7/27/2021

What Every Founder Should Know About Secondary Liquidity

As a founder, you often make sacrifices to build your company. You invest significant time, attention, and money into bringing the idea to life—sometimes putting off other major life decisions or taking zero salary for yourself. Even if the idea is successful, you usually have to wait years until you see a return. As the startup world and financing landscape evolve, however, the options for founder liquidity are evolving too.

Secondary liquidity is an opportunity for founders or other shareholders to sell a select number of shares to investors in exchange for cash—often before an official “100% sale” of the business. While this decision might have previously signaled a lack of faith in the company’s future value, secondary liquidity for founders is now widely perceived as a helpful way to meet near-time financial needs (especially for founders who have been in business for a longer period of time or take no-to-low salaries) while still being able to participate in the future upside of the business.

By relieving the financial pressure of waiting for a meaningful exit, secondary liquidity allows entrepreneurs to stay patient and focus on a startup’s long-term growth goals—a benefit to yourself, your early team, and your investors. It’s not an all or nothing: Founders can meet their immediate financial needs while still staying committed to their company and positioning themselves for further value and liquidity in the future. I often refer to this dynamic as “having a second bite at the apple.”

While you may have heard of secondary or shareholder liquidity, founders are often not fully aware of how it works. In this article, I’ll unpack an investor’s perspective on secondary liquidity—including why it’s becoming more popular, how to start a liquidity discussion, and what to expect.

Why secondary liquidity is becoming more popular

There are three main reasons why secondary liquidity is becoming more common. First, there’s just more money today in private markets. Second, it’s generally becoming less expensive to start and scale a business. And third, early founder liquidity is gaining social proof as a practical option.

1. More capital in private markets

The increase in capital has expanded funding strategies beyond venture capital, and the traditional “billion or bust” mentality—where companies had to go public or become a unicorn for the founders to see a return—is outdated. Today, founders have a variety of exit options available to them, from strategic acquisitions to growth equity to private equity buyouts. With an expanded set of exit options and more capital available in general, the opportunities for founder liquidity have become more accessible and flexible.

2. Increase in capital efficiency

In addition, capital efficiency has increased: While it’s certainly not easy to start a business, it’s generally less expensive to launch and scale a software product than it was a decade ago thanks to remote work, outsourcing, and cloud architecture. As companies generally need less funding to grow to the same milestones, private investors are re-evaluating how to guarantee meaningful returns. In some instances, funds are writing larger equity checks in general—and in other instances, they’re offering secondary liquidity to founders along the way in order to secure a more significant return or percentage of shares for themselves at the exit.

3. Positive feedback loop

Ten or 15 years ago, most investors balked at the idea of secondary liquidity. They wanted founders to believe that every company could be worth a billion dollars, so allowing founders to sell shares at a $50M or even $100M valuation seemed suspect and contrary to the bigger vision. Of course, as more founders pursue secondary liquidity without consequence (i.e. “This didn’t break the company, or hurt its future value”), the more other founders and investors have become willing to consider it as an option.

How to decide if secondary liquidity is right for you

Pursuing secondary liquidity is a highly personal decision. As a bootstrapped founder, it’s typical for most of your net worth to be tied up in an illiquid asset: your company. If you’re in need of more financial stability, secondary liquidity can be a supportive option.

Many of the companies in Elsewhere’s portfolio, for example, are capital efficient, bootstrapped businesses. For bootstrapped founders, every dollar matters: These founders accept no or below-market salaries, apply for second mortgages, or delay other life decisions in order to support the business. In addition, growth may be a longer road for bootstrapped companies, as you aren’t just throwing money at problems, but leveraging your resources incredibly strategically. We have empathy for a founder who wants to tap into some of the company value they’ve created—for family, a home, or other personal reasons—while remaining heavily invested in the company’s future.

Secondary liquidity might make sense for you if you’re a bootstrapped or capital-efficient founder aiming for a series of specific growth milestones before your complete exit. The early liquidity may not only support your material needs at the moment, but also extend your emotional and physical capacity for continuing to be involved in the business.

When to start a conversation about secondary liquidity

If you think you may be interested in secondary liquidity as an option, the best time to bring it up is during term sheet negotiations with investors.

Before you start a conversation with investors, however, talk to your advisors and mentors about secondary liquidity. Ask for their insight into your growth path and figure out why (and when) taking early founder liquidity could make sense for you.

With investors, wait to bring up secondary liquidity until you’re confident that they’re aligned with your vision, growth plan, and potential. Secondary liquidity can be a strong negotiating tactic—especially if you’re in conversation with multiple potential investors. You can define a potential dollar range of shares you might sell and outline it in your agreement.

In some cases, you can discuss secondary liquidity as an option outside of term sheets, but if you think it’s an opportunity you would ever consider pursuing, the conversation will be much smoother if it’s laid out at the term sheet stage.

Why we support secondary liquidity

For certain founders, we’ve found that selling a small number of shares back to investors can help foster patience for the next three to four years of growth—whether those years are spent working toward another major growth milestone or a final exit.

Our team understands the pressure of tying financial security to risk. Of course, we investors get to balance that risk between a portfolio of companies, while entrepreneurs bet on just one at a time. That’s why we’re supportive of secondary liquidity for founders in the right cases. The same logic extends to our support of majority investments in certain situations, too: We’ve partnered with founders who were eager to take a higher level of liquidity, while still maintaining a small stake to participate in the future upside.

While you may have made significant sacrifices as a founder, there are flexible ways to realize some of the rewards of your hard work along the way. Most importantly, you deserve investors who are as dedicated to your personal success as much as your professional success throughout your entrepreneurial journey.

Have more questions about the financing process? We’re launching a new series that honestly and transparently addresses founders’ capital and fundraising questions called Dear Investor. Submit your questions here.