Venture Secondaries with Dave McClure, Founding Partner at Practical VC (S1, E3)

Thanks for having me. Nice to see you again, Charlie.

Well, initially we were thinking about putting together a fund-to-fund platform for emerging managers, maybe similar to some stuff that VC Lab and a few other folks have been working on. And as we're going through that process, we were trying to think about investing globally and investing in early seed managers and got a lot of pushback on that being a tough story to go after. I still think it's an interesting area. But part of that story was trying to help people with liquidity and following on in some of the investments that our managers might be making. One of the ways to give them liquidity was buying secondaries. And as we got more into that, we realized that was a lot of unexplored territory, particularly at the fund level. And certainly outside the US, it's more challenging. Around 2020, I also was looking for some personal liquidity. I had a couple of funds that had done very well at 500 Startups. One of which had Canva and a few other assets in it. And I thought, okay, maybe I'll sell a little bit of my position and buy a house here in Silicon Valley, put some money away for the kids for college and some other things. It was actually fairly challenging to find a buyer for a more complex structure and fund interests even though some of the assets were really great. And long story short, I took some money off the table, which was great for me at the time, but kind of realized there's a big opportunity in doing these smaller secondary transactions, say below 5 to 10 million, which some of the other larger players have now moved beyond. So there's a whole bunch of opportunity in the secondary market. It's not really just one thing and over the last five, six years we've kind of explored that. And along the way we had COVID ups and downs and crypto ups and downs and Ukraine war and now Iran war and the AI boom. So there's just been all kinds of interesting things that have been happening in the secondary market and the growth of some really large companies.

For sure. Yes. Well, it worked out well in hindsight, but yeah, I think maybe I was early getting into some of that.

Well, the big thesis is just a shorter time to liquidity than a typical VC fund, which these days seems to be closer to 15 years than 10. It's just taken a very long time for many companies to get to an exit. That's kind of a result of public markets, at least in the US, requiring maybe half a billion to a billion in revenue or more for companies to go public. So the idea is like kind of take a company or a fund, cut the time to liquidity in half by buying in at halftime. That's kind of the idea that we talk about. And it turns out there are people who need liquidity after 5 to 10 years or want liquidity and depending on how much demand there is and how much supply, that can be an interesting area. A lot of attention obviously for some of the biggest names that are private, but there's also a market for a large number of companies that aren't in that top 10, 20, 50.

Oh gosh, it's different in 25 different ways I'm sure, but the biggest one being portfolio construction and time to liquidity and risk factors. So when we were investing at 500, I managed the first four funds there. We did roughly about 300 or 400 companies per fund, which is a little crazy, almost 2,000 across those four funds. And the attrition rates are high. We would typically see 60, 70% of those companies fail. Maybe half of them fail quickly within a few years. Half of them take a longer time frame and maybe they don't fail completely. They just don't generate a return. We'd have modest returns for maybe 20%, somewhere between 2 to 5x. And then really, the place where we were making money was probably in the top 10% of the companies in our portfolio that would hopefully have 10 to 20x exits, maybe five to 10 years. And then probably about 2% that would go public or have a very large exit. And some of those would take 10 to 15 years. In fact, some of them are still private. Canva being the notable one there. So that's just really asymmetric, very power law constructed portfolio design. We would probably make more than half of our overall return, if not two-thirds, from just that 2% and the remainder would probably come from that top 10%. So literally 70, 80, 90% of your portfolio is not generating material returns and most of the valuable returns come 10 years or more later. So that's a really challenging way to make money as I'm sure you are well aware. Whereas we look at what we do today, we probably look for liquidity in a three to five year horizon typically, looking at companies doing 100 million in revenue and up, hopefully growing at 30, 50% or more. So we're not so much guessing as to what's going to work. We're trying to bet on things that we think will get to an exit with high confidence in a short period of time.

Oh, oh, I see. Yes. Well, most of what people think of as secondary, at least outside the private equity world, people are buying shares of companies. And that could be through brokers on a marketplace or bilateral transactions or even company tenders. But people are generally buying a piece of a company that could be common shares or preferred shares. Could be more complex structures which are forward contracts. But you're usually evaluating a single asset and trying to understand valuation from probably later stage, Series C or D or later. So these are companies doing 50 to 100 million in revenue and up and probably have raised 50 to 100 million or more. And there's actual metrics to look at if you can get access to them. So that's a lot different than the... there's other secondary transactions that happen at the fund level. There's all different types of geographies where those might occur, although the majority of secondary transactions are probably in the US market right now. And again, you can get into very interesting and complex structure when there's not as many buyers for these assets. You can start to have additional structure around downside protection, maybe conditional payouts based on an initial amount and subsequent performance. But it's very bifurcated in the top names in the market, which are the majority of where the transaction volume is happening. It's more of a seller's market. There might be multiple layers of vehicles that you're buying into, multiple layers of carry fees as well. And sometimes you may not even know whether the seller has access to the assets. So it can get a little murky and crazy sometimes, particularly in some of the more in-demand names at the moment.

Well, I think we probably broaden that to not just be founders but also early employees and early angel investors as well. So this is anyone that holds equity in a company. There's slightly different dynamics for individuals who work at the company where they might be heavily concentrated in a single equity. And particularly founders, this is true, where they might have a very large position in the company. There's probably different stages of that founder's or early employee's career where they might only be looking for partial liquidity as the company's growing. Later, maybe as the company gets closer to an exit event, they might be looking for more substantial liquidity. And then there's also just employees who might want to be exercising part of their options and there may be some cost structures for them to think about there as well. I think the popular concern from a lot of investors, and this has maybe changed over the last 10 years, is if founders are cashing out before the company gets to a liquidity event, are they misaligned with the investors or are they getting too much liquidity before the company's really proven. Probably a company called Hopin is the notorious example where the founder took I believe tens of millions if not hundreds of millions off the table in an early stage round. This was kind of during COVID when a lot of the online meeting sort of stuff went crazy and that founder made a boatload of money. The company ended up being worth a very small amount of money later. So that's kind of an example of a very misaligned transaction. Kind of a function of the FOMO that was going on in the market at the time. There's some of that going on now too as a matter of fact. But I think what you would normally guess is that founders, early employees might be selling single-digit percentage points of their equity, maybe up to 10%, but that's maybe a lot. And they're trying to take maybe single-digit millions off the table to pay for some debts or maybe a house or help with early family planning stuff. So I don't think that's really going to create misalignment if they're just selling a small percentage of equity, taking a small amount of money off the table. The concerns are probably more if these folks are taking substantial double-digit percentage of their equity. Or if they're taking tens of millions of dollars off the table, that might create some misalignment with investors.

You know, this isn't so much our issue. We're buyers and we're not sitting on the management teams of the companies generally. But we have to be aware of what the overall dynamics are going on in the market. Numbers can vary a lot. I do think again there's sort of a balance between when the company gets to some level of product-market fit, maturity, and scale, but that's probably when the company's doing at least tens of millions of dollars in revenue. A lot of times people are identifying 30 to 50 million revenue, Series B or C sort of stages. Again, varies by business model and type, but when the company's had institutional rounds, multiple institutional rounds of capital and scaling substantially, you might suggest, okay, this company's figured out where it is in the market and growing. And that might be a time where at least it's not in a level of huge risk for the board and the management team to say, yeah, it's okay to take a little bit off the table. But I think the flip side of that is where there's actually a buyer for those shares. And that's where kind of we're seeing a concentration of focus around just a small number of names that are doing billions of dollars of revenue. You mentioned somebody taking money off the table at seed. That's very unusual. Even at A or B, it's kind of unusual unless we're talking about a really hot company or something. So it's pretty typically more like five to seven years in where there's a match of founders, early employees wanting liquidity and there being liquidity available.

Well, from the founder perspective, I don't know that valuation is the driver so much. Again, it's more like where's the company in its path to product-market fit and maybe in terms of an exit potential. But I think more and more we're starting to see this historical position of trying to keep founders in some kind of illiquid equity cage. That's not really a viable strategy these days. Again, the market defines more that liquidity than maybe the management team or board. So what we are seeing is that companies are staying private longer. That's a function of the capital markets requiring more revenue and that's creating misalignment with sort of vesting schedules, right? When employees are vesting in a four-year time frame and the company takes 10 to 15 years to get to an exit maturity, that's way out of whack, right? So at its essence, that's really the issue that nobody talks about is that vesting schedules are really misaligned with companies. As people maybe contribute to their companies and then decide they want to move on, what we're starting to see is more challenges around how do they finance their options, exercise their options before a company gets to a liquidity event. So not always an issue maybe for founders unless they leave or move on, but definitely an issue for a lot of employees where it may be expensive to exercise options, there may not be a price in the market for those options. If they leave, they might have to exercise within 90 days. So those are the dynamics that I think we're starting to see. And as companies are getting larger, some companies are offering regular tender offers. This is organized secondary sales by the company on an annual basis. And for very large companies like Stripe and Canva and others and Databricks, that's starting to be pretty common. That's not as easy for companies that are doing less than maybe hundreds of millions or billions of dollars to pull off. So still, secondary sales prior to 100 million in revenue, maybe Series C, is not very common. And so this is a high-class problem that's only available to maybe a handful of companies. It's not typically available to most Series A or B companies. And even for some Series C companies, it's not always typically available.

Yeah, it comes from both. I mean, if we're talking to founders or former founders, it might be a portion of their ownership. We did a deal last year with a former founder who moved on to another company. He was one of four people that founded the company. He probably owned somewhere between say 5 to 10% of the company. This was a company doing 50, 60 million in revenue, had already raised 100 million, but even at that stage, the company had been valued I think at 800 million a couple years back, there wasn't a huge market of buyers. And we ended up doing a rather complex structure using a forward contract. So I do think that there is a market for secondary that happens for very mature companies but it's still kind of nascent for companies that haven't really gotten to a certain size or level. So for us, the transactions we look at are probably typically 1 to 3 million, maybe up to 5 million in size. But for some founders they may be looking for more than that. For employees as you mentioned, that's probably a little bit more of a fit for us, maybe early angel investors and some seed funds as well. Slightly similar but different math at the fund level as well.

Yeah. So, just to explain that a little bit. Sometimes people sell and there's an exchange of shares that usually requires the board or management company's approval for that transaction. And sometimes that's okay. But sometimes it's not. And sometimes the company wants to maintain control over who their shareholders are. They may have what's called a ROFR or right of first refusal on any transaction. They may block or reject that transaction if the seller or the buyer is not someone they want. There may be tax-related issues for the seller where if they're trying to avoid a taxable event, they don't want a sale to happen. Or there may be what's called QSBS treatment. That's a term for reduced taxes for qualified small business stock in the US. So there may be a number of scenarios where either the seller or the buyer don't want an actual sale to happen. They want an exchange of economic interest. I give you a dollar today, I want either the shares or the economic value of the liquidity event in the future. So we talk about a forward contract. It's an exchange of money today for an economic interest that gets settled in the future. And sometimes there may be additional terms in there that allow for extra collateralization. So, I may buy a dollar's worth of shares from you, but I may want you to set aside two or three dollars' worth of shares to hit a target that I want for an absolute multiple or an IRR target.

Unfortunately, they're very limited for most funds that aren't already to some level of maturity and some level of big win. Things get generally more complicated when you go from a single asset to a basket of assets. So difference between a company or a fund. It's even more complicated when you're talking about a carried interest, which is kind of a derivative construct of profits as opposed to the LP interest which has asset value immediately. It gets more complicated when you have a smaller size transaction that's maybe not of interest to a buyer. Gets more complicated if you go from Silicon Valley to the rest of US to the rest of world where there's less competitive capital markets and less precision maybe in some of this data. So as you get outside a single large asset that's very attractive that might be a seller's market, as you get into more complex asset structures and maybe outside capital markets or small sizes, it becomes more of a buyer's market. So that's kind of the dynamic there. For folks who are running funds, they may be looking for liquidity for different reasons. They might be looking to take some money off the table in some of their bigger wins. So as an example, we were investors in Credit Karma pretty early and we sold partial secondary when I was running 500 Startups in that company three different times when it was valued at maybe half a billion, at a billion, and three billion, and eventually exited for nine billion to Intuit. But we sold between 10 to 20% of our position three different times in that company to sort of derisk. And sometimes that can be a good or bad decision, but that might help the fund manager with liquidity in a particular asset or reduce their risk concerns. They might also want to offer liquidity to all of their LPs. And so there might be sometimes where they're helping manage a transfer of an LP interest where an individual investor wants to get out of the fund or wants to sell. Or they may do a transaction at the fund level where they're selling an overall piece of their fund. That's kind of something that might happen. Also they might arrange a continuity vehicle when the fund's later in life. I might have started out with 30, 40, 50 investments. Fast forward 10 years later, there's really three companies that might matter. I might restructure and take those three companies into a new vehicle, have a conversation with my LPs about whether they want liquidity now or whether they want to roll into the vehicle. And then lastly, as we were talking about, there might be carry for the general partner where they want to try and realize some of the value of that carry sooner than maybe when the fund gets to full maturity, which could again take maybe 15 years.

Yeah. Well, I think what we're starting to see now is these structures are often described in the private equity world as GP-led or LP-led, where the GP is arranging a sale on behalf of the fund or all of the investors in the fund. And LP-led might be where the LP is selling just their position in the fund. And then we also might have where that's a single asset or a basket of assets. At least on the GP side, they might have that option. Right now because we're starting to see more people get into the secondary market, I think you're seeing an increase in fund-level secondary. The majority of the market historically has been company-level secondary, individual assets. But now we're starting to see similar behavior as has happened in the private equity market. These funds that are getting to 10 to 12 years, end of life is usually 10 plus two, but the fund still has great assets in it that might take 15 years or more to get public. And so some LPs might be patient enough to wait, some might not. And so we're seeing this kind of GP secondary restructuring into continuity vehicles where there's really an arranged sale with a third-party evaluation of the overall portfolio. Again, you might break that up into the higher quality assets and the lower quality assets where the higher quality assets are restructured into a new vehicle that has another five-year time frame on it. And the LPs are offered partial or full liquidity or they can roll with the new vehicle. So that's kind of nascent, but that is probably one of the fastest growing parts of the market, especially for larger ticket items. These are like hundred, multi-hundred million dollar transactions or even billion dollar transactions. That's very different than kind of what we do, which is more in the single-digit million dollar transaction with an individual seller. We might work with a GP on a carry deal structure for a smaller vehicle. Or we might buy out an LP interest in a fund where that might be an LP holds out a $1 to $5 million value interest. But again, there's lots of different sizes and transactions that might occur there. This is still not very common outside the US. Again, if we're talking about private equity, there's a lot of maturity in the market both in US and Europe. In venture capital, it's mostly concentrated in the US, and there's still maturity happening in the secondary market in the US. So that's even tougher outside the US, but it's very tough in emerging markets. We have done some transactions in Africa, in Europe, and Latin America. We have a partner, about 10% of our capital we're deploying in Latin America. There really are very few secondary firms across all of South America. I think there's one or two that are dedicated to venture. We're working on a $10 million secondary pooled vehicle right now. And one of the reasons we're doing it is because there's not much liquidity in that market. If you look at markets like Africa or Southeast Asia, there's hardly anything going on there. In India, there's some activity, but again tends to be in larger names and more individual buyers. There's not as many organized venture secondary funds outside the US.

I should say there's nothing going on and we've done one transaction there and we've looked at a few others. Actually, I guess we've done two. We bought a small secondary interest, LP secondary interest in a fund in North Africa as well. So we've done one direct and we've done one fund secondary in Africa. It's a function of there not being as much development of that overall market. So there's been very few IPOs. I think probably Jumia is maybe the only one of significant note and there's been a small number of large exits probably in payments and maybe in e-commerce. But there's not like in India you have hundreds of companies going public at least in the last couple years. There's no large public market in any single geography in Africa. I mean, I'm sure there are some regional opportunities there, but those are not super large. And at least not yet. We haven't seen multiple billion-dollar companies coming out of Africa. There are a few, but that's still kind of limited in scale. I'm sure it will get there over time. But if you kind of had to look at global south markets, I would probably say India, South Asia is the most developed, maybe Latin America second. Southeast Asia has had some opportunities in the past but it's more challenging right now. Middle East has certain markets that are developed. Saudi in particular and UAE to some extent. But again, it's a little bit smaller although that has been changing in the last few years in Saudi. Africa is probably the toughest story overall at least right now. With the exception of some activity maybe in Southern Africa, Western and Eastern Africa, but even those areas it's still a little bit challenging in terms of size and scale.

You know, we started out with a focus on more complex fund-level secondary. We've kind of come back to doing more direct now just because we found a niche in the market that is overlooked. Again, depends on what we're talking about from a buyer or seller perspective what the right strategy is. In some cases it is a zero-sum game where it's advantageous for a seller and not so much for a buyer and other places vice versa. We're probably a little bit limited by our size of capital and our check size. Sometimes that's an opportunity we think. But we manage a little over 100 million. Our second fund was about 50 million in size. So we wanted at least 15 to 20 transactions, maybe a few more than that. So ticket size for us was about 1 to 3 million and we're probably still continuing that in the current fund. We've done a few large transactions where they're multiple assets and those might have been 5 to 10 million, but in general, we're trying to arrange a portfolio of about 20 assets. That gives us enough diversification to feel comfortable and then depending on our fund size, divide by 20, that gives us maybe a median ticket size. So we wouldn't typically do something much smaller than 250 to 500K unless it's opportunistic. Wouldn't typically do something much larger than 5 million unless it was really compelling or presented some diversification. So that's kind of how we think about it. There are really lots of different opportunities to go after and it depends on the seller's concentration and structure. And so some people have a desperate need for capital and that creates an opportunity for discounts. Some people are less pressured sellers but they might be interesting assets. And so that dynamic drives a lot of structure. Again, if there's restriction on sale where it might not be available as a normal transaction, we might do a forward contract structure that might be something that other buyers can't do and so that might give us an advantage in the market. For many people, they don't want to buy indirect assets at the fund level. They only want direct assets. Or they might only want things where they've got high visibility on the financials and information. So depending on how comfortable you are with either a specific direct structure and ownership versus indirect and more complex structure and maybe lack of access to financials, that might change your ideas for strategy. For us, we're willing to do more complex structures, less conventional structures. We feel like that gives us an edge in buying assets that other people wouldn't go after, and as a result, we can get really great pricing on those assets. But there's also some times when we look at stuff that's more competitive and interesting to go after. That's not as typical for us. We're usually trying to be the only buyer in most transactions that we're operating in.

Oh yeah, it's really different. I mean, I'd say if you're operating in the primary market and you're doing particularly early stage or competitive deals, you're mostly competing on price. You're trying to compete maybe on your value-add to the company. You're racing to do deals under a very short timeline and maybe limited information. So deals happen in months or weeks, not typically multiple months. And usually you're just competing on what the valuation of the company is or how big your check size is or what your perceived added value to the company is. It's very different than in the secondary market or at least the types of deals that we want to get into where it's not very competitive. At least for us, there's again certain types of secondary transactions which are extremely competitive. But that's not usually where we play. We're not trying to pitch a value-add. We literally add no value whatsoever. We're not sitting on boards. We're lazy and I guess I would say very metrics, numbers-oriented. We're just providing liquidity. The value-add way I guess we would say is we provide liquidity to someone who might not otherwise get it and we can operate in more complex structures than maybe other folks. So most of our effort is focused on the transaction itself and then just waiting for a...

Liquidity event. There are a small number of people that are really operating in the areas that we do, and so for folks who are looking for liquidity, there's kind of a short list of names for them to go to figure that out. So a lot of our traffic is inbound. Some of it is happening just through our network. I mean, I've been in the valley for over 30 years. I've been investing here for over 20 years. I've done deals with literally hundreds of VC firms and other investors. So I'm modestly well known around the valley, and so that kind of opens up a set of opportunities that might not be available to someone who's less well known in the region and just gives us visibility to deal flow. But you know, strange and random ways that people come to us with deals. I've had Twitter conversations with people that ended up turning into deals. I've hung out in a restaurant or bar that turns into a deal. Other people who've done stuff refer us in. I guess more recently we've started with the podcast and trying to do some education and outreach on our website, and that's a little bit more broad-based. That's very different. You know, there's other people who are brokering a small number of names who are extremely competitive, and for them maybe it is more like the primary market. But for us, I would say, you know, because the secondary market is more opaque and less competitive than the primary market, it creates an opportunity to do structures that you wouldn't see in the primary market. And we're not, I don't say we're completely lazy, but you know, we're not rushing to do deals. We do deals typically over a quarterly time frame. You know, like my fastest deal we do might take a month. Longest deals maybe three months, but we've had a few that have taken, you know, nine months. I'm working on one now that I've kind of been working on for two years. Kind of amazing. So very different structure and timeline than a traditional primary market deal.

It really is. Yeah. I mean normally you underwrite and want to pay for it, but you know we also are trying to figure out like what does the seller want? You know, what do we want? And sometimes, you know, we try and close the gap on a difference in pricing or discount with structure and so really try to figure out how do we get the seller's needs met, whether that's structure, liquidity, size, price, whatever, and how do we get a return that makes sense for us and our investors. I mean, anecdotally, in fund one, which is 2018 vintage for us, we did zero secondaries acquisitions. In fund two, 2022 vintage, we've already done five I think it is.

So there's, you know, we're actually finding opportunities to buy into. We've always done it with the primary plus secondary, but there's always been that combination, but it didn't exist before.

Yeah. I mean you've identified an interesting part of the market where a primary sale is combined with a secondary sale, and that is starting to become more common. Maybe not at seed and A as much, although it starts to happen at A and maybe later in B and C where, you know, early angel investors might be sitting on a 10x or more return and they might be willing to sell part or all of their position to institutional round investors at A, B, and C. That can happen. People sometimes might call that cap table cleanup. I don't know if I really love that word because it's really not exactly what's going on. But you know, different time frames and risk tolerance for maybe earlier, smaller investors than later stage institutional investors. And it does present an opportunity for institutional buyers to pick up shares from earlier investors or the company founders occasionally maybe at slightly lower prices. And we've done secondary transactions which have been a combined primary and secondary at the same time. That's also been useful.