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.
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.
This story appears in the November 2001 issue of Entrepreneur. Subscribe »
