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VCs: Secondary Funding Markets Are A Double-Edged Sword

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A lot of things have changed in Silicon Valley in recent years — apps have access to a plug-and-play social infrastructure provided by the likes of Facebook and Twitter, the mobile boom has truly made the post-PC world a reality, services such as cloud computing allow startups to function at leaner levels than ever before, and so on. But for founders and investors, perhaps one of the most significant shifts has come from the increasingly common occurrence of late-stage funding rounds that are largely secondary stock purchasing situations.

In a panel discussion held last night by Wealthfront at the Rosewood Hotel, the longtime Silicon Valley dealmaking hotspot, VC heavyweights Sameer Gandhi of Accel Partners, Bill Gurley of Benchmark Capital, and Doug Leone of Sequoia Capital discussed the upsides and downsides of this seemingly unstoppable trend.

Robert Scoble was in attendance, and he captured the entire panel in the video embedded above — the panel starts talking secondary markets at the 47:00 minute mark. Sarah Lacy was also in the house, and you can check out her take on the evening’s discussion here at PandoDaily. To me, these were the most interesting bits:

According to Accel’s Gandhi, sites such as SecondMarket aren’t really as big on the radar of major VCs like him. The fact that founders are now getting cash outs before a proper exit (typically a sale or an IPO) is one of the most interesting things that’s happening now. “All the late-growth equity rounds are with some degree of liquidity, or a massive amount of liquidity. They’re not all primary capital. So that [earlier situation] of founder liquidity waiting for the IPO, that’s sort of a nonexistent factor,” he said. “That’s the more interesting part of secondaries than any of the organized, SecondMarket things, which in our case are total non-factors.”

Sequoia’s Doug Leone was quick to pipe up that he welcomes founders cashing out before the larger exit, since it gives them a reward for building a lucrative company up until that point and some degree of personal security — and, perhaps, the ability to continue to run the company while avoiding the dreaded burn out. “If you’re a young CEO and entrepreneur, and you own 30 percent of the company, and you can sell five percent or ten percent and put, say, $22 million in the bank and be safe, then go for it. I think that’s a good thing. Now, you do have to worry about [regulatory] things, the 409A. But somebody taking money out of the company, especially a growing company, is a good thing.”

There is a downside to this general “new new” funding environment of founder cash-outs, however. Leone went on: “Where we get offended is when a venture firm comes in to a company that has no revenue model, no revenues, and bribes a CEO and says, ‘We want to be your series A investor.’ Imagine this. Series A, and they haven’t done anything. And $2 million goes in [the founder's] pocket. That is a bad part of the secondary market that we hate to see.”

Bill Gurley of Benchmark also brought up how for companies, opening up themselves to secondary investors can be more trouble than it’s worth from an organizational perspective. Secondary liquidity is positive, he said, only “as long as it’s organized and controlled. But the problem is those markets actually can create disorganization, because they allow shares to flow down into the hands of people you don’t know. And you get many of the downsides of being public with less control over them. It creates a lot of risk, and a lot of 409A problems, and a lot of headaches. Don’t take my word for it — talk to the CEOs of the companies that have been exposed to it.”