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From unicorn hunting to discount chasing: the perils of secondary market dislocation

22 June 2023 | Shares on the secondary market are trading at steep discounts yet many investors remain cool. If owners, entrepreneurs, and investors don't adapt to new market realities and start working in sync rather than at cross purposes, they risk missing out on the next unicorn, argues SV Ventures CEO Erik Arnetz.

Leaving the first half of 2023 behind us, we see a year characterized so far by a growing dislocation between pricing in the primary and secondary markets for unlisted securities. Investors and founders alike have been slow to adapt to new market dynamics and their increasingly divergent views about what a good deal looks like could have dire consequences for both portfolios and bottom lines.


It’s no secret that the era of cheap money is over; that funding options for private growth-oriented companies have become increasingly complex; and that investors in the private markets have their hands full dealing with their existing portfolios. But when it comes to new investments, rather than placing bets on what they hope will be the next unicorn, investors have instead become obsessed with chasing big discounts and lost the ability to set terms themselves.


Left unchecked, this continued downward speculation in the secondary market – driven by dynamics that have little to do with business fundamentals – has the potential to put primary market funding rounds at further risk, starving promising growth companies of much-needed capital.


Chasing discounts, forgetting fundamentals


While shares on the secondary market have traditionally traded at a discount - roughly 20-25 percent below the most recent financing round on average - these discounts have jumped in the last 12 months. Today it’s not uncommon to see discounts of 50 percent or more on the secondary market. Digital health provider Doktor.se, for example, bullishly emphasized having maintained its most recent valuation mark of 25 SEK/share when announcing its latest financing round in August of last year. Today, less than a year later, Doktor.se shares are regularly trading hands on the secondary market at a mere 10 SEK/share.


Such steep discounts are no doubt attractive at first glance. But when left unchecked, this “how low can you go” mindset can have unintended consequence. Just ask the owners of electric boat manufacturer X Shore. In April 2022, X Shore raised a funding round at 30 SEK/share with participation from a significant number of UHNWIs.


But as these same investors sought liquidity amidst a more difficult economic environment, secondary market pricing began to decline during the fall. By the time X Shore announced plans for another funding round in March 2023, its share price had tumbled to 12 SEK/share, with the secondary market already trading below that at 10 SEK/share in advance of the funding round closing.


Today, less than three months after the most recent funding round closed, shares in X Shore are trading hands on the secondary market at just 8 SEK/share, with investors hunting for bargains by putting in offers around 6-7 SEK/share – a decline of around 80 percent in 15 months. In our view, such price volatility is a clear case of an emotionally charged hunt for the lowest possible clearing price, or the need among sellers to obtain short term liquidity.


Secondary market dislocation


This dynamic has also been on full display in the aftermath of the SBB meltdown which has forced founder Ilija Batljan to dump his stakes in several privately held growth companies. The fire-sale, prompted by SBB’s woes and Batljan’s own liquidity needs rather than problems at the companies themselves, sent these promising companies’ shares spiralling and cemented low price points, despite solid performance and a promising outlook.


In no case was this clearer than in Ilija’s largest unlisted investment, Exeger. The advanced solar cell maker’s share price cratered from the low 100s down to 50 SEK/share in a matter of weeks. As recently as December 2022, the company had raised an additional round of funding at 120 SEK/share, but as Ilija’s shares flooded the market, pricing decoupled from operational momentum.


These examples further illustrate the unprecedented level of dislocation in the unlisted market, both in terms of pricing and mindset. While primary market investors remain focused on evaluating a company’s operations and fundamentals, secondary market investors have become overly obsessed with pricing.


Primary funding rounds at risk


As a result, too many secondary market investors are sitting on their hands in hopes of scooping up shares at even steeper discounts, rather than pursuing deals at attractive levels that they would have jumped at 18 months ago. Meanwhile, other investors are happily buying shares at a big discount on the secondary market with no regard for how those price signals might affect companies’ chances of closing their next primary funding round.


So, what’s going on? Why is the secondary market leading the primary market, and what are the potential consequences?


Embracing the new normal


The main problem stems from a resistance among entrepreneurs to accept the “new normal”, which is exacerbating a lack of alignment in incentives between them, their current shareholders, and potential new investors looking to score a deal.


Admittedly, communication between these three main stakeholder groups wasn’t great to start with. But it’s gotten a lot worse in the last 12 months, and unless each group adapts their points of view to this “new normal”, the race to the bottom in the secondary market is likely to get worse before it gets better.


In the worst case, companies will miss out on vital funding; in the best case, founders will have to settle for large share dilutions. Investors, meanwhile, will miss out on the great opportunities that come with taking a more fundamental approach when evaluating both primary and secondary market transactions.


Founders: engage owners, welcome new investors


To start with, founders need to stop seeing action on the secondary market as a threat and instead embrace the opportunities that come with it. Rather than passively watching share prices drop, founders should engage with shareholders interested in selling.


Conducting a structured sale process can help keep prices up and give them a chance to meet potential new investors. And don’t estimate the value existing shareholders place on helping them gain liquidity.


In a small ecosystem, what goes around comes around - and one never knows how that goodwill might pay dividends down the road.


Owners: demand better information


Current shareholders need to start making more demands for better information from companies. It’s surprising how many management teams get away with sharing almost no information with their shareholders.


Sure, they have a company to run, but they are doing so thanks to investors’ money, and there’s no reason investors shouldn’t exercise their right to receive regular, detailed updates on the business.


Better information can help investors make better decisions about how to weigh their current liquidity needs against the company’s upside potential in the future.


Investors: focus on fundamentals, not pricing


And finally, investors looking for someplace to put their money need to start doing their homework and dare to put forth their own terms, rather than simply chasing the biggest discounts presented to them.


In this market, investors willing to engage and put their foot down in terms of what they see as attractive and acceptable pricing can make investments in solid companies at low valuations. Today’s private capital market dynamic mirrors previous economic downturns, which created tremendous returns for those investors who dared to act.


Now more than ever, entrepreneurs, existing shareholders, and external investors need to assess both downside risks and upside potential, so they don’t miss the forest for the trees. Working in sync rather than at cross purposes, they can help stabilize private markets and re-direct them back toward their inevitable long-term trajectory: upwards.


Hopefully market players can manage to change their behaviour before the next unicorn either shuts down or slips through their fingers.


Erik Arnetz

CEO & Founding Partner

+46 (0)707 92 76 18


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