The Business Angel's Cash-Out Guide

Early-stage investors should expect the highest ROI because:

• They bear the highest risks, investing in startups before success is proven.
• They invest earlier, resulting in a mechanically lower IRR than later-stage investors.
• They typically face higher risks of dilution, liquidity preferences, and more.

Traditional exit paths include:

• IPOs
• M&As (by another company, equity, or LBO fund)

However, IPOs and M&As have become less relevant for early-stage investors. Secondary transactions are now more popular, and if you are an early investor, you should definitely focus on this track! We tell you why, and how.

1. IPOs

IPOs have significantly reduced in volume and proceeds compared to 2020-2021, although there has been a slight catch-up in early 2024. This slowdown in IPOs has a major impact on proceed expectations since IPOs typically offer multiples that are 40% higher than other cash-out alternatives.

2. M&As

Since mid-2022, M&A activity has also declined in both number and value. Increasingly, M&As are being executed at lower valuations than the last funding round, negatively affecting investors' expected proceeds.

Early-stage investors are especially impacted by these lower valuations in M&A transactions. Typically, early investors hold common shares, whereas later investors negotiate preferred shares, which come with liquidity preferences (e.g., 1x, 2x). If an acquisition happens at a valuation lower than the last round, preferred shareholders have priority in receiving proceeds. Consequently, early investors with common shares (often pre-seed/seed investors) may not receive any proceeds from their investment.

3. Secondary transactions

The third option for early-stage investors to monetize their investments before an exit is through secondary market sales. The advantages include exiting earlier, setting the terms, and potentially maximizing ROI and IRR. 

Here is a guide in four rules we put together to help you maximize your investment returns.

‍Rule 1: Prepare your secondary - Understand the terms

‍Most difficulties in secondary transactions can be avoided by considering exit strategies during the initial investment discussions. An investor will find a smoother path to exit through a secondary sale if the investors takes it into account when signing the terms, avoiding any deterring conditions for secondary buyers.

Understand the implications of your investment contract

Depending on the type of investment contract, you will have varying degrees of flexibility.

‍Direct Investment‍

The most straightforward case: the investor directly owns shares in the startup. Subject to the conditions discussed below, you can freely transfer shares to other private investors.

‍SPV (Special Purpose Vehicle)

• Flexibility: An SPV offers more secondary flexibility than direct investment. Approval is needed from the SPV representative, not the startup board. Secondary terms are often defined in the SPV agreement and are usually less sensitive since they don’t create governance issues for the startup.
• Drawbacks: Selling shares of an SPV may be less attractive because:
  • You have no say if the startup allows shareholders to conduct secondary sales; this decision is made at the SPV representative level.
  • There is usually a carry, which negatively impacts potential proceeds and thus the sale price.

‍SAFE (Simple Agreement for Future Equity)

‍Typically, a SAFE is not transferable (check your SAFE terms to confirm this). Until a conversion event occurs (generally an equity financing), secondary sales are not possible. However, there are different ways to monetize a SAFE, which we will discuss in another article.

Be aware of the key legal terms impacting potential secondary transactions

When investing, there are various terms you may accept without fully understanding their impact on secondary transactions. Depending on when you invest and your negotiating power, you can either oppose certain terms or at least be aware of their potential risks.

• The Right of First Refusal (ROFR) (or “Pre-emptive right”)

When a shareholder engages in a secondary transaction process, he needs to notify the other shareholders of this transaction. The ROFR gives the other shareholders the right to pre-empt this transaction and buy.

Risk

This right can deter potential buyers from engaging in the transaction. Secondary investors may fear investing time and resources into due diligence and sales discussions only for the transaction to be pre-empted by others.

Additionally, if they are some rights associated with certain ownership thresholds and the secondary buyer ends up.

Tips

‍Anticipate discussions: Talk to founders and other shareholders early to gauge their willingness to accept or pre-empt a secondary transaction. This helps build your case in the event of a conflict.

‍Opt for ROFO: Consider a Right of First Offer (ROFO) instead of ROFR. This inverts the sales process: you first offer your shares to existing shareholders at a predefined price. If no one shows interest, you can offer them to third parties without risking preemptive opposition.. 

• The Liquidity Provision

A liquidity clause requires the founders to offer a liquidity solution for the investors (e.g., through an IPO, a buyout via an LBO, or appointing an investment bank to find a buyer) within a defined timeframe (generally 5 to 7 years after the investment).

Tip

Many founders fear such provisions as they may feel pressured to sell. Always understand the founder’s perspective and try to find a compromise, such as a price threshold or other provisions that assure the founders this clause won’t be used against the company's interests.

• Shareholder Agreement authorisation mechanisms 

Shareholder / Board authorization mechanisms may be explicit in investment agreement or shareholder agreement. Sometimes, this authorization mechanism may be less explicit. You may either find it in other legal documents, such as the company’s organizational documents or corporate law in the relevant jurisdiction. Other indirect approvals include:

• Inadvertent Triggering of Liquidation Waterfall: A change in control may trigger liquidation.
• Free Transfers: If the secondary sale does not fall into the Free Transfer list defined in the shareholder agreement, board approval cannot be waived.
• Non-compete provisions: These prevent shareholders from investing in companies with competing business activities and may deter secondary sales to certain shareholders.

Tips

There are legal “tricks” to avoid these selling restrictions, such as:

‍Upstream transfer: If shares aren’t owned directly but owned by an entity, the secondary buyer may acquire the holding company or part of it.

‍Total return swap: The buyer and the seller can set up an arrangement that provides the seller with indirect economics of a direct investment. In the event of liquidity, proceeds may be transferred directly to the secondary buyer under the total return swap agreement.

Risks

These tips come with potential risks, including:

• Complexity and cost of structuring such agreements
• Increased risk for the buyer, especially with total return swaps
• Opposition to these legal structures under the shareholder agreement

‍Rule 2: Chose the good timing

‍The optimal timing is usually in parallel with a fundraising round for four main reasons:

• Valuation: Founders may be reluctant to authorize transactions that set a price for their company, potentially contradicting their valuation rationale.
• Data Room: Secondary buyers often require confidential data to inform their investment decisions. Outside of a fundraising process, startups generally won’t have this data readily available to share.
• Opportunities Created by Financial Rounds: Startups may use financial rounds to trigger secondary processes, either offering a mix of primary and secondary shares to new investors or providing liquidity for their employees or themselves.
• Suboptimal Sales Outside Rounds: Outside of a financial round, any sale is likely to be suboptimal. If the price is lower than the share value, it will be pre-empted. If it is higher, the buyer gets a bad deal, which isn't attractive.

‍Identify the Best Round to Exit Depending on Your Investor Type

‍Generally, the best round to exit for an early-stage investor is around Series B because:

• Before this, you are still in the early stage of the process. Leaving at this stage may be seen as a lack of trust and support in the project.
• Considering the risks taken at pre-seed/seed stages, the expected return may be less attractive than exiting after Series B.
• From Series B onwards, you may face higher dilution risks with more sophisticated funds entering, bringing more sophisticated terms (such as ratchets or preferred shares) that may be detrimental to early-stage investors.

‍Communicating ahead of time with the startup

‍Define clear expectations with the startup you invested in. They are your best allies in envisioning a liquidity event:

• They may receive offers from potential buyers interested in a secondary sale.
• It pushes them to build a liquidity scenario for their investors.
• They may structure the upcoming fundraising with a portion coming from secondary sales.
• It may encourage founders looking for personal liquidity to organize a secondary process for themselves and investors.

Getting the startup's support in the secondary transaction is essential to create your secondary data room and share relevant and accurate information with potential buyers.

• Why can a secondary come to you before you even asked for it: When a startup gets more mature, several reasons can push founders to consider a secondary scenario:

‍Why a Secondary Sale Might Come to You Before You Ask for It

‍As a startup matures, several reasons might push founders to consider a secondary scenario:

1. Cap Table Cleanup: Founders may need to clean the cap table ahead of a financing round. Early stages often involve many different business angels, which can deter professional funds. Many investors on the cap table mean slower decision processes, heavier administrative burdens, and increased shareholder management frictions. Options include:some text
   • Offering new investors the chance to buy these shares on the secondary market at a discounted price.
   • Constituting an SPV to hold all business angel shares to facilitate management.
   • Proceeding with a share buyback to decrease the number of shares and increase ownership for remaining shareholders.
2. Love Money Investors: Founders may want to provide liquidity options to early supporters who invested out of "love" rather than rational investment. Even if you are not one of these investors, you may benefit from tag-along mechanisms allowing an early exit.
3. Negotiation Leverage During New Funding Rounds: While founders may resist decreasing the new round valuation, they may negotiate the actual price by offering a mix of primary financing at the defined company valuation and secondary financing at a discount, justified by lower liquidity and investor interest to sell.
4. Provide Liquidity to Employees: Being an attractive employer is crucial for success. Compensation is a central part of the company’s strategy to attract, satisfy, and retain talent. Therefore, secondary pool liquidation can be coordinated with the sale of historical shareholder stakes to provide liquidity to employees. This approach helps maintain a motivated workforce and aligns employee interests with the company’s growth and success.

‍Rule 3: Set the right price

‍When a secondary path is identified, the seller needs to structure the offer. Once potential buyers are identified and selling barriers are cleared, the next challenge is to set the right price. There are two main types of parameters to integrate into the pricing process:

Timing

• In Parallel with a Financing Round:‍
  • Use the fundraising valuation as the starting point. This provides a current and market-validated valuation reference.
  • Apply a discount to this valuation to account for the fact that secondary transactions typically involve less liquidity and higher risk compared to primary financing. The discount rate can vary depending on market conditions, the specific characteristics of the shares being sold, and the urgency of the sale.

• Out of a Financing Cycle:‍
  • Use the most recent valuation as a benchmark. This valuation should be adjusted based on the startup's current fundamentals
  • Adjust the price according to the type of shares being sold (discussed below).

Ultimately, the price is an adjustment between supply and demand. Valuation will be influenced by the fundamentals and the interest level among buyers versus the quantity of shares available for sale. In periods of high demand, prices might be closer to primary market valuations, whereas in times of low demand, discounts may need to be steeper.

Characteristics of the Shares

• Share Class:
  • Common Shares: These typically have less seniority compared to preferred shares. In a liquidation event, common shareholders are paid after preferred shareholders, which usually means a higher risk for common shareholders.
  • Preferred Shares: These often come with liquidation preferences, meaning preferred shareholders get paid before common shareholders. This seniority can make preferred shares more valuable and less risky, often justifying a higher price.
• Rights Related to the Shares:
  • Corporate Rights: Shares with voting rights or board representation can be more valuable as they provide more control over the company’s decisions.
  • Shareholding Rights: Shares with additional rights, such as anti-dilution provisions (ratchets) or the ability to participate in future financings, can command a higher price.
  • Dividend Rights: Shares entitled to dividends might be more attractive to buyers looking for income as well as capital appreciation.

In practice, setting the right price involves balancing these factors to reach an agreement that reflects both the seller's and buyer's perspectives. Sellers should be prepared to justify their pricing based on a thorough understanding of the company's financial health, market conditions, and the specific attributes of the shares being sold. Buyers, on the other hand, will weigh these factors against their investment criteria and risk tolerance.

‍Rule 4: Build your selling strategy

‍Building the strategy

Building a successful secondary strategy requires careful planning and consideration of multiple factors. These include understanding the market conditions, aligning with the startup's fundraising cycles, setting an appropriate price, and ensuring compliance with any contractual obligations. Here are the key steps:

• Strategic Planning: Develop a clear plan that outlines your objectives, the desired timing for the sale, and the expected financial outcomes. This plan should also consider any potential obstacles and strategies to mitigate them.
• Legal and Contractual Review: Ensure that your proposed secondary sale complies with all relevant legal and contractual requirements. This includes reviewing the shareholder agreement, investment contracts, and any other pertinent documents.
• Collaboration with Stakeholders: Communicate your intentions with the startup’s founders and other key stakeholders. Gaining their support can facilitate a smoother transaction and access to necessary information.
• Market Research: Conduct thorough research to understand the current market conditions and demand for secondary shares in your specific sector. This will help you set a realistic price and identify potential buyers.
• Documentation and Preparation: Prepare all necessary documentation, including a detailed information memorandum, financial statements, and any other materials that potential buyers might require for their due diligence.

The Datasset team can assist you in running this process efficiently. Reach out to us so we can work together to determine the best approach for your specific situation.

Identifying the Buyer‍

Finding the right buyer is crucial for a successful secondary sale. Here are some strategies to help identify potential buyers:

• Secondary Platforms and Funds: Leveraging a secondary platform or fund can streamline the process of finding a buyer. These platforms and funds specialize in secondary transactions and have extensive networks of potential buyers.some text
  • Top Platforms/Funds: Datasset has identified the top 10 secondary platforms and funds that can help you find a buyer more easily. These platforms offer access to a broad range of investors, including institutional investors, family offices, and high-net-worth individuals interested in secondary market opportunities.
• Direct Outreach: In addition to using platforms, consider reaching out directly to potential buyers who have shown interest in similar opportunities. This can include existing investors in the startup, strategic investors in the industry, or other venture capital funds.
• Networking: Utilize your professional network to identify and connect with potential buyers. Networking events, industry conferences, and personal connections can be valuable resources for finding interested parties.
• Advisors and Brokers: Engage advisors or brokers who specialize in secondary transactions. They can leverage their expertise and networks to help you find and negotiate with potential buyers.

If you want to get a list of the 10 best platforms/funds identified by Datasset, please reach out to us. We are here to support you through every step of your secondary transaction process.