Selling Secondaries

As companies mature, founders can sell a portion of their personal shares to new or existing investors, a process know as selling secondaries (in contrast with primary issuance where the company sells newly issued shares). Secondaries allow founders and early employees to realize some personal financial gain without waiting for an IPO or acquisition. It has become more common in recent years as times to exits have gotten longer.

Unlike a primary issuance of stock, secondaries are not dilutive to existing shareholders (since the transaction is simply existing shares trading hands). The buyer is typically buying common shares which do not have a liquidation preference associated with them (as distinct from preferred shares which do) . As a result, secondaries often trade at a discount to primary preferred stock. To sell secondaries a founder needs to (A) find a buyer, and (B) get the consent of the board.

When to Sell Secondaries

Secondaries typically occur during later-stage rounds, starting at Series C or beyond. For top-performing companies, secondaries can take place as early as Series B. There are also rare cases of secondaries occurring earlier: During the heyday of 2020, for example, A16Z famously bought $2M of secondaries as part of its $10M round to win the Clubhouse Series A sweepstakes. However, in today’s market, that would be a tough act for a founder to pull off.

Finding a buyer

• The ideal buyer is an existing investor looking to increase their ownership. They are already familiar with the business, and their willingness to buy secondaries sends a positive signal to others who might be contemplating buysing secondaries as well.
• The lead investor of the new funding round is also a potential buyer, though it’s a more challenging conversation if the round isn’t highly competitive.
• Over the past few years, a number of secondaries-only funds have popped up that have both the expertise and the dedicated capital for secondaries such as Industry Ventures, Truebridge Capital, NewView Capital, etc.
• Family offices, institutions and other limited partners of venture capital funds can also be buyers of secondaries—particularly once the company has become a recognizable brand name. LPs naturally are most familiar with companies in their fund’s portfolio, so your existing investors are the best source of introduction to those LPs.
• For later stage/pre-IPO companies, Investment Banks can be buyers

Getting investor consent

• Most companies will have a Rights of First Refusal on founder stock sale granting the company the right to buy any shares offered to other investors. Major investors also typically have a co-sale agreement allowing them to sell a pro-rated portion of their shares alongside the founders. So getting your lead investor / board member buy-in is a must to get the company and the major investors to waive these rights.
• Investors understand that providing founders with some liquidity will help alleviate undue stress and aligns incentives by removing the allure of a mediocre M&A event. At the same time, founders react differently to the newly found wealth. Selling large amount or selling at an earlier round (Series A or B) will be a red flag.
• Although a secondary round doesn’t dilute existing investors’ ownership, they may still oppose capital going to management instead of strengthening the company’s balance sheet—especially in a tight fundraising climate. To shareholders, a company’s capital needs trump a founder’s desire to cash out. As a result, it is critical to wait until the appropriate time to broach the topic with your board. Hold off on discussing secondaries until the funding round is clearly oversubscribed, otherwise the conversation could very well backfire.

How much Can I Sell?

There are no hard and fast rules. Secondaries are typically in the millions, although a $500K secondary sale is not uncommon.

Investor’s reception to secondaries will be a function of both how well the company is doing, and how much a founder is selling relative to their needs. If you’re selling a few percentage points to buy your first home for your young family, your investors will be supportive. If you’re selling 20% and are eyeing your next vacation home or yacht summer vacation in the med, they will push back. Make a compelling case to your board for why the cash will help you devote more time and mental energy to the business.

Price of Secondaries

The price of secondaries is typically at a discount compared to primary shares, reflecting their common stock status and lack of liquidation preference. However, the discount varies significantly based on the company’s performance:

• For top-performing companies in a clearly oversubscribed round, the discount is often negligible, with secondaries trading close to or at the price of preferred shares.
• For decently performing companies with some investor appetite, secondaries trade at a 10-30% discount to primary shares.
• For an average company, the discount can be substantial, potentially reaching as low as 50% or more of the primary share price. And finding a buyer will be a challenge.

As companies approach an IPO or other liquidity event, the discount on secondaries tends to narrow.

Things to watch out for

• Tender Offer: Depending on the number of sellers and other factors, the transaction may need to be structured according to the Securities and Exchange Commission’s Regulation 14E (e.g., offer kept open for 20 business days)
• 409A: Secondary sales can impact 409A valuations for common shares or options held by employees by providing a data point for the fair market value of common stock. However, the impact may be limited if the secondary sale price is significantly discounted compared to the preferred stock price or if the transaction volume is small.
• Shareholder count. Secondaries increases the number of shareholders on the cap table. For larger private companies, the Securities and Exchange Commission (SEC) typically imposes a 2,000 shareholder limit to avoid public reporting.
• QSBS taxation: Qualified Small Business Stock status offers significant tax benefits to both founders and investors, allowing them to potentially exclude up to 100% of their capital gains from federal taxes when they sell their shares. For the founder, a secondary transaction will qualify for QSBS once the shares have been held for five years. For the buyer, the newly acquired shares will not qualify for QSBS since they’re not primary issuance from the company.
• QSBS status: Sometimes the buyers ask the founders to convert the shares to preferred via a company buyback followed by new preferred issuance. The buy back can trigger a “Significant stock redemptions” event which would disqualify a company from maintaining its QSBS status for all existing shareholders. So any attempt to convert founders share from common to preferred through stock redemption should be considered very carefully by your counsel.
• Employee Morale: news of Secondaries can impact perception and morale for employees. The best practice here is to initially keep it under wraps and, when the time is right, open the secondary sale to other early employee of the company as well (i.e. every employee who has been there for more than 4 years can sell up to 10% of their shares, etc).