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Early investors in startups are looking to exit or at least trim stakes at a time investment flows have dried up, as the startup ecosystem endures a prolonged funding winter. This has led to a sharp drop in valuations for secondary stake sales in these privately-held firms, said industry experts.

In most cases, where there is no prospect of an immediate primary funding round that offers a window for early backers to take some money off the table, these investors are forced to do secondary sales at steep discounts of 50-60%. These valuations are typically benchmarked to the valuation of a company during its last primary funding round.

According to investment bankers, lawyers, fund managers and market intermediaries, a secondary stake sale is being worked out in startups such as Lenskart, Moglix, Postman, Chargebee, and Razorpay, among others.

The most important metric that funds track is Distributed to Paid-In Capital (DPI) or how much capital is sent back every year to the Limited Partners (LPs). The ecosystem is more disciplined when it comes to this metric, which is one of the major reasons for the rise in secondary deals, said Neeraj Shrimali, managing director - digital and technology investment banking at Avendus Capital, a homegrown investment bank.

“When good companies don’t have primary capital requirements, deals are stitched keeping in mind that secondary is the only way in which good investors can get access to these companies. Secondary transactions of scale are more plausible in slightly advanced stage companies such as growth stage, Series C+ and companies that have good cash in bank," he said.

Most industry experts also expect more capital flow back to LPs through secondary deals in 2023 and 2024, compared to the last couple of years.

“We are already seeing healthy number of enquiries from potential sellers desirous of seeking some kind of exit. As long as the funding winter continues, more sellers are likely to explore secondary sale options, rather than bank on an IPO or stay dependent on the portfolio company to provide an exit as part of a larger primary round," said Suchai Iyengar, MD & Head of Qapita marketplace, a secondaries platform facilitating buying and selling of private market securities.

Iyengar said sellers are mostly institutions looking to sell their holdings either partly distribute some capital back to limited partners, or entirely, on account of fund life considerations. “The discounts that are being offered by buyers for secondaries is up to 50% or even more in certain cases. This is more pronounced in companies with not so well-established business models and/or high burn. The best companies can even expect a premium depending on growth and profitability metrics."

At deep discounts of about 50%, only funds closer to maturity are likely to exit their investments, while those that are in the middle of their fund life are likely to stay put in the hope that sentiment will improve.

As liquidity dries up, most companies, except early-stage businesses, are finding it difficult to raise fresh capital. Those that are well capitalized and don’t have immediate need to raise fresh equity, investors are looking to cash out.

“A lot of businesses where the growth and unit economies are sustainable, there secondaries deals are easy to strike. In the late stage, valuation metrics have contracted," said Mohit Agarwal, head, digital and technology, investment banking, HDFC Bank.

Agarwal said funds are open to secondaries where there is a small primary component as well, with a discount on the secondary valuation, so that they get a blended valuation.

A blended valuation is where the incoming investor picks up a secondary stake at a larger discount and is also issued fresh equity at higher valuation, averaging out the per-share cost.

On the other hand, buyers include investors such as secondary funds, pre-IPO funds, crossover funds, private equity funds, family offices and so on, depending on the configuration of the stake being offered, these experts say.

With the late-stage investors are coming at a critical stage, they prefer to de-risk their bets in these companies.

“The buyers get most rights as they would get in a primary round, baring liquidation preference and anti-dilution. Given these companies are slightly later stage companies, there isn’t a binary risk in the outcome, thus buyers are fine without these rights," Shrimali at Avendus explained.

In most cases, the founders of these startups are helping facilitate these secondary deals to ensure they can exercise tight control on the capitalization table and can choose the incoming investor.

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