It sounds like a scene from your worst nightmare: Some of your
VC investors, feeling the effects of the struggling economy, decide
to bail out on your company and sell their stakes to secondary
investors you've never heard of. Now there's no telling
what the new investors will want from you and your business.
It's understandable that you may fear such a scenario, but
there's hardly any reason to panic. True, VCs have been
disappointed by returns on their investments, and it's easy to
see why: The VC industry saw its first negative return for any
12-month period as of July 2001, according to Venture
Economics and the National Venture Capital Association. But
that doesn't necessarily mean that venture funds are in dire
trouble—or that the businesses they finance will be affected
even if the limited partners do want out.
Secondary markets, which have been around for decades but have
been seeing increased activity in the past 10 years, offer limited
partners a way to exit their VC investments without hurting the
businesses they're funding. Limited partners often have to sell
their investments at a discount to unload them, but that
doesn't typically affect the funds or, more important, the
businesses, because the buyers assume all the financial
obligations, both present and future, says Chad Alfeld, principal
of Simsbury, Connecticut-based Landmark Partners, which has done
more than 170 secondary transactions. "We step into their
shoes, take over their capital account for the $5 million
they've already put in, let's say, and then take on the
obligation of the additional $5 million to be funded," says
Alfeld.
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Because limited partners are essentially silent investors, and
entrepreneurs deal only with the general partner, you might not
even know any of your VC players have changed until after the deal
is done. "There might be a concern from the entrepreneur's
standpoint of 'We don't really know who this limited
partner is—do they really have the money to continue
funding?'" says Alfeld. "But the general partner
would not allow the transfer unless it was a good, qualified
limited partner."
And even if half the funds' limited partners sold their
investments on the secondary market, the general partner would
remain the same—as would his or her expectations regarding
the business. "I'm not aware of any general partner
changing his or her strategy just because there was a sale within
the fund of the secondary interest," says Brent Nicklas,
managing general partner for New York City-based Lexington
Partners, one of the largest players in the secondary
market.
In most secondary transactions, the fund has the same amount of
capital after the deal as it did prior. Of course, if there were no
secondary market available to the limited partners and they could
not meet their obligations, "that obviously could affect the
entrepreneur because the amount of funding to the general partner
would shrink," says Nicklas. And not all investments up for
sale on the secondary market are attractive to buyers.
But even with the hyped-up images of investors running for the
door, it's always been the understanding that venture
capitalists, and their investors, are going to want to exit the
deal at some not-too-distant point in the future. "They're
not in it to run companies," says Jesse Reyes, global product
manager for Venture Economics. "They're in it to exit in
three to five years. Everyone knows that going in."
C.J. Prince is a New York City writer who specializes in
business topics and the executive editor of Chief Executive
magazine.