Newsletter & Research on Pre-IPO Unicorn Secondaries
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As you may know, in addition to helping private equity and venture capital GPs raise capital from the Middle East, I work as a broker in the pre-IPO unicorn secondary market as a broker at Rainmaker Securities. My colleague Kirat Lall -- with input from our CEO Glen Anderson & intern Michael Lu -- recently shared ten interesting observations about our market. Perhaps you may find them of value.
1. What is the secondary market?
The secondary market is a financial market in which existing stocks, options, and other financial instruments are purchased from or sold to other investors. Although the secondary market also includes exchanges such as the New York Stock Exchange, the London Stock Exchange, and Nasdaq, RainMaker Securities primarily focuses on secondary market transactions in the equity of private later stage companies.
2. Why are common shares worth less than preferred shares?
"The two types of equity in a company are preferred shares and common shares. The price for preferred shares is the price per share paid by investors in a Series funding round. Due to their low exercise price once converted from options, especially when issued early on, common shares often have a very low cost basis. In contrast, the cost basis of preferred shares is usually significantly higher, as it is determined by the price per share in the latest funding round.
The preferred stock is often more valuable than the common stock due to a multitude of factors. Whereas common stock profits are subject to changes in demand and the company’s ability to pay out dividends, preferred stocks take precedence over common stock and are paid a predetermined dividend.
Furthermore, in comparison to common shares, preferred shares have additional economic advantages such as a ""liquidation preference,"" meaning that should a company’s assets be liquidated, shareholders of preferred stock are able to redeem their shares first. Furthermore, in non-participating dividend rights, the investor has the choice of either exercising liquidity or converting preferred shares into common shares. The lower risk investors take on with preferred stock is reflected in its higher price."
3. What are some obstacles that can present themselves in a secondary transaction?
"A private later stage company has the option of restricting secondary transactions. Companies may block secondary transactions especially when nearing an IPO or round of funding. In the scenario of an IPO, the additional changing share ownership complicates the process. In both IPO’s and series funding, obstacles arise from the market uncertainty, delaying the secondary process as sellers may wait for price appreciation and buyers may desire greater market transparency.
Private firms desire a trustworthy and limited number of investors to ensure the alignment of company interests and prevent frequent short-term trading of shares. Additionally, firms use the ownership of shares both as compensation for employees and as a method of increasing employee retention. Thus, firms often require board approval when processing secondary transactions and only allow sponsored secondary tenders as means of liquidity. Sponsored secondary transactions consist of startup employees selling shares to venture capital firms. Due to a more targeted approach limited in employee outreach, Rainmaker’s secondary transactions lack sponsorship and may encounter the obstacles noted above.
Furthermore, there may be additional costs where some firms will require legal opinion to ensure the transferal of stock rights from seller to buyer; the price of this process typically ranges between $2-3k."
4. What is ROFR?
"ROFR, otherwise known as the Right of First Refusal, is the company’s option to decline a buyer from purchasing shares in a company. In presenting the company with an STA, a binding document stating the buyer’s desired number of shares and price per share, under the ROFR, the company typically has 30 days in deciding to refuse the transaction. However, in some cases, the company’s bylaws may state the ROFR only last a few weeks or may take several months.
Should the company exercise their ROFR, the seller would still be compensated for the sale of their shares, although the company itself or an early shareholder would represent the buyer. Even if the ROFR process were triggered, the seller would still receive funds instead of the initial buyer.
If ROFR doesn’t occur, the initial buyer would successfully obtain the shares and transfer the seller the agreed upon funds."
5. How long does a secondary transaction take?
Once the buyer and the seller have signed the STA, the transaction will then proceed to the ROFR stage. Furthermore, a few weeks are required to officially close the transaction in which the buyer wires the seller funds and the company transfers official ownership of shares to the buyer. In some cases, preferred stock transactions are exempt from the ROFR period and only require a few weeks closing.
6. Why might a seller want liquidity?
Through the sale of their shares, the seller is compensated with liquidity that can finance personal needs such as starting a business, buying a new house, or paying for college expenses of their children.
7. What happens when a company achieves an exit?
"There are two ways in which a company achieves an exit: an IPO and an M&A.
In the case of an IPO, the value of the common shares and preferred shares converge in either a stock split or reverse stock split. However, most common shares have a 6-month lock up period in which insiders who held shares before the company went public can’t sell for a specified period of time.
The second case is an M&A exit, in which the private firm undergoes “the waterfall phenomenon.” Following the sequential waterfall of investment (ex. Series E, Series D, . . . Series A), the most recent preferred shareholders can withdraw their initial equity or receive upside on their investment. In the case of Pari Passu liquidation, preferred shareholders regardless of funding round have the same seniority status which means that every investor will receive a portion of the proceeds. After the preferred shareholders obtain liquidity, common shareholders have access to the remaining capital."
8. Does RainMaker have exclusivity in marketing seller’s shares?
No, RainMaker doesn’t have exclusivity and is in competition with other firms focused on secondary market transactions.
9. Where does RainMaker get its pricing?
RainMaker obtains pricing data from Pitchbook. If there is a stock split or reverse stock split, RainMaker representatives utilize alternative databases for pricing information, as well.
10. What are the most traded secondaries in RainMaker’s history from 2018 to H1 2019?
Due to their being private for significant amounts of time, Palantir, 23andMe and Adaptive Biotechnologies have resulted in being the most frequent secondary transactions for RainMaker Securities. During this time period, Uber, Juul and Wish have been the most popular secondaries in terms of RainMaker’s trading volume.