When investors invest in a startup, they typically purchase a preferred stock directly from the company. Such a transaction is known as a Primary stock sale.
But what if the founders want to sell some of their common shares? Such a transaction is called a Secondary stock sale and has become an increasingly popular mechanism for rewarding the founders who achieved significant growth in their business.
1. Why do founders want to sell their stock?
The motivation for doing the Secondary stock sale is simple – the founders want to take some chips off the table.
Successful startups are very long and very risky journeys. Founders typically start the business by sacrificing a lot and paying themselves very little.
As the startup grows, the founders’ equity is building up, but they are still, often, cash poor.
By selling some of their common stock the founders are able to get rewarded for what they’ve built so far and shift some of their equity value into cash.
2. Why would investors agree to buy Founders’ stock?
From the investors’ perspective, there are two important dynamics.
First, investors feel that if the founders sell some of their stock now, they will be more motivated to “go all the way”.
That is, getting cash into the hands of the founders ensures that they will not be tempted by an early exit.
From the perspective of Series A, B, etc. investors this is critical. If they invest, and the company has a quick exit in the next 12-18 months, that’s typically not a good thing, and not likely get the multiple on the money that such investors look to achieve.
The second reason is the market dynamic.
Later stage financings are often very competitive and there is often not enough room to accomodate all investors through the Primary Stock sale.
Between the new money coming in, and existing investors fighting for pro-rata, the demand often causes more dilution than the founders and existing investors can agree to.
The solution is, instead of buying the stock from the company, is to buy it directly from the founders.
This solves for both, accommodating all the investor demand, and allowing founders to take some chips off the table.
3. When to do the Secondary Sale
The Secondary Sale typically happens at Series B and later. We sometimes see it at Series A, but it is less typical.
The reason is threefold.
At the earlier stage, the company has not achieved sufficient growth and investors may not feel like the founders should be rewarded.
On the other hand, the valuation at an earlier stage is lower, and founders may not feel like they would get a meaningful amount of money for their shares.
And lastly, there simply may not be enough demand in the earlier stage. For example, $10-$15M financing with the lead putting in $8-12M and insiders taking pro-rata just doesn’t have enough demand for the Secondary Sale.
4. How much is it appropriate to sell?
The answer really depends on the stage of the business and the demand.
Regardless, there are two considerations that make it difficult to sell “a lot”.
If the founders are looking to sell almost all of their equity, then investors will seriously question their incentives and motivation to stay in the business.
The second consideration is how much new capital is coming into the business. For example, it would be rather unusual for the Secondary Sale in the new financing to be bigger than the Primary Sale.
After all, the primary goal of most financings is to capitalize the business, not to cash out the founders.
The exception would be the case when Founders are selling their stock in a Secondary transaction and there is no Primary financing. This is less common, but certainly can happen, if the company is a rocketship, and a ton of investors want to jump in.
So from the practical perspective, a 10% of the round going to founders is a no-brainer. 50%+ of the round going to the founders is atypical. Anything in between is a possibility depending on the demand.
5. What is the appropriate price?
A few years back, when Secondary sales were not as common, the price was typically up for a discussion.
The investors who would be buying the stock from the founders would argue that since it is not a preferred stock but common stock that it should be discounted. The discount could range from 20% to 50%.
Today, pretty much all Secondary sales transact common stock at the price of the preferred.
This happens for a few reasons. First, in most later-stage companies, investors believe that common stock is just as good as preferred. That is, they believe that the company is headed for an IPO or a large M&A outcome and in that case Preferred stockholders would give up their preferred rights and convert to common anyway.
In addition, there are no mechanisms to run the Secondary Stock sale through the company, so that common shares are bought and Preferred shares are issued. There are some nuances around this mechanism, and you should consult your lawyers and accountants about the implications. Specifically, this might be relevant for QSBS exemption treatment.
6. When to bring it up
The founders are sometimes unsure when and how to bring it up, but to most later-stage investors the topic is straightforward.
There is absolutely nothing shameful about it, so the founders should feel free talk about to investors about their desire to sell some of their equity.
The right time to have the conversation is at the term sheet stage – right before or right after the term sheet is issued but not signed.
Sometimes, investors themselves will bring it up. This will usually be the case if it becomes clear that there is “no room” in the round for the new and existing investors.
7. Secondary Stock Sale Mechanism
The Secondary stock sale usually takes place simultaneously with the Primary Stock Sale.
The lawyers draft up a document, which is pretty standard these days, describing the purchase price, number of shares, and the relevant reps and warranties.
Regardless of whether the sale running through the company or not, the founders who sell the stock become parties to the agreement, as well as investors. The company participates only if there is an intended conversion from common to preferred shares, otherwise, the transaction is directly between the buyer and the seller.
The transaction itself and the documents are straightforward.
8. Offering the Secondary Sale opportunity to employees and early investors
Sometimes the Secondary Sale opportunity is extended beyond founders to employees and early investors.
For the employee to do so she would need to have the actual stock. Since most employees have stock options and not the actual stock, this complicates things. First of all, the employees need money to buy the shares at the strike price. The purchase also triggers an immediate taxable event for them. Typically, all of this capital would be covered by the sale itself, but there are nuances and complexity.
Things are simpler for the earlier investors since they already hold stock. Usually, early investors might be approached to sell by the later stage investors if there is a lot of demand. The rationale for early investors to sell some of their position is the same as for the founders – to take some chips off the table.
9. A fair treatment of shareholders during the Secondary Sale
All holders of the same class of stock should be treated equally in all situations, including the secondary sale.
For example, it would not be appropriate for one founder to be able to sell her stock but not to offer the same opportunity to the other. It is fine if one founder doesn’t want to sell but every founder, including founders who are separated from the company should be offered.
Similarly, if you have several early angel investors, it is not appropriate to offer the opportunity to some but not the others.
What are the consequences of not following this rule?
You may end up in a lawsuit with the shareholders who were mistreated.
10. Taxes, QSBS and Estate Planning
And finally, the founders should consult their accountants, do tax and estate planning.
Secondary Sale typically results in millions of dollars in income and is very life-changing especially for the founders who were living a very modest life prior to this transaction.
It is a big life change and you need to plan for it and prepare.
The most important thing is to understand the tax consequences and look into things like QSBS. The last thing you want to do is to sell your stock 1 month before your QSBS treatment.
In general, the Secondary stock sale is a good time to start doing your Estate Planning – again seems like a high-class problem, but it is indeed a problem and an unfamiliar territory for most founders, so it is best to prepare.