Dear Danny, I am a young founder currently finishing a fundraising process and have multiple term sheets at absurd valuations with no expectation of offering board seats. I am trying to find ways to distinguish between these offers, and I recently heard that some of my best friends are using VCs like ATMs, and taking millions off the table through secondary offerings. I only fly first class, but this secondary sounds premium. I was wondering if I can take millions off with my term sheet, and how many millions I should take? ~ Company Builder*
Company Builder, I congratulate you on developing your startup to the level where venture capitalists are willing to offer you obscene valuations with no hope of access to your board of directors. I understand getting to 100,000 users these days can be challenging, and I congratulate you on your tenacity to reach this special threshold.
As you heard from your friends, but far more likely from the media since it is unlikely you have many friends, venture capitalists are “fighting like drunken sailors” to get money into your startup, and that of your very own pocket. Through a device known as a secondary sale, you can put up some of your very own hard-earned equity in a fundraise process, and sell your shares at the round price.
Contrary to the beliefs of many (most notably anti-tech protestors in San Francisco), such secondary sales are actually in the best interests of the founder and the investor when done properly.
It’s all about incentives. When your startup is just starting out, your equity is worth less than the paper it is printed on. So there is very little threat of you giving up the business for an acquisition offer. Any offer is probably going to be too small to change your mind about building a company, and in fact, any offer will likely validate your beliefs that what you are doing is right (even though your cocky confidence probably doesn’t require any further validation).
But as your startup matures and finds success, turning down valuation offers becomes more and more difficult for even the most cocksure founder. It can be easy to ignore Google’s entreaties when they offer you $100,000 for your company (i.e. the starting salary for engineers at Google), but it is significantly more difficult to refuse when that number has another four zeros behind it.
That is where the conflict can brew between you and your investors. Your investors, particularly your later-stage investors, need you to push all the way to a massive exit in order to return any capital off of their previously ridiculous valuation. You, on the other hand, would probably be willing to accept a handsome payday of hundreds of millions of dollars.
To discourage you from selling early, venture capitalists will offer you secondary to align your interests together. By giving you some money up front, you don’t feel the same pressure to sell early to make a buck, and can instead concentrate on building a massive and sustainable business.
At its best, the secondary offered is commensurate with the remaining gains of a company. If you own, say, 25% of a company valued at a billion dollars, a couple of million or even $50 million in secondary is really not going to change the fact that a huge amount of money is still held up in paper equity. The kind of ambitious founders who can build such a valuable company rarely just quit when they get their first taste of cash.
Contrary to some of the analysis floating around, such secondary sales are hardly uncommon, and are in fact a typical consideration in later growth rounds where there is real concern that a young founder will be willing to charge through attractive acquisition offers in search of the big payday. In fact, unless a founder has had previously success in building a company (and getting wealthy from it), most later-stage VCs would be concerned if a founder never took secondary.
As you might have noticed, I have talked mostly about later-stage investors, while you, Company Builder, are running an early-stage company. Secondary in early-stage rounds is seemingly becoming more common for the most competitive deals, as we have seen with founders at Whisper and Secret. Here we have a bit more incentive conflict than we otherwise should.
If secondary is being offered earlier, there would certainly be an increasing incentive for a founder to quickly build notoriety and attention instead of a product, run around Sand Hill Road with open hands to receive term sheets, and quickly secure a multimillion dollar payday before anyone is the wiser. To my knowledge, such activities have so far been rare, but there is a serious risk for the ecosystem if millions are being offered before a product has even shown sustainability.
Ultimately, only you can decide what is right for your company and your own personal finances. Remember, this secondary isn’t free – it’s equity in your company that you are sacrificing for today dollars. If you are massively successful and grow the next Facebook, today dollars are going to look like a pittance compared to tomorrow dollars when your equity value has shot up. As long as you can pay the mortgage, I say, move forward.
*This email is fictional. I hope.