The only way to generate attractive returns in secondaries is to buy into quality companies that are managed by skilled investors. However, like primary side investors, secondary players want to have mechanisms in place to mitigate their downside risk. On the primary markets, these downside protection clauses are relatively well known, such as liquidation preference and anti-dilution protection. However, secondary investors, by the nature of the parties that they transact with, have the ability to increase their protection by adding a few clauses that are more commonly seen in M&A, PE or LBO’s.
When an investment turns sour, how can a secondary investor — who typically buys junior securities in the capital structure, embed downside protection mechanisms in its transactions?
As mentioned above, primary investors, such as venture capital funds, typically receive liquidation preferences and anti-dilution protection mechanisms attached to their shares. Similarly, secondary investors can protect themselves in their agreement with sellers of shares and not the company itself. Secondary investors can do so in the following ways:
1. Shared upside — The seller is offered a discounted upfront payment, but at the same time, will be offered to share the upside in a predefined ratio (for example, a 50/50 split) after the investor has received a guaranteed return target.
2. Guaranteed return — The buyer will offer to buy only a portion of the shares that are held by the seller but will request the rest of the shares be held in an escrow account until the buyer has reached its return target.
In situations where the shares that are being sold are owned by employees or management, and it is hard to align pricing expectations due to liquidation preference:
a.The company will buy the shares from the seller at a discount and diminish them.
b.The company will issue the same amount of stock but at the most senior preferred stack.
c.The buyer will purchase the shares at the last round PPS.
Good for everyone. Why?
● The sellers reached liquidity
● The company can keep the residual amount between the discounted PPS to the actual amount received by the company — which can be millions of $.
● For shareholders — because the company kept the same amount of shares, there is no dilution, and at the same time, their company received a cash infusion.