Secondary Sales in VC-backed startups: A Primer for Entrepreneurs

Secondaries have become popular for founders, employees and investors (img src: kiplinger.com)

What is a Secondary Sale?

A “secondary” sale is when a shareholder (typically one of the founders or an early employee or an early investor) of a private company sells his or her shares to another buyer.

Why secondaries have become popular in Silicon Valley

One of the main reasons why secondaries have become popular in Silicon Valley is that IPOs have been less common since the crash of 2008 (and way less common than during the dot com boom of the 1990s). Traditionally companies went public with smaller revenue/valuations than is the case today, so investors and early employees could cash out upon an IPO. Since startups are staying private longer, this means that early founders and employees can’t get liquidity for their shares, sometimes even 5 or 10 years after the company started, even if the company is doing well.

  1. supply and demand of the company’s stock. When a company is doing well, investors want to get stock in the company, but a startup may not need the financing or not want to dilute its existing shareholders by selling stock, so its stock may be hard to come by.

Who Buys Secondary Shares?

The first question I get from entrepreneurs is who they might sell their shares to. That’s like saying, who invests in startups? There are many people who want shares of successful startups. Here’s an overview of the different groups I’ve seen participate in buying secondary shares:

Existing and New Investors.

The most popular buyers of private secondaries are usually either existing investors or new investors in a round of financing. Why? Because these investors know the company well -they have done due diligence on it. If the company is doing well, then investors want to buy as much of the company as possible.

  • Primary: Investor X and Y will put in $18 million into the company and get new Series C Preferred stock (for 15% of the company)
  • Secondary: Investor X and Y will buy up to $6 million in common stock from existing founders, employees, and investors for another 5% of the company

Matching Websites and Micro Funds

There are a number of websites and organizations who specialize in secondary sales — three of these include Shares Post, Second Market, and Micro Ventures.

Secondary-specific funds

Thousands of startups are founded each year in Silicon Valley alone; very few of them make it to a series A, fewer to a successful series B or C, and even fewer make it to a late stage series D or E or an IPO. A few years ago, investors realized that they could reduce their risk by investing in the handful of companies that have already made it onto an IPO track. They wouldn’t make as much money as the early investors in those companies, but they would take considerably less risk. That is of course the logic of most late stage private equity/VC firms. However, in recent years, a few funds have been formed specifically for buying secondary shares of startups that are taking off, such as Industry Ventures. And some standard early stage VC funds have set aside some amount of capital for late stage investments, which often occur as secondaries.

Private Investors and SPV

In many cases, there are private individuals who are willing to buy your shares in a hot startup that’s doing well. In 2008, a friend approached me about buying shares in Facebook, which was still a private company. At that time, still years before an IPO, one of the early employees of Facebook wanted to sell his shares to get some liquidity. A group of private angel investors had formed an LLC, often referred to as an SPV (special purpose vehicle) for the sole purpose of buying the Facebook shares. The actual deal was a little more complicated than the employee simply selling shares to the LLC — he contributed his shares and became a shareholder of the LLC, and participated in some of the upside on those shares. While this was a complicated vehicle, the idea of forming an SPV for selling to private investors that you know is not uncommon. The SPV is also a way for the company (in this case, Facebook) to stay within their 500 shareholder limit — since on the company’s register the shares are moving to only one shareholder, but in fact there might be 10 investors participating.

Investment banks

In a special case, we once hired an investment banker to go out and sell our shares in a mobile advertising company that had grown very big. Investment banks become interested in secondaries only when the dollar amounts are large enough that their fees can be meaningful, or to build a relationship with the sellers. Some investment banks are better at helping you negotiate the sale process, others may be better at finding buyers since they have a spectrum of client. In the case I was referencing, although the investment bank approached many outside investors, they ended up negotiating a deal with an investor who already had shares in the company and wanted more. Be sure to do your background reference checks to find out what the investment bank is good at.

What is the Price of Common Stock vs. Preferred Stock?

OK if you’ve found someone who’s interested in buying your shares in a successful startup — so how much should they pay per share?

Figure 1: Value of Common Stock vs. Preferred Stock

A Few Important Considerations and Gotchas

Let me wrap up with a few important considerations if you are going to be involved in a secondary sale of shares in a startup. Each of these can complicate a secondary sale. You should be aware of these items before getting into a secondary sale.

Right of First Refusal.

Most companies have a right of first refusal on any stock you may be selling in a secondary. This basically means that if you want to sell your stock to someone other than the company for $X, the company has the right to buy it back from you at the same price. While most startups (even ones that are growing towards an IPO) won’t want to use the cash they got from investors to buy back stock, it is a risk that could happen in most secondary sales. For one thing, it would reduce the number of shareholders if the company buys your stock, whereas selling some of your stock to another shareholder might actually increase the number of shareholders and run the risk that the company is getting closer to the SEC limit before they have to public..

Right of Co-Sale

Another common right that investors often ask for is the right for them to sell a pro-rata percentage of their share at the same price that you, the founder are selling for. The main reason for this clause is that they don’t want the founder getting a “sweet” deal on his stock that the investors can’t get. So let’s say someone offers to buy 1000 of your shares @ $2.00 per share. They will have the right to sell some part of the 1000. In a simple example, let’s say an investor owned 10% of the company, they might be entitled to up to 10% of the sale, or 100 shares — and you would only be able to sell 900, but the buyer would still get 1000 shares.

Company co-operation, asymmetric information, SEC rules.

Sometimes the company may not be happy that you are selling your shares, but they won’t exercise their right of first refusal either. In fact, they may stay silent and not co-operate, which means that the buyer won’t have any information about the company. This is often referred to as “asymmetric information” — because one side (the seller in this case) may know more about the company than the buyer who is a new investor. I’ve also seen “asymmetric information” go the other way — when the buyer (who perhaps is a major investor in the company with information rights, board seats, etc.) may be privy to information that the seller (who may be an early employee who is no longer with the company) doesn’t know. This is a tricky area that can run up against SEC regulations, and both sides should be really careful here. It’s also possible that the company won’t cooperate because they don’t want more shareholders, because they don’t want to run up against the SEC limits of 500 shareholders and don’t want to be “forced” to go public. Doing a transaction without the participation of the company can be difficult.

Restrictions on Shares.

Any buyer of secondary shares should be aware that almost all private stock comes with restrictions and lock up periods for when they can sell. Let’s consider a scenario: Suppose you were approached about buying shares just before a well-known IPO was coming up. You might have a bit of a dilemma — while you might want to own some shares from the company, if you buy them before the IPO, you might get a good price, but the shares would be restricted and you couldn’t sell them for 6 months. On the other hand, you could wait and buy the shares once the company was public and have no restrictions on buying or selling the shares, but the price may have gone up considerably in the IPO. If it was Snap, then you might have wished you bought the shares since it started trading above its IPO price. If it was Facebook, it turns out that Facebook was trading below its IPO price for quite a few months before going on its meteoric rise, so you might have been better off just waiting until after the IPO, rather than just before the IPO.

Founder Series FF Preferred.

At one point, secondaries were becoming so popular that founders were creating a special class of stock, Series FF Preferred, which had preference over the common but was subordinate to any other preferred. If you were one of two equal co-founders in the company, each of you normally starts with 50% of the company. But you might have 10% of your shares (or 5% of the company) in FF Preferred and the rest in common. Why? Because investors usually want preferred stock, and this gives you, the founder, the ability to sell them preferred stock if the company is doing well and the stock is in demand, but the shares aren’t yet liquid. This seems like it’s not as common now as it was a few years ago, but it’s something to keep in mind.

Conclusion

Secondary sales can be great for entrepreneurs and early investors and employees because they provide liquidity when a company is doing well but there is no exit in sight.

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Riz Virk

Riz Virk

The Simulation Hypothesis, Play Labs @ MIT, Startups/VC, Sci Fi, Bitcoin, Consciousness, Space, Video Games: visit www.zenentrepreneur.com