confused by fundraising use of proceeds
I'm really confused why the money doesn't go to the founders.
Hypothetical:
I'm at a tech start up, 100% owned by the founders. They are about to do a seed round where they are giving away a 10% stake in their company for $1m.
Technically the founding team just sold 10% of their shares for $1m so surely it would be both legal and acceptable for them to just take the money and go buy a lamborghini?
but what i'm confused about is that's not how it works.. the money has to be used for the business itself i.e. spent on things to grow the business such as hiring. marketing etc.
So I'm confused when can the founding team ever cash out from selling their shares?
Does it have to do with primary and secondary deals? e.g. a seed round would be raising new money via a primary issuance diluting the founders, instead of the founders actually selling their shares directly to the new investors?
You're on the right track! When a startup raises funds, it's typically through a primary issuance of shares. This means the company itself is selling shares, not the founders. The money raised in this way goes directly into the company's bank account, not the founders', and is used to grow the business. The founders can indeed sell their shares, but this is usually done in what's called a secondary transaction. In a secondary transaction, the founders (or other early shareholders) sell their shares directly to new investors. The money from this sale goes directly to the founders, not the company. However, secondary transactions are less common in early-stage startups because investors usually want to fund the company's growth, not line the founders' pockets. So, in your hypothetical scenario, the founders wouldn't be able to buy a Lamborghini with the seed money unless they did a secondary transaction. But even then, it might not look great to potential future investors if the founders are cashing out so early. It's more common for founders to cash out during a sale of the company or an IPO.
Sources: (Mis)adventures in PE fundraising (part 2), Troubled fundraising processes
Interesting question. You got it, that is the distinction. Funds raised from primary rounds go straight to the balance sheet because the company issued new shares for the round. Just logically - the investors want the company to succeed so they are providing cash to fund the company’s operations, growth, etc., not fund the founders’ early retirement.
There are occasionally situations where some of the funds raised in a primary will be spent on buying back shares from employees and investors, or issued as a dividend, but it’s not very common.
Secondary transactions are just sales of existing shares. Shares of private companies are subject to some restrictions like ROFRs and aren’t always transferable by default. A founder looking for liquidity would have to verify transferability and get the board to waive their right to buy the shares.
A founder could definitely buy a Lambo from a secondary sale, but current founders probably wouldn’t want those optics pre-exit. We have purchased shares from current management of our portfolio companies and we just have to make sure they retain a large enough portion of upside in the company to keep incentives aligned. Most of our transactions will provide single digit $ millions of liquidity that we have seen sellers generally use for down payments on houses and to pay off debt / major expenses.
More often, we buy from former founders, departing employees, and long time shareholders like angels and VC funds near the end of their life. Former founders are often working on a new project and don’t want to be so exposed to their old company.
Source: I work in secondaries
Super helpful, thanks for the write up.
Thanks for the write up! Just curious - I thought secondaries just do GP or LP transaction, what kind of secondaries / shops allow you to deal with early stage secondaries transaction?
You are correct. The typical vanilla secondaries deal is LP led, and more recently GP led transactions have been popular (continuation funds, single asset vehicles).
My shop does direct secondaries and the occasional GP led deal. We have also made some LP commitments to 'friends of the fund'. We mostly operate like a normal growth stage investor, just buying existing shares instead of primary. Much larger than my fund, but as a proxy Industry Ventures approaches venture assets in a similar way.
What other firms besides Industry Ventures operates in this secondaries space?
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