Founder Secondary Sales: A Primer
Increasingly, founders desire liquidity with respect to a portion of their equity stake before the company goes public or completes a complete exit event (like an M&A sale). Liquidity is desired for many reasons, including (but not limited to) to diversify their net worth or to simply pay life expenses. (After all, one cannot pay a child’s college tuition or make a mortgage payment with appreciated private company stock—at least not yet!) Founders are often expected to take below a market salary for their contributions and the longer this expectation remains, the more the financial pressure can mount.
While there are many potential ways for founders to achieve company-related liquidity, one common method is through a secondary sale of their common stock to an institutional investor. This type of sale is explored further below.
Changing Narrative
In the past, the act of a founder requesting to “take some chips off the table” would have likely been interpreted by the company’s investors as a faux pas, signaling a lack of confidence in the company’s future prospects. However, founder liquidity is now a much more conventional aspect of a company’s lifecycle. There are many reasons for this shift in sentiment, including:
Timing. All else equal, the best time to explore a secondary sale is during the company’s next “priced” equity raise. From a process perspective, almost all of the workstreams necessary for a secondary sale can be completed by “piggybacking” onto the hard work inherent in putting together an equity raise (including, for example, negotiating the company’s equity value with investors and completing the investors’ due diligence processes). In addition, there could be favorable dynamics for the founder if the company’s equity raise is a competitive process (as noted above).
Other Key Considerations
The startup ecosystem is now much more willing to accommodate founders’ needs for liquidity, including through secondary sales at the time of a primary financing. A successful process requires advanced planning by the founder, including early and thoughtful communication with various company stakeholders such as the company’s board of directors, advisors and current investors. Founders should consider an investor’s position on founder liquidity before bringing them onto the cap table to avoid significant pain and frustration when it matters most.
While there are many potential ways for founders to achieve company-related liquidity, one common method is through a secondary sale of their common stock to an institutional investor. This type of sale is explored further below.
Changing Narrative
In the past, the act of a founder requesting to “take some chips off the table” would have likely been interpreted by the company’s investors as a faux pas, signaling a lack of confidence in the company’s future prospects. However, founder liquidity is now a much more conventional aspect of a company’s lifecycle. There are many reasons for this shift in sentiment, including:
- Longer Time Horizon. Many successful ventures are opting to remain standalone private companies for longer periods of time compared to what was customary in the past. There are many reasons driving this change (including the ability to raise larger sums of money in the private market), but the upshot for the purposes of this article is that investors are more sympathetic to the reality that founders may need to supplement whatever they are receiving in the form of salary if the IPO or ultimate exit event is further off in the future.
- VC Strategy. In addition, some venture capitalists now see founder liquidity as a potential lever to further their own strategic purposes:
- Negotiating Dynamics. If a company is in the process of a competitive equity raise, venture capitalists can propose secondary sales to (i) make their term sheet more attractive and/or (ii) increase the amount of money they can “invest” (particularly if the “primary” allocation of the round is oversubscribed) because the secondary creates room in the cap table without dilution of the other stockholders.
- Alignment. Founder liquidity can also be viewed as a mechanism to ensure go-forward alignment between investors and the founder. To illustrate the point, consider the motivations of a venture capital firm that invests in a company at a $100 million valuation, as compared to the motivations of the founder that owns 35% of that company. Post-investment, the venture capital firm will be focused on the company becoming a unicorn to lock in a 10x return or more (given the now-universal wisdom that the performance of venture capital firms is heavily driven by their massive successes). Conversely, the founder could become more risk-averse at this very moment, knowing that a relatively stable equity value would likely lead to an exit event that crystallizes significant personal wealth for the founder ($35 million or more). One potential way to solve this tension is through founder liquidity, locking in a base-level of financial security for founders and thereby freeing them to align with the venture capital firm’s goal to “swing for the fences” moving forward.
Timing. All else equal, the best time to explore a secondary sale is during the company’s next “priced” equity raise. From a process perspective, almost all of the workstreams necessary for a secondary sale can be completed by “piggybacking” onto the hard work inherent in putting together an equity raise (including, for example, negotiating the company’s equity value with investors and completing the investors’ due diligence processes). In addition, there could be favorable dynamics for the founder if the company’s equity raise is a competitive process (as noted above).
Other Key Considerations
- Structuring and Tax Analysis. From a legal perspective, there are many ways to structure a secondary sale. Tax considerations will be key in determining the best course of action—both with respect to the tax impact on the founder, as well as for any purchaser (who may be focused on Qualified Small Business Stock status under Section 1202 of the Internal Revenue Code, as discussed here). Bottom line: Tax advisors should be consulted early and often in connection with this process.
- Transfer Restrictions. Whether the secondary sale is completed during the company’s next equity raise or not, such a sale will very likely need to be approved by the company’s board and (at least) a subset of existing investors. This reality is due to the fact that company bylaws and existing stockholder agreements (like a Right of First Refusal and Co-Sale Agreement) likely restrict the ability of founders to freely sell their common stock to third parties. This dynamic encourages founders to first gauge the interest of existing investors (as opposed to starting with a new third-party investor identified by the founder).
- 409A. Founders should consider whether their sale of common stock would impact the company’s then-current 409A valuation. (409A valuations are further discussed here.) One potential knock-on effect of a secondary sale is that the stock options granted by the company to employees in the future may need to reflect an increased exercise price, potentially hindering its ability to sufficiently incentivize those employees moving forward. This is of particular relevance if there are many other “sellers” participating in the secondary sale (like co-founders or other early-stage employees).
- Tender Offer Rules. In addition to 409A considerations, if there are other “sellers” participating in the secondary sale, then legal counsel will also need to analyze whether the transactions constitute a “tender offer,” requiring compliance with applicable federal securities laws. As a rough rule of thumb, a secondary sale involving 10 or more sellers will likely qualify as a tender offer (whereas a secondary sale with less than 10 sellers may also qualify, depending on the particular facts and circumstances).
The startup ecosystem is now much more willing to accommodate founders’ needs for liquidity, including through secondary sales at the time of a primary financing. A successful process requires advanced planning by the founder, including early and thoughtful communication with various company stakeholders such as the company’s board of directors, advisors and current investors. Founders should consider an investor’s position on founder liquidity before bringing them onto the cap table to avoid significant pain and frustration when it matters most.