Secondary Share Sales Explained: Benefits, Risks, and Best Practices for Founders

This can create financial stress and limit personal financial planning options. Secondary share sales offer a potential solution, allowing founders to sell a portion of their equity without waiting for an IPO or acquisition.

This article explores the ins and outs of secondary share sales, providing founders with a comprehensive understanding of the process, its benefits, potential risks, and best practices to consider.

What Are Secondary Share Sales and Transactions?

Secondary share sales occur when existing shareholders in private companies sell some of their shares directly to new or existing investors. This process allows early stakeholders, such as founders, employees, or early investors, to liquidate a portion of their equity without waiting for a traditional exit event like an IPO or acquisition. Unlike primary financing rounds where new shares are issued and the company receives the capital to fund operations or growth, in secondary transactions the proceeds go directly to the selling shareholders. This means the company’s overall capitalization doesn’t change, but the ownership structure shifts as shares transfer from existing holders to new investors.

There are two main types of secondary transactions:

1. Direct Secondary Sales

In a direct secondary sale, an individual shareholder (like a founder) negotiates directly with a potential buyer to sell a portion of their shares. Key characteristics include:

• • Deals are not typically organized by the company: The shareholder initiates and manages the transaction independently, which can lead to a more streamlined process but may also require more effort from the seller to find interested buyers.
  • Price paid is negotiated between buyer and seller: This allows for potentially higher prices if there’s strong buyer interest, but also means the seller needs to be prepared to justify their valuation and negotiate effectively.
  • Limited standardization in terms of information disclosure: The amount and type of information shared can vary widely, which gives the seller more control but may also lead to longer due diligence processes as buyers seek to understand the company’s position.
  • The company may have a right of first refusal (ROFR) to purchase the shares instead of the external buyer: This provision, often included in shareholder agreements, allows the company to maintain more control over its cap table by choosing to buy back the shares at the negotiated price instead of allowing them to be sold to an external party.

2. Tender Offers

A tender offer is a structured, company-organized process that allows multiple shareholders to sell their shares simultaneously to one or more predetermined buyers. This approach provides a more formalized and equitable way for employees, founders, and early investors to gain liquidity, while giving the company greater control over the transaction. Tender offers are often used by later-stage startups as a way to provide partial liquidity to a broad base of shareholders without the complexities of going public.

Key features of a Tender Offer:

• • The company sets the share price, maintaining more control over 409A valuation (for US companies) impacts: This allows the company to manage potential fluctuations in its 409A valuation, which determines the strike price for employee stock options. By controlling the price, the company can mitigate unintended consequences on its equity compensation strategy.
  • Can be structured as an auction to determine fair market value: An auction format can help establish a true market price for the shares, potentially leading to better outcomes for sellers while ensuring buyers pay a fair price. This approach can be particularly useful when there’s significant interest from multiple potential buyers.
  • Often have standardized disclosure requirements: The company typically provides a standardized information package to all potential buyers, ensuring equal access to information and streamlining the due diligence process. This can include financial statements, business projections, and other relevant company data.
  • May be paired with a primary financing round: Combining a tender offer with a primary investment round can be an efficient way to satisfy both existing shareholders’ liquidity needs and the company’s capital requirements. This approach can also make the overall deal more attractive to new investors by offering them a larger ownership stake.

It requires board approval to ensure control and mitigate risks associated with unrestricted sales.

Benefits of Secondary Sales for Founders and Early Investors

Secondary sales can offer several advantages for startup founders:

1. Personal Financial Diversification

Selling stock through secondary sales can provide immediate liquidity for founders, without waiting for an IPO or acquisition. Founders can sell a portion of their shares to investors, providing them with immediate cash while still retaining a significant stake in the company. This can be particularly useful for diversifying personal finances or funding new ventures. 

This can help founders:

• • Reduce financial stress and improve work-life balance
  • Invest in other assets or ventures
  • Pay off debts or make major purchases (like buying a home)
  • Build a financial safety net

2. Maintaining Control and Motivation

By selling only a portion of their equity (typically 10% or less), founders can realize some financial gains while retaining their significant ownership stake and motivation to grow the company.

3. Potential Tax Advantages

Depending on how long you’ve held the shares, a secondary sale may qualify for favorable tax treatment:

• • Long-term capital gains rates (for shares held over 1 year): In many countries, holding shares for at least one year qualifies the sale for long-term capital gains tax rates, which are often lower than ordinary income tax rates. This can result in significant tax savings, especially for high-income individuals.
  • Potential Qualified Small Business Stock (QSBS) exemption (for shares held over 5 years, subject to other qualifying criteria): In the United States, QSBS rules allow for up to 100% exclusion of capital gains on eligible stock held for more than five years, up to certain limits. This can provide substantial tax benefits for founders and early employees of qualifying startups, potentially eliminating capital gains tax on up to $10 million in gains or 10 times the adjusted basis of the stock.

It’s important to note that tax implications can vary significantly depending on the source country, and rules differ across jurisdictions.

4. Signaling Effect

A founder’s willingness to hold onto the majority of their equity can signal confidence in the company’s future prospects to other investors and employees. By selling only a small portion of their shares through a secondary transaction, founders can demonstrate their long-term commitment to the company’s success. This approach allows founders to access some liquidity without diluting their own ownership, as would occur in a primary funding round, potentially reinforcing stakeholder trust in the company’s trajectory.

Risks and Considerations

While secondary sales offer clear benefits, they also come with potential drawbacks that founders should carefully consider. 

1. Impact on Existing shareholders

These transactions can significantly impact the venture capital landscape and existing shareholders, including founders and early investors, by providing an alternative exit strategy for venture capitalists during substantial fundraising rounds.

2. Pricing Complexity

Determining a fair price for private company shares can be challenging. Factors to consider include:

• • Recent primary valuations and company’s stock performance: The valuation from the most recent funding round provides a starting point, but it may not reflect the current fair market value. Consider how the company has performed since the last round and any changes in market conditions that could impact valuation.
  • Company performance and growth trajectory: Current financial metrics and future growth projections play a crucial role in determining share value. Investors will closely examine revenue growth, profitability (or path to profitability), market share, and other key performance indicators.
  • Lack of liquidity in private markets: Unlike public stocks, private shares cannot be easily bought or sold. This illiquidity typically results in a discount compared to what the shares might be worth if the company were public. The size of this discount can vary based on the company’s stage and perceived time to a potential exit event.
  • Preferred vs. common stock distinctions: Most employees and founders hold common stock, while investors typically hold preferred stock with additional rights and protections. This distinction often results in common stock being valued at a discount to preferred shares, reflecting the different risk profiles and liquidation preferences.

Secondary shares are often sold at a 10-20% discount compared to the most recent primary round valuation due to these factors.

3. Information Disclosure

Buyers will likely require access to company financial information and projections. This raises questions about:

• • How much information to disclose
  • Potential confidentiality concerns
  • Time and effort required to prepare disclosure materials

4. Impact on Company Valuation

Secondary sales can affect your company’s 409A valuation, which determines the strike price for employee stock options. A lower 409A valuation can be beneficial for attracting talent, but it’s important to understand and prepare for these potential impacts.

5. Regulatory Compliance for Private Companies

Secondary sales must comply with securities laws. This may involve:

• • Ensuring buyers are accredited investors
  • Filing appropriate documentation with regulatory bodies
  • Adhering to any transfer restrictions in existing shareholder agreements

6. Perception and Morale Issues

If not handled carefully, founder secondary sales can negatively impact employee morale or investor perception. Team members might question why they aren’t offered similar liquidity options, or investors may worry about founder commitment.

Best Practices for Founders Considering Secondary Sales

To maximize the benefits and minimize risks associated with secondary sales, consider the following best practices:

1. Timing is Key

The best time for a secondary sale is often during or immediately following an oversubscribed primary funding round. This ensures:

• • The company isn’t missing out on needed capital
  • There’s clear market validation of the company’s value
  • Investor demand exists to absorb the secondary shares

2. Limit the Sale Amount

Most investors and board members are comfortable with founders selling 10% or less of their holdings in a secondary transaction. Selling a larger percentage may raise concerns about your long-term commitment.

3. Extend the Opportunity to Your Team

To maintain strong morale and alignment, consider offering similar liquidity options to other employees with vested equity. This could involve:

• • Structuring a tender offer open to all eligible shareholders
  • Allowing employees to sell the same percentage of their vested equity as founders

4. Engage with Your Board Early

Discuss your intentions to pursue a secondary sale and obtain board approval with your board of directors well in advance. Their support and guidance can be invaluable in structuring a transaction that works for all stakeholders.

5. Understand Tax Implications

Consult with a tax professional to fully understand the tax consequences of your secondary sale. Consider:

• • Holding periods required for long-term capital gains treatment
  • Potential eligibility for QSBS exemptions
  • How the sale may affect your overall tax situation

6. Be Transparent About the Process

Clear communication with your team, existing investors, and potential buyers is crucial. Be prepared to explain:

• • Your motivations for the secondary sale
  • How it aligns with the company’s long-term goals
  • Any potential impacts on the company’s valuation or operations

7. Prepare for Due Diligence

Even in direct secondary sales, buyers will likely require some level of due diligence. Prepare key documents in advance, including:

• • Financial statements and projections
  • Cap table and detailed shareholder information
  • Key contracts and intellectual property documentation
  • Information on the competitive landscape

8. Consider Using a Specialized Marketplace

Several online platforms now facilitate secondary transactions for private company shares. Private investors can use these marketplaces to purchase shares in high-potential ventures. These marketplaces can provide:

• • Access to a broader pool of potential buyers
  • Standardized processes and documentation
  • Assistance with regulatory compliance

Examples include EquityZen, Forge Global, and Nasdaq Private Market.

9. Respect Existing Agreements

Review your company’s bylaws, shareholder agreements, and any prior investment documents for provisions that may affect secondary sales, such as:

• • Rights of first refusal (ROFR)
  • Co-sale rights
  • Transfer restrictions

Ensure you comply with all existing obligations to the company and other shareholders. 

10. Plan for the 409A Impact

Work with your finance team or external valuation experts to model the potential impact of the secondary sale on your company’s 409A valuation. This will help you prepare for any necessary adjustments to your equity compensation strategy.

Conclusion

Secondary share sales can be a powerful tool for founders to achieve some personal financial stability while continuing to lead their companies to greater heights. By carefully considering the benefits and risks, and following best practices, you can structure a secondary transaction that works for you, your team, and your investors.

Every company’s situation is unique. It’s crucial to consult with legal, tax, and financial advisors who can provide guidance tailored to your specific circumstances. With the right approach, a secondary sale can provide the financial breathing room you need to focus on long-term value creation for all stakeholders.

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