(i) Asymmetry in venture: dispersion in early stage returns, information asymmetry and negative signalling
Returns in early investing can be best described by a Power Law distribution, that is the majority of returns are made by a small number of portfolio investments. In addition to this, early stage VCs often invest in businesses characterised by high information asymmetry: the best investors will be intimately familiar with the space they have invested in and have significant operational and financial know-how, but nothing substitutes for the information you get being in the business day to day. The more disruptive and fast moving a startup is, the more investors pay attention to signals made by the startup about its probability of success, in addition to the other information being provided directly. This is equally important for employees who know that a large part of their compensation package has a very low probability of being valuable and a very high probability of being worth nothing at all. All shareholders watch management signals avidly.
Why do we care?
In the absence of contextual information, shareholders will usually settle for the simplest interpretation of a signal (that’s the thing about signalling) and take management desire to do a large secondary sale as an expression of doubt about the viability of their projections, a lack of commitment to their vision or a high internal discount rate. None of these are good from an investor perspective.
This can become hugely problematic for a high-performing startup and all shareholders, in the context of future rounds and indeed for the secondary transaction itself. Great teams can find themselves in an unnecessarily difficult situation. We have walked away from several high quality businesses because we could not reconcile the amount of secondary being asked for with management conviction - a logic which most investors abide by.
As discussed, there are often entirely valid reasons for secondary liquidity. So how can management solve for this negative signalling? By framing the discussion very carefully. That means being thoughtful about (i) the timing, and (ii) the amount of secondary while (iii) being as communicative as possible with current shareholders. The earlier the sale and the larger the quantum, the greater the likelihood this is a negative signal and will rightly be interpreted as such.
The sensitivity investors show about secondary isn’t just to do with signalling about the current performance of the business, it’s also to do with the role equity plays in startups over time.
(ii) Restoring symmetry and the principle of reciprocity: skin in the game as a guard against adverse incentives and moral hazard
The principle of equity funding in venture is predicated on great teams sharing some of the value they create with investors, in exchange for investors taking on significant financing risk. Equity compensation and "skin in the game" enshrines the principle of reciprocity between investor and founder and can guard against adverse incentives and certain negative outcomes. In the startup world, having unrealised equity gains is an important safety valve both investors and founders use to keep teams hungry, either by technically limiting the risk of moral hazard (founders increasing their risk unacceptably when liquidity acts as a financial insurance policy), disincentivizing the entrance of bad actors (venture as the ultimate ponzi scheme with teams raising ever larger rounds and cashing out) or, more benignly, correlating effort to reward.
Given the dynamics described above, excessive and poorly timed liquidity can create as many complications and adverse incentives as pain points it solves. Hence investors usually set parameters around the acceptable secondary amount for founders and the stage at which it should be considered. As a good rule of thumb, we would not expect a founder to sell more than 10% of their overall holding at the growth stage.