Are VCs Paying Portfolio Companies to Stay Private?

Welcome to Bite Size, an invite-only publication for private market limited partners that shares focused insights and fund updates from Jackson Square Ventures. Our first post is from JSV Managing Director, Victor Echevarria. 

For the past few years, many VCs have subtly encouraged companies to stay private by misaligning incentives between management and shareholders. Fund managers often blame the extended illiquidity entirely on outside factors. You’ll hear about macro-conditions, hostile regulatory pressures, and public market investor strategy shifts. The supposed new requirement to IPO, says Coatue, is “$1B of high margin revenues” leading to a $10B market cap.

This is all true, but questionable VC behavior also drives extended illiquidity. Many investors pay companies to stay private by offering founders and employees liquidity through secondary sales. Adding insult to injury, boards often further dilute shareholders with generous (and dilutive) stock-based compensation packages to re-up founders. Reducing these practices will restore the alignment of interests between management teams and investors by focusing management on liquidity events that benefit all shareholders, including limited partners.

In 2021 and 2022, founder and management secondaries—where founders sell a portion of their stake for their own personal liquidity—exploded in popularity. Data indicate that almost a third of all Series A+ financings in 2021 included substantial secondary liquidity for founding teams. While this dropped to 10% in late 2023, secondaries ticked back up this year. These were historically unpopular with investors who sought to align the time horizon of founder and investor outcomes. “Liquidity for all,” used to be the preferred philosophy. During ZIRP, though, investors who wanted to win deals and curry favor with founders offered generous secondaries to sweeten deals, and we saw immense wealth funneled to founders without any liquidity for shareholders. Simply put, the market ripped, VCs wanted to win deals, and Berber Jin from The Information wrote this gem: Startup Founders Use Record-High Valuations to Cash Out Earlier.

Here is the root of the problem. Founders selling shares gives them money now and results in them owning less. This encourages short-term thinking since they will focus more on the immediate reward and less on the value that comes from long-term compounding growth. Shareholders, on the other hand, really want long-term compounding growth. Just like that, the ones who run the company have different incentives from the ones who own the company. The companies who should be going public, are instead cashing out employees with secondaries.

Unfortunately, most companies allow secondaries without board approval. Most investors have co-sale guarantees, giving them the right to sell alongside the founders at the negotiated price, but this is not ideal. Founders have common shares while investors have preferred. Common shares are less valuable in a private company, so selling at the same share price means that preferred shareholders would be selling at a discount relative to the founder. A savvy buyer knows this and will ask why investors would be so eager to exit at a discount. This red flag might kill the transaction, and the signal is likely to make its way into the public domain, damaging the company’s reputation. The simplest, and in our opinion, the best way to limit founder secondaries is to require that they be subject to board approval.

Post-transaction, founders recognize that they have fewer long-term gains to capture, so many will demand refresh grants. Boards shouldn’t ignore these requests since they serve as a way to realign incentives. There are two gotchas here: a refresh dilutes shareholders and past behavior predicts future behavior. The cost of a refresh is a decline in an investor’s ownership, and in all likelihood, founders will seek to do another secondary before long, repeating the cycle of shareholder dilution and compounding the misalignment of founder incentives through premature liquidity.

Boards have to do something to realign incentives. At Jackson Square Ventures, our strategy for founder refreshes is to use value vesting hurdles, where options vest not just based on time, but also on a company valuation target that is set in a financing, acquisition, or IPO. Founders will only get their shares if they create long-term value. It isn’t as good as eliminating or severely restricting secondaries, but it goes a long way to maintain the alignment of shareholder and founder incentives. 

At the early stages of a company’s life, we believe founder secondaries are harmful to companies except in limited circumstances, and we have used all the tools described above to discourage them. We have also supported founder secondaries where appropriate in scale and circumstance.  We’ll look to require board approvals for founder secondaries where feasible and use the value vesting hurdle grant strategy for substantial refreshes. 

This is an important stewardship and governance matter.  Founders who repeatedly sell shares and demand refreshes substantially erode shareholder ownership. In the era of companies staying private longer, constant and repetitive dilution must be avoided at all costs. Limiting the secondary and refresh cycle is the most important mechanism for maintaining an alignment of incentives and encouraging transactions that generate liquidity for everyone.