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📈 How does a price get set in the secondary markets?

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Hi there,

Vieje here again and it’s good to be back. We’re officially in March and I’m personally counting down the days to the end of winter. It’s been a rainy and gloomy 2024 so far in San Francisco. While my golf game is suffering, I've been catching up on my TV and movies list. I just watched Dune 2 in IMAX 70MM yesterday and 10/10 would recommend.

One positive for all of us in 2024 is that the secondary markets have picked up a bit to kick off the year. If there’s a successful Reddit IPO later this month, we could see the markets opening up even more. And it’s about time as there’s a high demand for liquidity right now from private company employees.

In today’s newsletter, I wanted to talk about secondaries. If you are looking to sell your shares in your private company, then you need to navigate the secondary markets. Before you do, you need to understand how a market forms and what investors are looking for to give you the best shot to get a deal done and at the best price possible. Let’s jump in.

📊 How does a market form?

Before we get into specifics, it’s important to understand the dynamics of a market. While we all probably know that a market forms when there are buyers and sellers of a product, it’s important to contextualize this in the form of your company’s stock.

Unfortunately, for the vast majority of private companies out there, there is not a current secondary market. Oftentimes, this could be because your company does not allow secondary transactions to take place. Most companies will have some sort of restrictions on selling your shares in order to protect their cap table. Even though there are potential buyers and sellers, if your company does not allow secondary transactions to happen, there is no market because no deals can be done.

Another reason why there may be no secondary market for your company’s shares is because there are no interested buyers. We’ll discuss the specifics of what investors look for in the next section, but for now, just know that for the majority of private companies, there are typically only sellers and no buyers.

If there is a market for your company’s shares, meaning that transactions are allowed to take place and there are both buyers and sellers, then transactions can happen and we can observe a “market price” (i.e. where supply and demand match and a transaction occurs). For purposes of simplicity for this newsletter, I’m going to speak at a high level and ignore some of the intricacies that could affect price such as the right of first refusal (ROFR), data rights, and structured deals.

👛 How does a price get set?

In a market where stocks are traded, you have both buyers bidding on shares and sellers offering their shares for sale. In the public markets, you can nearly instantaneously buy and sell shares electronically through brokerages when the market is open at very low cost. However, in the private markets, transactions are more manual and take much longer to process. Once you manually find a buyer, you have to process the transaction through your company.

Supply and demand sets the price in the private markets as it does in the public markets. The difference is that public markets are standardized and electronic, and private markets are not. In both cases, though, you have sellers asking a price for their shares and buyers bidding on shares.

If you are an employee or shareholder of a private company, you prefer a lot of demand from buyers. If there is an imbalance of buyers and sellers at a particular price, then the price of the stock will move to an equilibrium where supply and demand are balanced. Here’s a simple example. One fund decides they want to buy shares of your company at $10. If another fund also wants to buy your shares (more demand), they will likely have to bid at $10 or higher in order to have their order fulfilled. Add in a few more investors and you can see how the price continues to get bid up.

Unfortunately, for the majority of private companies and especially during this market environment, there are fewer buyers interested at prices sellers are asking. When this happens, the price tends to trend downwards as there are more shares for sale than there is demand to buy them. In other words, sellers who are looking for liquidity will often compete with each other on price to get their shares sold first.

Through a combination of sellers and buyers, an equilibrium market price is set and transactions happen at that market price. New buyers will look to put in bids at around the market price or lower. New sellers will look to put in offers at around the market price or higher. Depending on supply and demand, the market price may move up or down.

Here’s another simplified example. Let’s say that the market is around $20 with many sellers around that price and also buyers around that price. A new seller who comes to the market and lists their shares at $30 will be unlikely to be matched with a buyer in the short-term as these buyers will just buy the shares at $20.

The same goes for buyers who list below the market price. If a buyer puts in a bid at $15, they will be unlikely to be matched up to a seller in the short-term if the seller can sell for $20. But let’s say that multiple transactions get done at $20, and the buyers who were buying at $20 have fulfilled their orders and are no longer buying. That $15 bid may be the best bid in the market and if so, the price could move down.

🔎 What do secondary market investors look for?

Now that we’ve discussed how the secondary markets work, I want to discuss what secondary investors typically look for. Understanding this aspect can help you gain the edge in getting the best execution when you decide to sell your shares. One thing to note is that every investment fund is inherently different in their strategies so I’m going to speak generally and by no means is this meant to be comprehensive of all funds as there are always exceptions.

A majority of institutional investment funds will only buy common stock in late stage companies. While the term “late-stage” can be subjective, most companies with secondary market interest are usually the ones that are only a few years or closer to an IPO, valued in the billions, and have revenues in the hundreds of millions. This is primarily driven by the fact that larger later stage companies are generally safer investments than earlier stage companies. For this reason, there is usually not a secondary market for early stage companies even if the company allows sales.

It’s also worth mentioning that investment funds will always look to buy shares for as low of a price as possible. Most funds get paid on investment performance and the lower the price paid, the better the returns. Funds also need to balance execution with price, so availability to fill an order with committed sellers is also important (i.e. they are confident they’ll be able to get all the shares they are looking for in their target time frame).

On top of price, funds will typically look to fill their buy order with as few sellers as possible to limit the administrative work involved. If an investor wants to buy 1,000 shares of your company, they would most likely prefer to buy the full 1,000 from one party rather than 100 from 10 different parties. There are exceptions, perhaps they can buy at a lower price from 10 different sellers, but the legal cost of these contracts add up so volume does matter in the secondary markets.

Putting yourself in the buyer’s shoes will hopefully make things easier to become a successful seller when time comes.

📈 Some final tips to help you navigate a secondary sale

This was a simplified view into the inner workings of a secondary market and secondary investment funds. Understanding the basics will help you navigate the markets but be aware that things can be more complicated in the real world. Luckily you can get some help when you decide to go through the process.

If you’re looking to sell your shares in the secondary market, you will need to be working with a broker whether that’s an individual or a platform. As most things when it comes to finances, it’s a business of trust and it’s important that you work with only a partner who you trust. The best brokers will be transparent and brutally honest with you while also being able to explain the intricacies of the secondary markets.

Your broker should paint the picture of the secondary market for your company and help you understand the situation you’re in. If you’re in a situation where there are more sellers than buyers, you need to know, so you can make the best decision possible. Waiting for an extra few cents or dollars may leave you empty handed if there are limited buyers.

On the flip side, if you are in an enviable position that can command a higher price, you want your broker to fight for the best price possible for you. Of course a lot of this is dependent on your personal situation and needs so make sure you communicate that. Beware of the folks that only tell you what you want to hear.

Lastly, your broker should help you understand the current state of the secondary markets. On a macro level, we’re unfortunately in a period right now where there is high demand for liquidity and there are more sellers as a general rule. As always, there are pros and cons in trying to get something done now versus waiting and the partner you choose to help you navigate the market should be able to help you decide, even if it means waiting things out.

As always, we’re here for you if you need anything. Feel free to reply back!

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