves. As dollars become more scarce over the next few year, secondaries should self correct a bit. But, again, it’s up to investors to actually determine whether secondaries make sense, and whether a big secondary is necessary or creating the wrong incentives for founders. 

(Big thanks to Jay Edlin for the story idea!)