Guide to Investing in Pre-IPO Secondaries

Michael Buono
Dec 10th, 2020

Overview

EquityZen, where I work as an Investment Associate, is a platform bringing private markets to the public. To date, we have closed 11,000+ investments for over 200 private, venture-backed, technology companies like Spotify, Unity Technologies & DraftKings. 

Our investment vehicles offer exposure to individual companies, diversified managed funds, and thematic funds in the pre-IPO space. They are available to accredited investors around the globe.

This guide will provide an overview of the asset class and a framework for investors to evaluate potential investment opportunities. If you'd like to learn more, please reach out to mike@equityzen.com.

What is the private secondary market?

The private secondary market is one in which shareholders of private, venture-backed companies (employees, ex employees & early investors) seek to transfer the ownership of their shares to an investor in exchange for liquidity. The investor on the other side of the transaction exchanges cash for shares of the private company. The proceeds of the sale go to the selling shareholder, not to the company itself.

A primary issuance is the source of equity for a given company. Primary issuances happen when a company issues a new class of shares and grants those shares to employees (generally in the form of options) or sells them to investors in a capital raise. The employees & investors who own primary shares may choose to sell them in the secondary market, through EquityZen, at a later date.

Transactions in the secondary market are called secondaries because they are one step removed from the primary stock issuance that originally created the securities.

 
The graph above displays how value creation from 1986 through 2018 has shifted from the public markets (green) to the private markets (gray). Roku's private valuation multiple based on Series B to IPO. Companies shown may not be actual portfolio investments of any EquityZen fund.

Proliferation of secondaries & how you can take advantage

Given the cost of going public (which can be substantial in terms of time and resources)1 and the short-termism of the public markets (which can cause public companies to focus on quarterly earnings rather than long term growth)2, technology companies have fewer reasons to go public than they did a decade ago. As a result, venture-backed technology companies are increasingly reaching $1B and even $10B valuations before they go public, which leaves less potential upside on the table for public market investors. In 1999, US technology companies typically went public after 4 years; today, the average technology company IPOs after 10+ years.3

Because companies are taking longer to go public, their earliest investors and employees have to wait longer for liquidity than they would have in the past. Enter EquityZen and the secondary market.

There are many reasons why early shareholders of now valuable private companies might want to tap into liquidity through EquityZen. An early stage venture capital investor, for example, might want to return capital to limited partners ahead of the launch of a new fund. An early employee of a now late-stage company might want to sell shares to finance a major life event like buying a house.

EquityZen acts as an intermediary between the shareholders who need liquidity, and the investors who want investment exposure to proven technology companies before they ultimately go public or get acquired. If the company goes public, investors receive shares after the lockup period (which restricts private market shareholders from selling their publicly traded shares, typically for 180 days). If the company gets acquired for cash, investors receive cash.

There is estimated to be over $50 billion of value locked up in private, pre-IPO companies 4 - the secondary market is unlocking that value for investors who had previously been shut out due to high minimums and exclusivity.

Secondary market pricing

Primary market pricing is set by the investors who participate in the financing event; secondary transactions are typically priced relative to the most recent round of funding. The price can also be influenced by factors of supply and demand. If a private company is in high demand, the shares might trade at a premium in the secondary markets (in other words, the shares would be priced higher than the price per share from the most recent round of funding). If there are more sellers than there are buyers for a particular security, the shares might trade at a discount (lower than the price from the most recent round of funding).

Aside from the influences of supply & demand, there are other factors that can affect the price per share of private market secondaries, which I’ll outline below: 

 

  • Share Class: Two of the primary types of shares are preferred stock and common stock. 
    • Preferred stock is a type of equity security that has certain rights over common stockholders. These rights may include, but are not limited to, liquidation preferences (which you can read more about here: All that Glitters Is Not Gold: Startup Valuations and the Liquidation Preference Overhang), dividends, anti-dilution clauses, and managerial voting power.
    • Common stock is a type of equity security that is most frequently issued to founders, management, and employees. In a liquidation event, preferred shares generally take priority over common shares.
    • Preferred stock, given its structural seniority, generally commands a higher price per share than common stock does.
  • Discount for Lack of Marketability: A valuation discount exists between stock that is publicly traded and liquid, and stock that is not publicly traded and illiquid. Because EquityZen offerings are relatively illiquid, it’s not uncommon for offerings to price at a discount to the most recent round of financing. 

A framework for evaluating investment opportunities

The framework below will help you think through the key components of a pre-IPO investment opportunity and, ultimately, make an investment decision. The examples in each section below are general and non-exhaustive; each investment memo that you write will be unique. You can refer back to your write-up in the future to see how you were thinking at the time about the market and the specific company.

Overview. This first section should be a clear, concise overview of the approach that the company is taking to capitalize on a market opportunity. What does the startup do, and how does it generate revenue?

 

  • What does the company do?
    • How do they differentiate themselves from competitors?
    • What makes this company's product unique?
  • How does the company generate revenue?

 

Market. An analysis of the size of the market that the target company is seeking to capitalize on.

 

  • What is the total addressable market (TAM)?
    • If revenue figures are available, what is the company's market penetration at the time of your analysis?
    • How much more market share can the company capture if things go according to plan
  • What is the company's go-to-market strategy?
  • Who are their customers & how many customers do they have?

 

Team. Quick background on the leadership team - what gives each key team member an edge?

 

  • Past experience & expertise
    • Have they started and exited a company in the past?
    • Do they have strong knowledge of the market in which they are operating?
  • Has the company hired a CFO? Does that CFO have experience taking other companies public or through acquisitions?
  • Has the company hired outside board members or advisors? How can they add value?

 

Why they win. Put pen to paper on what makes this company great - if you can find customer testimonials, this would be a great place to add them.

 

  • What makes customers choose to pay for the product?
    • Is the product an order of magnitude better than competing products?
    • Does the product save time and money for their customers?
    • Does the product help customers generate revenue?
    • Have their customers switched from incumbent / legacy player? Why?

 

Investment terms & comparable analysis. The terms at which you'll be investing & how your target company stacks up against its competitors.

For your analysis and for record keeping, it will be helpful to outline the terms at which you'll be investing:

 

  • Price per share
  • Valuation from the company's last round of financing
  • Implied valuation based on the price per share of your investment
  • % premium / discount
  • Deal structure
  • Amount invested

 

Next, we'll pull financial details on existing private, publicly traded and previously acquired competitors that compete in the same market. Do this for the company that you're evaluating as well. Helpful metrics for each company, where available, include:

 

  • Enterprise value if public; valuation from last financing round if private
  • Amount of capital raised if private
  • LTM Revenue
  • LTM P/S or LTM EV/S Multiple
  • Growth rate

 

For publicly traded competitors, you'll find this information and more in annual 10-K's, quarterly 10-Q's and on websites like Yahoo Finance and publiccomps.com. For private companies (including the one you're evaluating), you'll have to get creative in finding research and articles online. At the bottom of this article, I’ll provide a list of resources that I personally use to find information on private companies. Calculating multiples for your target company and its competitors will allow you to compare your target company to its peer group on a relative basis and will put you in a better place to estimate the value of your potential investment. 

Devote some time to searching online for companies that operated in the same sector and were ultimately acquired. If any competitors from the peer group were acquired recently (within the past 5 years), you can conduct a precedent transactions analysis. This analysis will give you a clearer picture of what an exit might look like for your target company and will also highlight trends in the industry that you should be aware of.

Once you've identified relevant transactions, you'll need to search for the price paid by the acquiring company and the most recent revenue metric known at the time of each acquisition. Use this information to calculate the multiple of revenue that the acquiring company paid in each acquisition.

Now that you've calculated revenue multiples from recent acquisitions, you can apply the average, median, max and/or minimum of the data set to your target company's most recent revenue figure. This will provide you with an estimate of the valuation that your target company might achieve if it were to be acquired.

Ascribing a valuation to a private company can be an exercise in assumptions and best guess estimates, but the analysis outlined in this section should help you get a sense for where your target company fits in the market.

Highlights. A handful of bullet points on why your target company makes a compelling investment opportunity. Each investment will have its own unique highlights; some things to think about below:

 

  • Has your target company reached product market fit?
  • Is the company profitable? Does it have a strong balance sheet?
  • Have top-tier Venture Capital investors invested in the company?
  • Do you have the opportunity to purchase shares at a compelling valuation?
  • Is the company quickly gaining market share in a large and growing market? Do they have room to go?

 

Risks. An outline of what could go wrong and, if applicable, how the target company is taking steps to mitigate those risks. These risks will be unique to your target company at the time of analysis and could include things like economic risk, competition risk, financial risk & operational risk.

It’s also important to note that pre-IPO investments may be speculative, and there can be no assurance that any private company will go public or be acquired, or that any IPO or acquisition will result in a successful investment.

Outcomes. A write up of potential outcomes for your investment. Use the information that we put together in our Comparable analysis, Highlights and Risks sections to estimate a base, bull and bear case for your investment. EquityZen provides its investors with a scenario generator to help quantify exit scenarios.

Investment Decision. If you've gotten this far, you're likely set on making the investment. For a high-risk, illiquid investment, it's important to have a thesis that accounts for what could go - really - right. Let's end with that.

Resources for researching private companies: 

 

  • EquityZen - for accredited investors, EquityZen provides private company research and capitalization table information.
  • Atom Finance - is a public market data provider; they have a tool called “X-Ray” that allows you to search for the names of private companies within public filings.
  • Public Comps - for benchmarking against public SaaS companies.
  • Getlatka.com - information on top SaaS companies & podcasts with founders.
  • Google & YouTube - for interviews & articles featuring company leadership 

Sources:

 

  1. https://www.pwc.com/us/en/services/deals/library/cost-of-an-ipo.html
  2. https://hbr.org/2015/10/yes-short-termism-really-is-a-problem
  3. https://www.mckinsey.com/industries/technology-media-and-telecommunications/our-insights/grow-fast-or-die-slow-why-unicorns-are-staying-private#
  4. https://www.industryventures.com/estimating-the-size-of-the-secondary-market-for-venture-investments/

 

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