New restrictions turning up in term sheets include requirements that founders do not sell more than 10% of their stake via secondary transaction and, separately, that founders notify investors immediately of negotiations to sell stock, so that VCs and the company can prepare to exercise right of first refusal over the deal.
Sources speaking with peHUB declined to identify the portfolio companies they had imposed restrictions on, only saying the practice has been established recently. While some said the new requirements are a point of contention with entrepreneurs, most agreed they did not feel they lost deals as a result of new policies. Of course, because secondary markets only recently created an impetus for investors to guard against early founder exits, there are still years’ worth of funds raised by entrepreneurs from VCs that place no restrictions on how individual stakes are managed. In most cases, VCs agreed, it would be almost impossible to retroactively shoehorn in language preventing founders from making private stock sales ahead of investors’ exits.
VCs’ decision to restrict founders’ secondary market participation is juxtaposed against what many investment veterans say has been a recent increase in portfolio valuations driven by private stock transactions that massively boosted the worth of some assets. They are, essentially, trying to tamp down the same activity that is partially responsible for individual portfolios’ resurgence, often thanks to one or two highly touted startups.
One VC suggested secondary market deals are a primary factor in valuation boosts. “The recent IPOs are all still in lock-up, and M&A has been interesting but not overwhelming” in 2011, the source said.
Indeed, founders are not the only startup stockholders heading for an early exit. Some VCs have utilized secondary markets to make partial exits from successful investments. Daily deals site LivingSocial earned Grotech Ventures a massive return on its investment, and singlehandedly turned the firm’s seventh fund into a success—all through hastily executed private stock transactions of around $200 million.
Other VCs are concerned with secondary markets’ impact on options—the unregulated trading of private stock is creating a ripple effect that has the potential to alter the shareholder base, even after a transaction is completed.
“One area we are increasingly paying attention to are stock option agreements and what the terms are regarding an employee’s ability to sell their stock on these secondary markets,” said another VC who has been monitoring secondary markets. “The challenge with the company or investors purchasing stock directly from an employee is that is can have an impact on the company’s 409A valuation which is used in determining the strike price of an option.”
The National Venture Capital Association acknowledges that Internet and e-commerce companies’ trajectories have fueled portfolio rebounds, but the organization is reticent to say secondary deals have been the special sauce in VCs’ recipe.
A report provided by the NVCA and Cambridge Associates notes the e-commerce companies that VCs invested in during 2009 and 2010 posted mammoth IRRs of 82.18% and 167.75%, respectively. The report also noted that VCs’ returns were boosted over the first quarter of 2011.
Secondary deals “are certainly having an uplifting” effect on asset valuations, says Cambridge managing director Peter Mooradian. He said the deals, including websites brokering private stock sales and transactions involving larger, institutional investors “represent a small percentage of overall dollars—it’s the exception, rather than the rule.”
A separate study from SecondMarket indicates most buyers of private stock have increasingly sought social media and e-commerce companies this year. Among the top 10 most-monitored companies on SecondMarket are Groupon, Gilt Groupe and LivingSocial. Further, the report stated, of the $268 million in deals that took place in the first half of 2011 (which marked a 75% year-over-year increase), most of the activity came in the first quarter of this year. SecondMarket’s figures do not account for deals like Grotech’s, or for other competing secondary trading operations, including brokerages. Another secondary market trading source suggested that Facebook transactions alone, some of which have occurred through private brokerages, would push deal activity into the billions-of-dollars range for the beginning of this year. No one can say for sure what percentage secondary market deals represent of overall return dollars.
But it would appear that the VCs evaluating their portfolios and their lobbying arm aren’t quite seeing eye-to-eye.
“I do not think that secondary market trading has had any impact on venture returns as the amount of secondary trading by the few venture firms that have participated and by fund is not enough to move the needle,” said Mark Heesen, NVCA president. “At this point I think it is also too early to determine if returns from secondary trading in general will have a noticeable impact on individual funds, individual firms and the industry as a whole.”
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