The increase in activity in the pre-IPO secondary market means that founders, early employees, and investors are receiving liquidity much sooner in a company’s life cycle than ever before. For most startups and privately-held companies, liquidity is often an issue for stockholders, as no market exists for selling shares and/or transfer restrictions can prevent their sale. Secondary stock transactions, however, are a way to work around this problem.
Secondaries are transactions in which an existing stockholder sells their stock for cash to third parties or back to the company itself before the company undergoes an exit. Traditionally, an exit refers to a merger, acquisition, or initial public offering.
Offering secondary transactions to founders is a tool venture capitalists have been using to win deals. For example, if a VC promises that the founders will receive $1,000,000 in cash through a secondary sale from a $15,000,000 venture financing round, the founders will likely prefer that VC’s term sheet to a term sheet from a VC that does not offer that deal.
Here’s a quick look at how they work and what to keep in mind, especially if you’re going through the process for the first time.
Why would a founder consider a secondary sale of their equity?
Though it may at times be interpreted as a lack of faith in the company when a founder sells equity prior to an IPO, it can actually be a beneficial transaction for the company.
Many founders pour everything they have into their companies. It can strain anyone to run a company for the number of years it often takes to reach an exit. During this time, it’s understandable for founders to entertain offers that provide them with significant short-term gains, but which typically won’t result in the greater potential gains to be had in a future exit when the company is more developed.
Venture capitalists, other stockholders, and a board of directors all want founders to focus on big exits, not the easy path to quick liquidity. Secondaries help to bridge this gap, providing compensation that enables founders to hold out for the years it might take until their company has developed enough to reach the larger merger, acquisition, or IPO.
A common counterargument is that a cash windfall from a secondary payout change the motivation of a founder to continue pursuing an exit: if they already have cash in the bank, why keep sprinting?
Each situation has its own unique circumstances and there are myriad factors that can affect the thought process of a founder considering a secondary sale. In general, though, there are at least two sides to every secondary transaction and any agreement comes down to balancing the need for liquidity against the desire to stay motivated and focused on building the company.
How do secondary transactions work?
Generally, secondaries for Series A through mid-stage startups occur during financing rounds. The three most common secondary structures are:
- A purchase of the founder’s shares by the company itself (a buyback or repurchase), using cash from the venture financing with the agreement of the lead investor;
- A direct purchase of the founder’s shares from an existing or outside investor;
- A direct purchase of the founder’s shares by an existing or outside investor, followed by a conversion of those shares to preferred stock.
Roughly two-thirds of secondaries involve the third structure, mainly because of tax considerations that are applicable to early-stage companies.
There’s a range of prices at which founders tend to sell their common shares. In practice, founders have sold their common shares for anywhere between 70-100% of the price of the preferred stock being sold in the financing. For example, if the lead venture capital fund is purchasing preferred stock at a per share price of $1.00, founders can generally sell common stock for anywhere between $0.70-$1.00.
Often, this is contingent on the common stock being “flipped” to preferred, using the third secondary structure described above. That’s because most investors want the advantages (and most importantly, the liquidity preference) of preferred stock, and founders want to sell their common shares at the highest price possible.
How can founders prepare for a secondary transaction before fundraising?
- Consider founder’s preferred stock: When first incorporating, learn about and consider issuing founder’s preferred stock. There is a structural advantage to founder’s preferred stock, and you should discuss this with your lawyers and accountants when incorporating your company.
- Create demand: Run a very thorough, competitive fundraising process to create demand among investors and try to obtain multiple term sheets. Without proper negotiating leverage (i.e. multiple term sheets), a founder might receive pushback on their request for a secondary transaction. However, VCs may be willing to offer a secondary transaction to win a deal.
- Find likely investors: If a secondary matters to you, then as part of your research, identify investors who are known to participate in secondaries. Think of investors outside your network or perhaps investors who have always supported the company but have not yet invested—these may be your most viable options.
- Hustle: Investors are more likely to agree to a secondary if the founders have already built a great company that the investors can’t wait to buy more of. Focus on building your company, and not just on a quick exit, and your work will likely be reflected in a higher company valuation during term sheet negotiations and a higher price per share on your shares of common stock or founder’s preferred stock.
Disclaimer: LTSE is neither a law firm nor provides legal advice. Before making decisions on matters covered by this post, readers should consult their legal adviser.