Venture capital is a relatively illiquid asset class. In other words, since there isn’t a public market with significant supply and demand which produces real-time asset pricing, it isn’t easy to sell a venture capital investment after you’ve made it.
This illiquidity is correctly viewed as an additional risk which investors earn a risk premium for taking.
However, the same illiquidity also carries an advantage. Specifically, it is a natural opposing force to the human tendency to continually check asset prices and to trade in and out of assets when driven by greed and fear.
Frequent trading behavior is known as active management and studies show that the average active investor underperforms his more passive counterpart who simply buys and holds. This is to be expected because, each time that an active investor trades an asset, they lose the spread between the bid and ask prices of the asset while also incurring brokerage fees. And the average active investor’s returns don’t improve as a result of this frequent trading behavior.
This doesn’t mean that all active investors underperform. Some of them produce higher returns than passive investors. However, in the public markets, these are increasingly computer algorithms with tremendous data processing capabilities and low latency. The average active investor, who is increasingly a processing power-constrained and high latency human, produces lower returns than his passive counterpart.
In other words, the illiquidity of venture capital makes it harder to actively manage a venture capital portfolio. It forces you to buy and hold for much longer periods of time, and that’s a good thing.
The illiquidity of venture capital is also the reason why computer algorithms have yet to displace venture capitalists. Although that day will likely come, the success of a buy and hold strategy is less dependent on sheer processing power and low latency than the success of an active management strategy. Instead, the success of a buy and hold strategy depends on having creative and often contrarian insights. That’s where, for the time being, humans still have an edge.
As startups mature, existing shareholders can look to sell some of their shares in order to convert some of the increase in the paper value of their ownership into actual cash. Such transactions, which can be initiated by both employees and investors, are known as secondary share sales.
When a secondary share sale takes place, it’s important to note that it will take place at a lower valuation than the valuation that would be placed on the company if the transaction were a primary investment. A primary investment is one where the investment goes towards buying new shares which are being issued by the company. As such, the proceeds from a primary investment are used by the company for its growth.
There are two reasons why secondary share sales of startups take place at a lower valuation than if the same company at the same moment in time were accepting a primary investment.
The first reason is that startup shares are a relatively illiquid asset class. Unlike public market shares for which there is a steady stream of demand, private company shares have less buyers. So when a potential buyer evaluates the purchase of secondary shares in a startup, they keep in mind that their purchase would let the owner of an illiquid asset class achieve liquidity. And once they become the owner of these shares, they’ll be subject to the same illiquidity constraint as faced by the original owner. It will likely take years before the company goes public or is acquired and they’re able to get a cash return on their investment. So they apply a discount to account for the illiquidity of the shares they’re buying.
The second reason why a discount is applied to secondary valuations is because primary valuations take into account the growth that the company will be able to achieve once it receives the capital injection. Money that is used to cash out an existing shareholder is money that isn’t used for the company’s growth. As a result, the company will be less valuable than the same company which has the funds available for its growth.
I’ve seen discounts on secondary share sales range anywhere between 30% and 50%. So, a company that could raise a primary round at a price per share of $10 may see its shares trade for between $5 and $7 in a secondary transaction.
That said, the discount percentage could be lower than 30% or higher than 50%. The same illiquidity that is partially responsible for the discount applied to secondary shares is also responsible for the large variance in the ultimate price of secondary transactions.