Primary vs. Secondary Transactions in Startups: Decoding the Cash Out

For every Indian startup that dreams of ringing the bell at the stock exchange, there’s a less glamorous, yet equally significant, financial mechanism at play behind the scenes. It’s a dynamic game of primary and secondary transactions—a game where early-stage investors often find their golden ticket.

But what exactly are primary and secondary transactions, and why do they matter in the thriving Indian startup ecosystem? TICE breaks it down and uncover the nuances that drive these deals.

A Tale of Two Transactions

In the startup world, raising funds is often viewed as the lifeblood of growth. When a startup decides to raise money, it typically does so through primary transactions. Here, the startup issues fresh shares and receives capital in return. This capital is then used to scale operations, develop products, or expand into new markets.

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On the other hand, secondary transactions don’t inject fresh funds into the startup. Instead, they involve existing shareholders—often early-stage investors—selling their stake to new investors. These transactions provide a lucrative exit route for those who invested in the company’s initial days, enabling them to pocket significant returns on their investments.

Anatomy of a Secondary Transaction

Let’s take a closer look with an example. Imagine a startup raising $25 million at a $100 million valuation in a Series C funding round. Out of this $25 million:

• $20 million is primary capital, where the startup sells new shares to raise fresh funds.
• $5 million involves a secondary transaction, where new investors purchase shares directly from early-stage investors.

This setup benefits everyone:

1. The startup secures the capital it needs for growth.
2. Early investors get a chance to cash out at an attractive return, often 15X or more on their original investment.
3. New investors acquire the stake they desire, setting the stage for future returns.

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Why Do Secondary Transactions Happen?

Secondary transactions usually occur because large venture capital (VC) or private equity (PE) funds aim for substantial ownership—often 25% to 30% of a startup. However, startups might not always be willing to dilute their equity to such an extent by issuing new shares.

This is where secondary transactions come into play. The startup’s board facilitates a deal between early investors and the new fund. If the offered price is enticing, early investors sell their stake, achieving liquidity while the new fund secures the desired ownership without impacting the startup’s equity structure.

The Discount Dilemma

One intriguing aspect of secondary transactions is that they typically occur at a discount to the startup’s current valuation. In India, this discount has ranged between 25% to 40% in recent times—a stark contrast to the lower discounts observed during the funding frenzy of 2021 and 2022.

Why the discount?

• No Fresh Capital: Since the money exchanged doesn’t go to the startup, it doesn’t directly contribute to its growth.
• Higher Risk: Buying shares from existing investors is perceived as riskier because the capital isn’t being deployed to strengthen the startup’s fundamentals.

Investors seeking secondary shares often negotiate lower prices to account for these factors.

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What’s in It for the Ecosystem?

Secondary transactions play a crucial role in fostering a vibrant startup ecosystem:

• Liquidity for Early Investors: They provide an exit route for early-stage investors, rewarding them for their risk and enabling them to reinvest in other ventures.
• Growth Without Over-Dilution: Startups can raise the capital they need while maintaining control over their equity structure.
• Access for Larger Funds: New investors, often large VC or PE funds, get an opportunity to own a stake in promising startups without the startup needing to issue new shares.

As India’s startup ecosystem matures, secondary transactions are becoming an integral part of its financial fabric. They represent a delicate dance of negotiations, valuations, and strategic decisions that balance the needs of startups, early investors, and incoming funds.

For those watching India’s startup story unfold, understanding the interplay between primary and secondary transactions offers a glimpse into how dreams are funded, fortunes are made, and the ecosystem continues to thrive.

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