What is Secondary Venture Capital Investing?

October 31, 20225 min read
What is Secondary Venture Capital Investing?
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One of the most notable trends of the current tech boom has been the rising valuations of startup companies, many of which reach “unicorn” status of being worth more than $1 billion before they even go public.

The explosive growth of privately held companies, along with the deep pool of venture capital fueling them, has led to a robust secondary VC market. The secondary market has the potential to benefit existing investors in the space facing liquidity issues and potential investors on the sideline wanting to join in on the action. These days, it is more common for companies to remain private for longer, which means VC funds can be locked up for longer. The secondary market allows VC funds and other stakeholders that invested in the company in the very early stage the opportunity to realize their investment before a potential initial public offering (IPO).  Therefore, the secondary VC market allows new investors to gain access to the high-growth potential offered by startups that have already experienced some maturation and scale.

The Secondary Venture Capital Market at a glance

There are so many unicorns today that it’s hard to keep track. Many are household names, such as TikTok’s parent ByteDance, SpaceX, and Instacart, to name a few. A few decades ago, startups like these would hatch an idea, raise some money, and then go public via an IPO as quickly as possible to raise more cash. Public investors hoped to capture some of the upside growth potential of newer, less established companies that were primed for growth and perhaps disrupt an industry.

Today’s startups, however, tend to approach their financial lifespan differently. There are typically several private rounds of fundraising for a company. As a result, they aren’t as reliant on the potential capital raised through an IPO anymore. In this day and age, it seems like there’s more private capital available than places to invest it. With the plethora of available capital and an increasing timeframe to exit, the venture capital secondary market is growing in importance and popularity. Specific VC funds are now focused on solely investing in startups that have already evolved beyond the early stages. These secondary VC funds acquire equity stakes, limited partnership interests, and buy shares from founders and management team members.

Offering a way for existing investors to realize their returns before the IPO

One of the potential benefits of the secondary market is that it can allow early VC investors to realize their returns and exit sooner than they might if they wait for a potential IPO/acquisition. Since companies remain private for longer periods, VC funds can often be locked up for longer durations, which may not suit their liquidity needs. A robust secondary market allows VC funds to obtain liquidity ahead of a formal exit and provides meaningful opportunities for new investors with deployable capital to get in on the action while substantial company growth still exists. 

Understanding the risks related to the VC secondary market

Like we mentioned above, the venture capital secondary market indeed presents a host of unique opportunities for investors, but, like all investment avenues, it’s not devoid of risks. Understanding these risks is important if you’re exploring these investment opportunities.

One of the primary risks is market volatility. The value of secondary investments can fluctuate significantly in response to changes in market conditions, economic factors, or investor sentiment. Unpredictable geopolitical events, shifts in consumer behavior, or macroeconomic factors such as interest rates, inflation, and unemployment can all impact the secondary market. It’s essential to remember that while the overall trend of the secondary market has been positive, short-term fluctuations can be quite severe, and investors need to have the stomach to weather these swings.

Another significant risk is the potential for startup failure. Even though secondary market investors typically enter at a later stage when a startup has proven its concept, there is still a chance that the company could fail. Factors that could contribute to this include a sudden competitive threat, changes in market conditions, poor management decisions, or financial difficulties.

One should also consider the risk of over-valuation. With so many startups reaching unicorn status, there’s a possibility that some of these companies are not truly worth their lofty valuations. This could be due to over-optimistic projections, manipulation, or simply market exuberance.

Lastly, there is a risk inherent in the secondary market’s lack of liquidity. Unlike publicly traded stocks, secondary investments cannot be sold easily or quickly. While the secondary market does provide some liquidity for venture capital investments, it is not as liquid as the public market.

Still opportunity for meaningful returns before an IPO 

VC investors utilizing the secondary market to exit a position realize their return on an investment’s growth at that point in time. However, this does not mean that the company won’t continue to experience additional growth as it gets closer to its IPO. Gaining exposure to a high-growth company that is further along in its lifecycle stands to benefit some investors because the risk involved can be substantially lower. At this age, the company is often more than a concept. It typically has proven technologies, capabilities and is now often showing signs of scale. Investors joining at this stage via the secondary market can find comfort in knowing that the likelihood of failure is somewhat reduced due to a demonstrated track record. Secondary investments also tend to outperform the broader venture capital market, as those selling their stakes often do so at a discount, sometimes as much as 30-35%. 

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The Secondary Opportunity for Investors

Investors seeking to add private markets exposure to a portfolio may find secondary VC assets an attractive option. One of the benefits of investing in the secondary market is that it typically shortens the time horizon between the initial startup phase and the rate of return growth. Startups tend to follow a “J curve” pattern of returns – dipping down into negative territory for a period before the high growth phase. Secondary investors can potentially skip over the negative growth phase and invest in startup companies already growing — often at a discount to the company’s value. Secondary funds focus on investing in startups that have matured and have either reached profitability or are expecting to arrive there soon.

Overall, the venture capital secondary market has the potential to provide meaningful returns to investors, while benefiting VC funds and investors in the space who need liquidity. By identifying stakeholders in the early stages of start-ups, an investor can find companies that have advanced beyond the initial phase to one where profits and returns have matured and stabilized. This potentially reduces risk and optimizes returns in a historically volatile asset class.

To learn more about the opportunities available in this space, check out a recent conversation from The Yield on venture capital investing, current market opportunities, and why companies are staying private for longer. If you’re curious about opportunities in the VC space available on Yieldstreet, consider the StepStone VC Secondaries Fund currently on the platform.