(Saturday Deep Dive) - VC Exit through Secondary Funds

In today’s deep dive, we explore Secondary funds in the startup ecosystem in India. Secondary funds are an essential tool for creating liquidity in venture capital, offering early investors a way to exit their long-term commitments before startups reach public markets or acquisitions.

Traditionally, venture investments are locked in for 7-10 years, allowing startups to mature and maximize value. However, this extended wait can limit flexibility for investors who want to redeploy their capital sooner. Secondary funds address this by purchasing stakes from these investors, enabling early exits while providing new buyers access to later-stage, more stable companies at discounted prices.

In India, secondary funds play an increasingly important role in the startup ecosystem, facilitating liquidity, driving growth, and expanding access to high-potential ventures.

Secondary Funds: Creating Liquidity in an Illiquid Market

Secondary funds were created to solve a core problem in venture capital and private equity: creating liquidity in an investment space designed for long-term horizons. When venture capitalists or private equity firms invest in startups, they typically lock their capital in these companies for anywhere from seven to ten years, awaiting a strategic exit via an IPO or acquisition. This extended timeline is necessary for startups to scale, mature, and maximize value. However, for many investors, waiting that long can prove challenging—especially for funds nearing the end of their lifecycle or for investors looking to redeploy capital into other opportunities.

Secondary funds exist to bridge this liquidity gap. They serve as a strategic exit mechanism under specific circumstances, such as:

• Limited Partners (LPs) or fund managers requiring liquidity before a company's IPO or acquisition. Early liquidity is sometimes necessary for LPs to meet cash flow requirements or reallocate capital to new investment opportunities.

• Original investors looking to cash out while the startup remains private, which could be driven by shifts in their investment focus or portfolio rebalancing needs.

• Institutional and strategic buyers interested in accessing companies at later stages of growth. Buyers, such as secondary funds and large private equity firms, often want stakes in companies with a proven business model, validated product-market fit, and a higher likelihood of going public.

For early investors, selling shares in the secondary market can help realize gains (or losses) sooner. This allows them to reinvest proceeds, meet LP demands for returns, or close out positions in older funds. For buyers, secondary funds offer an opportunity to invest in promising later-stage startups—often at a discounted price—entering at a time when companies are more stable and likely on a trajectory toward exit events.

Primary Vs Secondary Transactions in Venture Capital

In venture capital, primary and secondary transactions represent two distinct methods of investing in startups, each fulfilling different needs in the funding and liquidity lifecycle.

• Primary Transactions: A primary transaction directs new capital into a company, typically in rounds like Series A, B, or C. In these funding rounds, capital flows from venture capitalists and institutional investors directly to the startup, helping it fuel operations, expand its market presence, and invest in growth initiatives. In exchange, the investors receive equity in the company. Primary transactions are often characterized by higher growth potential, as investors are betting on the company's ability to use the new capital to scale rapidly and reach key business milestones.

• Secondary Transactions: In contrast, secondary transactions are exchanges between investors without any new capital going into the company. This means that rather than the startup receiving new funds, an existing investor (such as a VC firm, LP, or early-stage investor) sells its stake to another investor, often a secondary fund or private equity firm, that sees value in acquiring shares at this stage.

  The process of secondary transactions usually begins with a seller seeking liquidity. This seller might reach out to secondary funds or potential buyers to assess interest in their shares. The transaction often includes due diligence, where buyers evaluate the company’s financial health, growth potential, and associated risks. Given that no fresh capital is added, secondary sales are typically priced at a discount to reflect the lack of immediate value to the company. Additionally, to balance risk, shares from multiple companies may be bundled together in the transaction, including both high-performing and underperforming assets.

Discounts and Bundling: Core Strategies in Secondary Sales

Discounts and bundling are fundamental strategies in secondary transactions, allowing both buyers and sellers to negotiate favorable terms and structure transactions to meet their objectives.

• Discounts in Secondary Sales: Discounts incentivize buyers by pricing shares below the latest valuation, compensating them for the risk of buying an illiquid, and sometimes distressed, asset. Several factors affect discount rates:

  • Seller Liquidity Pressure: When a seller urgently needs cash, they might offer a higher discount to secure a faster exit.

  • Company Performance: If the company is nearing an IPO or acquisition and performing well, discounts tend to be smaller. Conversely, discounts are typically larger for struggling companies with unclear growth prospects.

  • Market Conditions: During economic uncertainty or market downturns, buyers may demand larger discounts to offset the added risk.

  In 2021, Edtech company Unacademy saw early investors sell shares at a secondary share sale of $20 million. This allowed new investor’s entry before Unacademy’s anticipated IPO, balancing the risk associated with an unlisted asset against the growth trajectory of a high-performing startup.

• Bundling Strategies in Secondary Sales: Bundling enables sellers, often VC funds or large investors, to include high-performing assets with lower-performing or "dud" investments. This mix improves the attractiveness of the overall package, as buyers gain exposure to strong companies while taking on a few higher-risk positions.

  Sequoia Capital India used bundling in a secondary sale involving BYJU’S shares. Alongside BYJU'S, Sequoia included stakes in other, less successful companies in its portfolio, balancing liquidity needs across both high-performing and weaker assets.

Key Examples of Secondary Transactions in India

In India, secondary transactions have become integral to the startup ecosystem, allowing early-stage investors to exit partially and enabling new investors to participate in the growth of high-potential startups. Here are some notable instances:

1. Elevation Capital and Urban Company: Early investors like Elevation Capital and Accel Partners have leveraged secondary sales to gain liquidity. In Urban Company’s case, Elevation and Accel exited part of its holdings, selling shares to institutional investors. This transaction allowed Elevation and Accel to return capital to its LPs while retaining a stake in a high-growth business expected to expand significantly in the services marketplace.

2. Tiger Global and Ola: In a high-profile exit, Tiger Global partially sold its stake in Ola, India’s largest ride-hailing platform, to SoftBank through a secondary transaction. This move allowed Tiger Global to realize gains on its investment without waiting for an IPO and provided SoftBank with a controlling stake to influence Ola’s strategic direction.

3. Sequoia Capital and BYJU’S: As BYJU'S gained traction, Sequoia Capital India sold part of its stake through a secondary sale, enabling global investors such as Silver Lake Partners to participate in the rapidly growing ed-tech space. This transaction helped Sequoia secure early returns for its LPs and retain potential upside by holding a portion of its position.

4. Accel Partners and Flipkart: Before Walmart’s acquisition of Flipkart, early investors like Accel Partners completed secondary transactions, selling shares to new stakeholders like SoftBank. This secondary sale allowed Accel to exit at an attractive valuation and enabled new investors to position themselves just before Flipkart’s acquisition, which became a landmark transaction in Indian e-commerce.

5. Kalaari Capital and Dream11: In 2021, Kalaari Capital executed a partial exit from Dream11 through a secondary sale valued at $400 million. This transaction allowed Kalaari to realize returns while Dream11 continued its growth trajectory.

Balancing Goals in Secondary Sales

Secondary sales require a balance between early investors seeking liquidity and buyers hoping for future returns. Each party must navigate different objectives and risks, making negotiation critical.

• For Sellers: Venture funds use secondary sales to manage liquidity, wind down portfolios, and provide returns to LPs. For many funds nearing the end of their lifecycle, secondary sales offer a way to show partial or full exits, return capital, and sometimes refocus on higher-growth assets.

  Elevation Capital’s partial sale in BookMyShow enabled the firm to return capital to its investors while allowing BookMyShow’s growth trajectory to benefit new investors.

• For Buyers: Secondary funds and institutional investors use discounts to enter companies at reduced valuations, balancing the risk of taking on assets that might not perform as strongly as primary investments.

  Mirae Asset’s investment in Rebel Foods (parent company of Faasos) included stakes in both high-performing assets and lower-performing ventures, structuring the deal to maximize growth potential while managing the risk from weaker companies.

• Reputation Management: For venture capital funds, reputation is paramount. Successfully managed secondary sales enhance a fund’s track record, signaling to LPs that the fund can generate returns and manage liquidity effectively.

  In an early-stage secondary transaction, Accel Partners exited partially from BookMyShow, a ticketing giant, allowing new investors to join before its anticipated IPO. Accel balanced the need for early returns with the potential for future gains from its retained stake.

Advantages and Disadvantages of Secondary Funds

Pros of Secondary Funds:

• Liquidity Creation: Secondary funds provide an option for investors seeking early liquidity, essential for funds nearing end-of-life or requiring returns for reinvestment.

• Discounted Entry: Secondary transactions often occur at discounted valuations, offering buyers entry at lower prices and enabling potential gains when companies exit.

• Risk Mitigation: By investing in more mature companies, secondary funds offer lower risk than early-stage investments, as these companies have established product-market fit and are closer to profitability or exit.

• Diversification: Secondary funds provide diversification across multiple high-growth companies at various stages, reducing the risk associated with early-stage startups.

• Late-Stage Access: For investors who missed early rounds, secondary funds enable access to high-potential companies nearing exit.

Cons of Secondary Funds:

• Limited Upside: By entering at a later stage, secondary buyers miss the high-growth phase typical of early investments, resulting in potentially lower returns.

• Discounted Valuation Risks: Although discounts offer lower entry costs, they may indicate issues within the company or market pressures impacting growth prospects.

• Complexity and Costs: Secondary transactions involve complicated negotiations, legal fees, and deal structuring, especially with bundled assets.

• Potential Reputational Impact: Exiting through secondary sales at steep discounts may indicate distress or other issues, affecting fund reputation.

Future Trends in Secondary Markets for Indian Startups

The market for secondary transactions in Indian startups has grown rapidly, and several trends are likely to shape its future trajectory:

1. Increased Secondary Activity in Pre-IPO Companies: As more Indian startups approach IPOs, demand for pre-IPO secondary transactions is expected to rise. These transactions allow late-stage investors to gain exposure to companies with significant growth potential, positioning them for public listing gains.

2. Larger Fund Allocations for Secondary Transactions: Given the success of secondary funds in recent years, many venture capital and private equity firms are likely to allocate larger portions of capital specifically for secondary purchases, focusing on high-growth sectors like fintech, SaaS, and consumer technology.

3. Specialized Secondary Funds: Secondary funds that focus exclusively on buying out stakes in later-stage startups are gaining traction. As the market matures, we can expect more dedicated secondary funds entering the Indian market to capture opportunities in sectors with robust growth.

4. Regulatory Developments: As SEBI (Securities and Exchange Board of India) continues to streamline regulations around private markets, secondary transactions could become more transparent and easier to conduct, increasing confidence among global investors.

5. Growing Role of Sovereign Wealth Funds and Pension Funds: Large institutional investors, such as sovereign wealth funds and pension funds, are becoming more active in secondary transactions, diversifying their exposure to emerging markets like India while maintaining risk profiles suited to their investment mandates.

Conclusion

Secondary sales have become an essential part of the venture capital ecosystem, providing a flexible and strategic means for investors to access liquidity, exit positions, and manage portfolios. For venture capital firms, secondary transactions offer opportunities to return capital to LPs and showcase successful exits, even in the absence of IPOs or acquisitions. By facilitating partial or full exits, secondary transactions allow funds to highlight high-performing assets and maintain strong LP relationships, critical for future fundraising.

Secondary fund buyers gain access to promising companies at a discount, offering a lower-risk path to potential returns. By focusing on later-stage investments, secondary funds can diversify their portfolios, mitigating the high risks typically associated with early-stage ventures.

However, the secondary market does come with its complexities. Sellers need to balance the need for liquidity with the potential reputational impact of discounted exits, while buyers must carefully evaluate valuation discounts, as they can sometimes reflect inherent issues within companies. Furthermore, the intricate deal structures often involved in secondary sales —especially with bundled assets — add layers of negotiation and legal costs, requiring both parties to navigate these challenges thoughtfully.

Overall, as secondary markets continue to mature in India, these transactions will play an increasingly pivotal role in the venture capital ecosystem. By providing alternative exit routes, supporting fund liquidity, and expanding market access, secondary sales will continue shaping the dynamics of startup financing, enabling funds and investors to achieve diverse strategic goals in India’s rapidly evolving venture landscape.