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As a startup accelerates and the valuation rises, early investors and employees may desire liquidity in the form of a secondary sale of shares. Making a guided decision as a founder, employee, or investor requires awareness of the subtleties of secondary sales. This is while keeping the equity structure and the long-term viability of the business. Here is an all-around guide on secondary stock sales in startups.
What Is a Secondary Stock Sale?
A secondary stock sale is when current shareholders, often early employees, founders, or angel investors, sell their shares to other individuals or institutions. Unlike primary funding rounds, when startups issue new stock to obtain capital, secondary sales transfer existing share ownership without getting new capital into the company.
These sales are typically driven by liquidity needs, particularly in companies delaying their IPOs or acquisitions. Founders will sell shares for diversification of personal wealth, and employees can sell part of equity for individual spending or financial objectives.
When Do Secondary Sales Make Sense
Secondary stock sales typically happen after a startup has achieved a level of maturity, perhaps Series C or D. At this point, the company will likely have high investor confidence, a validated business model, and strong traction. This creates the kind of confidence necessary in which to draw secondary investors.
Companies usually form official liquidity events, including tender offers or stock buyback programs approved by the company, to enjoy an equitable and orderly process. Such events also control price expectations and maintain a stable capitalization table.
Key Considerations for Stakeholders
Before a secondary transaction, all the founders and employees, right down to investors, should know the impact. Among the foremost things to be considered are:
- Value and pricing: Secondary sales typically discount the most recent primary value.
- Right of first refusal (ROFR): Current investors or the company may have the right of first refusal to buy shares before they can be sold to the external world.
- Board and legal approvals: Before any transfer, most companies need board approval or legal sanction.
- Tax implications: Timing and structure of sale can significantly impact personal taxation.
Founders and employees alike must know the financial impacts of a secondary sale, particularly where equity incentives are at play. It is wise to learn more about 409a deferred compensation, particularly in cases of stock options or other equity incentives, as it affects the tax treatment of the sale. Doing research early will help prevent tax consequences and achieve IRS compliance.
Best Practices for a Smooth Process
For smooth secondary share sales, firms and participants must adhere to the best practices, which include the following:
- Regularly communicate with all shareholders.
- Utilize qualified legal and finance experts.
- Establish well-defined timing and eligibility policies.
- Ensure correct securities compliance and documentation
- Prioritize rational sales against corporate objectives and investor demand.
Benefits and Risks of Secondary Sales
Secondary transactions have several strategic benefits. For sellers, it has the advantage of realizing liquidity and planning personal finances. To buyers, it allows them to invest in a great business with reduced dilution and greater assurance of business performance. Startups are also favorably impacted by hiring and retaining quality talent with the promise of liquidity.
However, there are also risks. Secondary sales can be symptomatic of insiders losing faith and scaring other investors. Mishandling of the sale can also spook the cap table or bring in challenging stakeholders. Transparent policies and open communication avert these risks.
Endnote
Secondary stock sales are very attractive to startup stakeholders who want to achieve liquidity without waiting for a public exit. Priced correctly, these transactions will benefit sellers, buyers, and the firm. With the process, the law, and finances in mind, all involved can make informed decisions, resulting in long-term expansion.
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Over the years, he's worked with a range of clients and contributed to design publications like Design Your Way, Designmodo, WebDesignerDepot, WPDean, Speckyboy, and Slider Revolution among others.
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