The dry IPO market is creating demand for alternate liquidity

The second quarter, closing Monday, is expected to be the worst in recent history for initial public offerings, as the stock market continues to face stormy conditions. An estimated 44 IPOs were pulled during the year due to lousy market conditions. And that has shareholders, including venture capital funds, looking for alternative sources of liquidity.

Among the stops for anyone who needs to turn shares into cash are secondary funds such as Industry Ventures in San Francisco. Hans Swildens, principal and founder, said that he’s getting a lot more queries from shareholders who are thinking about selling their shares in venture-backed companies.

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“They want to know what kind of price they can get,” Swildens said. “There are more people selling too. It’s what you would expect in this environment. If they can afford to wait a short time, they will. But they don’t want to wait for years.”

Swildens’ firm has $400 million under management and it owns interests in 50 venture funds and 75 companies as a result of purchasing stakes in venture funds or directly buying out the shares of company founders, senior managers, or venture fund investments in companies. Typical transactions range from $1 million to $50 million, so Industry Ventures isn’t aimed at providing liquidity for the smallest shareholders.

The downside, of course, is that shareholders can’t expect to get top dollar for the shares that they sell. Industry Ventures and its competitors may thus be viewed as a liquidity source of last resort.

The industry is thriving with, an estimated $2.5 billion in transactions last year. Swildens sees a pipeline of more than $1 billion in possible business at the moment. The industry is perhaps three times bigger than when Industry Funds started eight years ago. That has drawn some competition. Other secondary funds include Goldman Sachs Vintage Fund, CS First Boston Strategic Partners, Pantheon Ventures in San Francisco, and Paul Capital Partners in San Francisco. Swildens has 10 employees and recently added one.

This week alone, the following companies withdrew IPOS: software maker Initiate Systems, chip designer Sonics, and emphysema treatment company Broncus Technologies. As of June 20, data tracker Dealogic reported that 41 IPOs were pulled, 23 were priced, and 56 were filed since the start of the year. In the same period a year earlier, 13 were pulled, 91 were priced, and 140 were filed.

Merger and acquisition numbers are also likely to be down during the period, though perhaps not as dramatically as IPOs. IPOs are getting repriced or postponed. Shareholders may be getting impatient and may need to cash out 25 to 50 percent of their holdings. Venture capitalists invested in 23,935 deals between 2001 and 2007, but only 11 percent, or 2,700 venture-backed companies, had exits during the same time, according to the National Venture Capital Association.

All of those statistics point to why selling to a secondary fund makes sense as a third option to cashing out in an IPO or M&A deal. It’s the same reason why there are secondary funds for securities, mortgages, durable goods, energy and even sports tickets.

Swildens noted the value of providing liquidity, like when the Federal Reserve injected money into the financial markets when Bear Stearns was on the ropes. Older venture funds are typical sellers. They may be nearing the end of their 10-year terms and may need to cash out. Swildens said there are about 245 venture funds started in the 1999 to 2000 time frame that are reaching their time limits.

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But there are others who want to sell as well. Some employees of Facebook, which Microsoft valued at $15 billion when it invested last year, also want to cash out part of their gains, Swilden says. Such employees keep most of their shares for an eventual IPO but may want to cash out some money as an insurance policy. We’ve separately heard that early Facebook employees have done just that. The company received funding from venture firm the Founder’s Fund, which offers a form of stock where founders can sell some of their shares during subsequent funding rounds. It’s possible that Facebook employees have been selling some of these so-called “Series FF” shares.

“If your shares are worth $20 million on paper but you want to cash out $5 million, it makes sense to do so,” Swildens said.

Holders of hedge funds, which have a shorter time window for earning returns than VC funds, are also more likely to sell their shares to secondary funds. But Swildens noted that his fund isn’t seeking to buy stock in failing companies. Industry Ventures’ returns aren’t expected to be as high as VCs expect, partly because the firm is investing in later-stage companies and funds.

Swildens said that secondary funds can restore peace among fighting boards where some investors want to cash out and others want to hold on.

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“We can create stability and keep funding the company,” he said. Swildens said he is raising a new fund right now.