Secondary Sales - An Angel's Best Exit Strategy
Secondary sales as a portfolio strategy offer multiple advantages, and the most notable advantages to that strategy is (1) the reduction of risk, (2) increased liquidity, (3) valuation gains, (4) portfolio realignment, which are not always available through traditional exit strategies such as acquisitions or IPOs. More on these advantages below.
In its simple form, a secondary sale is selling one's equity in a startup to another private investor or entity before the company goes public or is acquired.
Advantages of Secondary Sales
Liquidity
Secondary sales stand out for providing early liquidity to investors. Angel investors typically lock their capital into startups for several years and secondary markets offer a pathway to access funds earlier, which can be particularly beneficial in personal financial planning or reallocating capital to new investment opportunities.
Risk Reduction
Investing in startups is inherently risky, with many uncertainties from market competition to regulatory changes. Through a secondary sale, angel investors have the opportunity to reduce their exposure to these risks by selling their stakes before a definitive exit event, securing their returns earlier in the startup’s lifecycle.
Valuation Gains
Secondary sales allow investors to capitalize on the appreciation of the startup's value over time. By selling their shares at a point where the startup has demonstrated growth but before a public listing or acquisition, investors can realize significant gains on their initial investment.
Portfolio Realignment
For angel investors, portfolio strategy is key to achieving diversified and robust returns. Secondary sales enable the reallocation of resources to newer ventures, allowing investors to pursue emerging trends and opportunities without waiting for traditional exit events.
Let’s put this into practice with an example of an angel investor put in $150,000 into a pre-seed round and invested in a startup valued at $1.5 million pre-money. 2 years later, the startup raised 2 consequent round (1) a seed round 1 year after their pre-seed round, and (2) Series A round 1 year after their seed round at a valuation of $75,000,000 pre-money.
Initial Investment
Pre-Investment Valuation: $1.5 million
Investment Amount: $150,000
Investment Date: 2020
By investing $150,000 in a startup valued at $1.5 million pre-money, the angel investor essentially buys a 10% stake in the company. This is calculated as follows:
Ownership Percentage = Investment Amount / Pre-Investment Valuation + Investment Amount
Ownership Percentage = 150,000 / 1,500,000 + 150,000 = 150,000 / 1,650,000 ≈ 0.0909 or 9.09%
For simplicity, let's assume the post-money valuation here reflects a straightforward 10% ownership. The subsequent rounds of dilution are as follows:
Subsequent Rounds and Dilution
Dilution in Round 2: 15%
Round Date: 2021 - 12 months after the initial round covered by the angel investor.
Dilution in Round 3: 15%
Round Date: 2022 - 12 months after the 2nd round
When a startup goes through funding rounds and issues new shares, existing shareholders get diluted if they do not invest further to maintain their percentage of ownership. If the investor owns 10% before the dilution and does not participate in the new rounds, their stake will be diluted as follows:
After Round 2:
Post-Round 2 Ownership = Previous Ownership × (1−Dilution Rate of 15%)
Post-Round 2 Ownership= 10% × (1−0.15) = 10% × 0.85 = 8.5%
After Round 3:
Post-Round 3 Ownership = Previous Ownership × (1−Dilution Rate of 15%)
Post-Round 3 Ownership= 8.5% × (1−0.15) = 8.5% × 0.85 = 7.225%
Exit Scenario
Valuation at Exit: $75 million
Investment Lock-In Date: 2 years
Ownership at Exit: 7.225%.
The value of the angel investor’s stake at the time of exit is calculated as follows:
Value of Stake at Exit = Company Valuation at Exit × Ownership Percentage at Exit
Value of Stake at Exit = $75,000,000 × 0.07225 = $5,418,750
All in All…
With a holding period of 2 years, the angel investor initially acquires a 10% stake in a startup for $150,000, with the startup valued at $1.5 million pre-investment. After experiencing a total of 30% dilution over two rounds (15% per round), the investor's stake is reduced to 7.225%. Upon exiting after the third round, when the startup is valued at $75 million, their stake is worth approximately $5,418,750.
While this is an outlier case, this reminds us all as angel investors why we need to diversify our portfolio to increase our chances of investing in that outlier and this is why Falak Angels was founded. If you are interested in starting your angel investment journey but need the know-how and tools to be able to build your knowledge and network, apply your interest via: https://www.cognitoforms.com/FalakInvestmentHub/FalakAngelsApplicationsForm
Startups interested in announcing your rounds via Falak Angels? Apply now via: www.falakangels.com
