How Secondary Sales Work in Venture Capital

Secondary sales in venture capital are a way for existing investors to sell their shares to new investors, often at a profit. This process involves a transfer of ownership, not the underlying company.

A secondary sale typically occurs when a venture capital firm has invested in a startup, and later decides to sell some or all of its shares to another investor. The sale price is usually determined by the market value of the company.

The secondary sale market is relatively small compared to the primary market, where startups raise new capital from investors. However, it's growing in popularity as more companies opt for secondary sales.

Curious to learn more? Check out: Secondary Equity Market

A secondary sale is a sale by an existing stockholder to a third-party purchaser, the proceeds of which benefit the selling stockholder.

The main difference between a secondary sale and a primary sale is where the proceeds go - if to the company, it's typically a primary sale, if to existing shareholders, then it's a secondary.

In a secondary sale, the shares being sold have belonged to someone else, whereas in a primary sale, the shares are newly issued.

Secondary sales must meet various SEC requirements, so it's best to have the company's law firm involved, if possible, and if necessary, a separate lawyer representing you, the shareholder(s) that is selling their shares.

Secondary sales involve a range of considerations for both sellers and buyers. Sellers must be aware of local laws regarding the sale and taxation of secondary stock. Different countries have different laws, so it's essential to research and understand the specific regulations that apply.

Contractual restrictions can also impact a secondary sale. Sellers may be bound by restrictions on transfer, such as rights of first refusal in favor of the company or third-party investors. These restrictions can limit the seller's ability to sell their shares.

Company cooperation is crucial for a successful secondary sale. Buyers generally pay more when they have greater insight into the company's recent performance, financial condition, and projections. However, companies may not always be willing to cooperate, and sellers must be prepared to navigate this situation.

Information is also a critical consideration in a secondary sale. Sellers may have agreed not to share confidential information with third parties, but insider trading rules still apply. Sellers must carefully consider whether they have material, nonpublic information that the buyer does not possess.

Pricing is also a key consideration in a secondary sale. Compliance with securities and transfer restrictions, company cooperation, and readily disclosable information can all help to reduce the illiquidity discount and improve pricing.

Here are some key considerations for sellers:

These considerations can impact the success and price of a secondary sale. Sellers and buyers must carefully navigate these factors to achieve a successful transaction.

When participating in a secondary sale, companies should consider the rights of third parties, such as investors or co-sale obligations, that may be affected by the transaction.

Companies may want to exercise their rights or assign them to a friendly third party, but they must ensure that the seller's obligations have been satisfied in full or properly waived.

A secondary sale can be a distraction for management, impeding the company's progress and growth, and setting expectations among other stockholders for future support.

Companies may impose a transfer fee to defray the costs of evaluating compliance with applicable law, gathering and disseminating information, and reviewing transfer documentation.

To protect confidential information, companies should provide it using a non-disclosure agreement, so that it is not shared with others or used for any purpose other than evaluating the transaction.

The impact of a secondary sale on option pricing should be considered, as it may affect a board's view on the fair market value of the company's stock.

Here are some key considerations for companies whose stock is subject to secondary sales:

An IPO (Initial Public Offering) is when a company issues shares for the first time to the public. This is a significant milestone for a company, marking its entry into the public market.

The company proposes newly issued equity stock in an IPO, which increases its capital. In contrast, a secondary offering involves the sale of existing shares by current shareholders.

In an IPO, the company receives the funds from the sale of new shares. This allows the company to use the money for various purposes, such as expanding its operations or paying off debt.

Here's a comparison of IPO and secondary offering characteristics:

Overall, an IPO is a significant event that allows companies to raise capital and enter the public market.

Venture Capital is a way for companies to raise funds by selling shares to investors. This type of funding is often used by startups and small businesses to grow and expand their operations.

A secondary sale in VC is an exit strategy for stakeholders and employees. It allows them to sell their shares to another investor, making room for new investors to participate in business development.

In a secondary sale, investors or employees sell their shares in a portfolio company to another investor. This sale is a common exit strategy for stakeholders who want to cash out their investment.

Secondary sales are a way for investors to monetize their investment in a company. They can sell their shares to another investor, realizing a return on their investment.

Investors can sell their shares in a secondary sale to other investors, allowing new investors to participate in the company's growth.

See what others are reading: Investment Sales Broker

Secondary sales can be a complex and challenging process, and it's essential to understand the risks and challenges involved.

Valuation is a significant risk, as establishing an objective value for a share in a private company requires a lot of work.

Liquidity is another challenge, as finding a buyer for shares in a private company can be difficult.

Regulation can also be a restriction, as secondary sales may be subject to SaaS legal and regulatory provisions.

Signaling is a concern, as secondary sales strategies can send different signals to potential buyers.

Here are some of the key challenges companies face when dealing with secondary sales:

The secondary sales market has become increasingly popular in Silicon Valley, particularly since the crash of 2008. IPOs have become less common, and startups are staying private longer, leaving early employees and founders without liquidity for their shares.

Many private companies are now raising series C, D, and even series E preferred stock, with some having over $100 million in revenues. Some of these companies have become "unicorns", with valuations over $1 billion.

These private companies are attractive to investors, and the demand for secondaries has increased as a result. If you can get the stock of a hot private company that's doing well, it's likely that an IPO may be coming in a year or two, rather than having to wait 5 or more years as was the case previously.

Some notable examples of companies that have reached unicorn status include Uber, Facebook, Twitter, Pinterest, and Palantir. These companies have valuations well over $1 billion before they went public.

For another approach, see: Harley Finance Private Sales

Here are some of the key risks and challenges associated with secondary sales:

A secondary sale is a sale of shares by a stockholder to a third-party, but it can't happen alongside an acquisition of the company. This means the sale must be to another investor, not as part of a company buyout.

To be considered a true secondary sale, the sale must not occur alongside an acquisition of the company, and the stockholder must sell their shares to another investor.

Some secondary sales come with restrictions and legislation. These can include needing board approval or giving the company a right of first refusal to buy the shares.

Secondary sales differ from primary sales because in primary sales, the company sells stock to its investors and keeps the money. In secondary sales, the proceeds go to the stockholder, and the company doesn't see a cent.

Here are some implications that can come into play for secondary stockholders:

A secondary sale is a sale of shares that has already been publicly traded. For example, Acme Inc. had an IPO and is now publicly traded, and one of its early investors sold some shares to a new investor.

This type of sale provides a way for existing shareholders to cash out some of their investment. Secondary sales are common in the startup world.

Existing shareholders can sell their shares to new investors, who can then buy into the company. This can also provide additional capital for the company to use for growth and expansion.

Silicon Valley has seen a surge in secondary sales, primarily due to the decline in IPOs since the 2008 crash. IPOs were once a common exit strategy for startups, but now companies are staying private longer, leaving early employees and founders without liquidity for their shares.

This trend has led to the rise of secondary sales, allowing early shareholders to cash out part or all of their holdings. Secondary sales have become a popular option for those who want to get liquidity for their shares, especially if an IPO is expected in the near future.

The demand for secondary shares has increased, not decreased, despite the rise in tech IPOs. This is because investors can get in on a hot private company with a high valuation, potentially leading to a future IPO.

Rarely do employees stay at one company for more than a few years, but successful startups may not have an IPO for 5-10 years. This leaves employees wanting to cash in on part or all of their holdings as a reward for their early participation.

Founders may also want to cash out enough to buy a decent home in Silicon Valley, as being a millionaire "just on paper" can be stressful. VCs have become more sympathetic to founders selling secondary shares, acknowledging the need for liquidity.

Here are some key statistics on the popularity of secondary sales in Silicon Valley:

The rise of secondary sales has created a new market for investors and sellers alike. As more companies stay private longer, the demand for secondary shares is expected to continue growing.

A secondary sale is a common occurrence in the startup world, where existing shareholders sell their shares to new investors. This provides a way for existing shareholders to cash out some of their investment and for new investors to buy into the company.

Existing shareholders sell their shares through an underwriter who assists in setting the price for the shares and the public offering, which is quite similar to an IPO but focuses on existing shares rather than new ones.

In a secondary offering, the underwriter plays a key role in setting the price for the shares and the public offering. This process is often used to provide additional capital for the company to use for growth and expansion.

Company-sponsored secondary transactions are often structured as a direct purchase of shares by one or more investors, either paired with a primary equity financing of the company or as a stand-alone transaction.

Existing and new investors are the most popular buyers of private secondaries. They know the company well, having done due diligence on it.

Existing investors are often eager to buy more shares of a company that's doing well. They may have specific percentage thresholds they want to reach or maintain, such as keeping a 20% ownership stake.

New investors, like venture capital funds, may also be interested in buying shares of a successful startup. However, if the round is oversubscribed, they may not be able to get in on the primary sale.

In such cases, buying shares from existing shareholders becomes a viable option. This allows the fund to get some stock in the company and avoid waiting for the next round.

Some investors, like those in the Zynga example, may even buy shares in subsequent rounds, with the amount of money increasing significantly from series A to series C or D.

Suggestion: Buy Secondary Market Silver

Here's a breakdown of the different groups that participate in buying secondary shares:

These groups often have a strong interest in buying shares of successful startups, as it allows them to increase their ownership stake or get in on a company that's doing well.

Matching websites and micro funds can be a great way to buy and sell shares of companies. There are several organizations that specialize in secondary sales, including Shares Post, Second Market, and Micro Ventures.

These websites are often "matching" sites, where you post what you're looking to buy or sell, and if enough people match, the organization brings buyers and sellers together. Un-curated versions of these sites allow you to post your interest in buying or selling shares of a specific company.

In curated versions, the organization selects which shares they think will be of interest to their investors and packages them up for sale. This is often better for well-known companies in Silicon Valley that are doing well.

These curated versions usually involve investors who are putting in smaller amounts to be aggregated.

Intriguing read: Independent Sales Organization

Private investors can buy your shares in a hot startup, as seen in a 2008 deal where a friend was approached to buy shares in Facebook.

In some cases, a group of private angel investors forms an LLC, known as an SPV, to buy shares from employees. This SPV is a special purpose vehicle used for the sole purpose of buying shares.

The actual deal can be complicated, as in the case of the Facebook employee who contributed his shares to the LLC and became a shareholder. He even participated in some of the upside on those shares.

An SPV is a way for the company to stay within its 500 shareholder limit, as the shares are registered under one shareholder, but multiple investors are actually participating.

Expand your knowledge: Private Equity Secondary Investments

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, while others may be better at finding buyers since they have a diverse range of clients.

In a special case, we once hired an investment banker to sell our shares in a mobile advertising company that had grown very big, and they ended up negotiating a deal with an existing investor who wanted more shares.

Be sure to do your background reference checks to find out what the investment bank is good at, as this can make a big difference in the outcome of your secondary sale.

The right of co-sale can be a tricky thing to navigate in a secondary sales market. It's a common right that investors ask for, ensuring they can sell a pro-rata percentage of their share at the same price as the founder.

This right is meant to prevent the founder from getting a better deal on their stock than the investors. For example, if someone offers to buy 1000 of your shares at $2.00 per share, the investors with a co-sale arrangement would be entitled to sell a corresponding percentage of their shares.

The economics of the deal can be affected by this right, as the founder may end up selling fewer shares than expected. It can also complicate the deal timing, as a notice needs to be sent to all other shareholders, giving them a specified period to respond.

Ignoring these notices is not uncommon among shareholders, especially in VC-backed companies. To avoid potential issues, it's essential to get the company cooperating with the sale or at least not opposing it.

Restrictions on shares can be a major obstacle in the secondary sales market. These restrictions are common in private companies and can limit the buyer's ability to sell their shares.

For instance, shares in private companies often come with lock-up periods, which can last anywhere from a few months to several years. This means that even if you buy shares, you might not be able to sell them right away.

Check this out: Secondary Sale Private Equity

You might have a dilemma if you're approached about buying shares just before a well-known IPO is coming up. 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.

It's essential to understand the restrictions on shares before making a purchase. This will help you make an informed decision and avoid potential pitfalls.

Here are some common restrictions on shares to be aware of:

Understanding these restrictions can help you navigate the secondary sales market with confidence.

Founder Series FF Preferred is a special class of stock that was created by founders to sell to investors. This stock had preference over common stock but was subordinate to any other preferred stock.

Founders would often hold a small percentage of their shares in FF Preferred, like 10%, to give investors what they wanted - preferred stock. This allowed founders to sell shares when the company was doing well and the stock was in demand.

This type of stock was popular a few years ago, but it's not as common now. It's still something to keep in mind when navigating the secondary sales market.

In a company-sponsored secondary transaction, the company decides which stockholders can sell their shares and sets limits on those sales. This typically includes current employees and limits the offer to those with vested holdings.

The company may limit the amount any one employee can sell to a small percentage of their vested shares, such as 10%, to ensure they continue to have meaningful equity incentives.

A company-sponsored transaction can be structured as a direct purchase of shares by investors, paired with a primary equity financing, or as a stand-alone transaction. Alternatively, it can be structured as a buyback of shares by the company, funded with cash on hand.

Here are some possible structures for a company-sponsored secondary transaction:

There are websites and organizations that specialize in secondary sales, such as Shares Post, Second Market, and Micro Ventures. These sites are often "matching" sites that bring buyers and sellers together.

In the un-curated version, you can post that you want to sell or buy shares of a company, and if enough buyers or sellers match, the organization will put together an LLC to buy those shares or introduce buyers and sellers to each other.

Thousands of startups are founded each year in Silicon Valley, but very few make it to a series A, let alone a successful IPO. This is why investors are turning to secondary shares as a way to reduce their risk.

A few funds have been formed specifically for buying secondary shares of startups that are taking off, such as Industry Ventures.

Founders can create a special class of stock, Series FF Preferred, which has preference over common stock but is subordinate to other preferred shares. This allows founders to sell preferred stock to investors when the company is doing well, providing liquidity without liquidating common shares.

Investors often prefer preferred stock, making it a valuable asset for founders to leverage. Secondary sales can provide liquidity for entrepreneurs, early investors, and employees when a company is thriving but an exit isn't imminent.

Founders typically hold a majority of the company's shares, but a portion of those shares can be in Series FF Preferred, such as 10% of their shares or 5% of the company. This setup is designed to meet investor demand for preferred stock.

Setting stockholder expectations early on can make a big difference in a company's journey. A private company tends to feel pressure to provide liquidity to its stockholders as it increases in value.

It's unlikely that employees and investors will have an expectation or desire to sell their shares in a company's early years. This changes as the company grows in value and remains privately held.

Setting expectations clearly and consistently can help avoid confusion and disappointment down the line. Whether you decide to engage in a secondary transaction or require stockholders to wait until an IPO or M&A event, it's essential to communicate your approach to stockholders.

Private companies often feel pressure to provide liquidity to their stockholders, especially as the company's value increases. This pressure can lead to stockholders expecting to sell their shares at some point.

A different take: Enterprise Value-to-sales Ratio