Equity On Discount: How The Startup Secondary Market Is Shaping Up For VCs, LPs

Festive season sales are right around the corner, and it’s not just ecommerce marketplaces offering discounts. In fact, many of the startups running these sales are also being put on the market at steep discounts, thanks to the spate of secondary deals involving prominent Indian startups.

The wave of secondary deals in the first half of the year saw more than a dozen such deals, which gave early investors exits from the likes of Capillary, ixigo, Urban Company, Porter, and Pocket FM, among other startups.

Many of these deals came at a discount. Other similar deals such as Meesho are reported to be in the works as well which would see the ecommerce unicorn raise funds at a 20% valuation cut, while giving an exit to some of its existing shareholders.

And there are dedicated secondary funds being floated to accommodate this wave of secondary rounds. For instance, former Peak XV Partners managing director Piyush Gupta set up a secondary-focussed fund, which intends to work closely with Peak XV to facilitate secondary transactions involving the latter’s portfolio companies.

Similarly, asset management company 360 ONE Asset launched the INR 4,000 Cr Special Opportunities Fund-12 to invest in late-stage startups. The company claimed that this is India’s first alternative investment fund (AIF) dedicated to the private equity secondary market.

And many of these funds are coming into the picture for startups at a critical stage, closer to the exit point than early investors. This has given a lot of comfort to LPs that have been stung by the long-horizon primary investment route at the early stage.

Plus, the entry of new micro VC firms with tighter entry and exit points is also attracting attention from LPs, who are looking at returns through secondary deals in a couple of years, or even smaller IPOs on the SME board of the Bombay Stock Exchange.

The secondary market has several dimensions, with angel investors in the mix, as well as early-stage institutional funds, incubator-style funds (for example, Y Combinator), and family offices. And when we talk about VC firms or funds, it goes without saying that limited partners (LPs) are just as keen on getting the right secondary structure.

Incidentally, many of the angel investors that have found exits through secondaries in 2021 are also LPs in funds that executed these secondaries. In these cases, their investments as angels could very well have netted them a better return in 2021 than the capital they invested through a fund after that.

Exits are more readily available for angels since these investors enter very early in the company’s life cycle. Even some seed and growth funds might want to clean up cap tables during subsequent transactions. Angels are typically the first to get exits if the company is performing well. This is the key factor:

“That doesn’t change in any market or any stage. That, obviously, is a precondition or a given. But three years ago, the market had a fairly heady period post-Covid. Most of the funds are sitting on huge amounts of dry powder and have slowed down deployment. This has repressed some of the value that would have gotten unlocked with more consistent funding,” according to an angel investor, who runs a pan-India real estate company.

So today, these clean-ups are happening at a discount.

Raining Discounts For Secondary Investors

To put it plainly, secondaries are beneficial for outgoing investors in a good market. But with even primary capital slowing down, the current secondary market is heavily skewed in favour of buyers. Even in the case of strong assets, investors often face discounts, which is difficult for many to accept.

Today, the question isn’t whether there will be a discount, but how steep it will be. In late-stage deals, incoming investors are almost guaranteed a significant discount.

“Older funds want to exit, and they know they have an overvalued asset, so a small discount is palatable. But it’s not one or two companies that have gotten tremendously high valuation — pretty much every company did during the 2021 capital rush. Now many of these without a successful product-market fit have that money in the bank. The company’s valuation doesn’t get challenged because the company doesn’t come to the market for funds. If you’re not in the market, your valuation is not relevant. But as soon as you go to market, your valuation is shredded,” a general partner at a consumer-centric fund claimed.

We’re not yet past this phase. Over the next 6 to 12 months, more companies will likely seek funding, which will challenge their valuations. Some companies have realised that it’s better to manage valuations proactively by talking to current investors to create an exit path, even if it requires some sacrifices.

There are multiple instances of funds cutting valuations and companies raising secondaries during down rounds. We will see some of this continue to play out over the next 12-14 months. Many of these startups raised large amounts of capital in the 2020-2021 period. For them, secondaries are not very easy to come by.

“Many of these companies are going at a discount compared to their on-paper valuation, and this is not the liquidity discount that one typically sees in a good market. Whereas in a bull market, the discount ranges from 10%-20%, nowadays companies are being put on the secondary market for as high as a 50% discount,” a principal at a Mumbai-based growth and early fund told Inc42.

As one investor puts it, this is more of an “erosion” than a discount, but this is the reality for many venture capital firms looking to close the books on existing funds under SEBI guidelines.

Valuation Correction Or Erosion?

Many investors played their cards well during the liquidity boom of 2021, but by 2024, those same investors are struggling to exit their overvalued assets.

“We got a very good exit and with very good founders. There was a startup, which wanted to clean up the cap table. They wanted all the angels gone. So there are times when the incoming investor wants to clean up the cap table, especially the non-institutional players that have been around since the pre-seed days,” the principal quoted above added.

In many instances, angels would have preferred to remain on the cap table, but contesting larger investors could lead to greater value erosion. In the past, early investors may have fought against forced secondaries, but today, few are contesting them. Most companies pursuing secondary rounds are backed by funds nearing the end of their term.

“VC firms are sitting on dry powder, and if they are investing primary capital into the company, they like taking a little bit of a bite from the secondary as well. From that perspective, it helps them get a slightly better blended valuation. Here we are seeing lower discounts so even the outgoing investor is happier. It helps the new shareholders manage the valuation a little bit better,” said a Mumbai-based angel investor who has backed more than four unicorns at the seed stage.

The Tricky Secondary Market For Startup VCs

However, from an LP perspective, the outlook is less optimistic. Secondary deals are trickier for funds, as few companies can maintain their peak 2021 valuations. With many funds approaching the end of their lifecycle, they’re listing their best-performing companies for secondary sales.

“But the reality is that they have to sell off at least a large chunk of their portfolio, if not the entire portfolio. That’s where we are seeing some of the funds are either trying to create a continuity fund or buy out their own assets. But these are getting different kinds of responses from LPs,” added a Kolkata-based entrepreneur, who runs a family office that invests in funds and consumer brands.

As is often the case, some deals succeed, while others don’t. Opportunistic entities are stepping in, with LPs supporting secondary funds that buy the most attractive portions of existing portfolios. But this is easier said than done. Many companies with potential lack a clear exit path for large institutional investors.

The situation may improve over the next year or two. Even in a market ripe for secondaries, more capital is still going into primary investments. “No incoming institution will consider giving exit to outgoing investors as a primary objective. They will first look at the underlying investment, which means they want to allocate their resources to the company rather than the earlier investor,” noted a multifamily office manager in Delhi NCR.

This presents a significant challenge in the current market. SEBI has also increased pressure on funds regarding extensions, performance, and liquidation timelines. While the secondary market is becoming more significant for startup investors, many older funds will struggle to reach favourable resolutions.