Secondary transactions: A founder’s guide

Secondary transactions let startup shareholders sell existing shares to private investors before an IPO or acquisition. Unlike primary transactions, which bring in new capital, secondaries transfer ownership of existing stock without diluting other shareholders.

For founders balancing years of sweat equity against financial pressures, secondary sales can provide much-needed liquidity. They also help retain employees through early cash-outs and may attract new investors.

Handled thoughtfully, secondary transactions can create win-win outcomes for both founders and incoming investors.

What are secondary transactions?

Secondary transactions are the sale of existing shares by current shareholders to private investors, rather than on the public market. Unlike primary transactions, which issue new shares to raise capital, secondaries transfer ownership without changing the company’s balance sheet or diluting other stakeholders.

They often occur when early employees want to cash out stock options, or when founders need financial liquidity before an exit. Secondary sales also appear in late-stage fundraising, where new investors buy from existing shareholders, or through tender offers that let multiple employees sell at once.

Key stakeholders include selling shareholders (founders, employees, early investors), buyers (growth equity firms, hedge funds, special purpose vehicles), and the company’s board, which typically must approve transfers. Existing investors may also exercise a right of first refusal (ROFR). Larger or multi-party transactions often involve lawyers and brokers to manage approvals and documentation.

Why founders consider secondary transactions

Secondary transactions give founders and employees access to cash while supporting company growth. Common reasons include:

• Personal liquidity: Convert equity into cash after years of below-market salary and reinvest in your life outside the company
• Risk diversification: Reduce exposure by turning paper wealth into savings or other investments
• Major life events: Cover significant expenses like a home purchase, education, or medical costs without waiting for an exit
• Employee retention: Provide early liquidity to key team members who might otherwise leave for higher salaries
• Talent attraction: Demonstrate that equity has real monetary value, not just future potential
• Investor alignment: Bring in new investors who want a stake when no primary round is open

These benefits explain why secondaries have become a standard tool for managing wealth and motivation at high-growth startups.

Potential downsides to secondary transactions

Secondary transactions also carry risks that founders need to weigh carefully:

• Negative signaling: Large founder sales can raise doubts about commitment or confidence in the company’s future
• Misaligned incentives: Shareholders who cash out may feel less pressure to drive growth and maximize value
• Control complications: New investors may push for board seats, information rights, or other governance powers
• Investor friction: Existing backers may resent being excluded from attractive opportunities
• Valuation disputes: Pricing often creates tension between buyers seeking discounts and sellers wanting full value
• Administrative burden: Transfer approvals, legal documents, and ROFR processes can be time-consuming

The key is to balance personal needs with company health while maintaining trust with your investors and team.

Key legal and financial considerations

Secondary transactions come with significant legal and tax requirements. Board approval, compliance with right of first refusal (ROFR) provisions, and adherence to securities regulations are essential. Experienced legal counsel can help avoid pitfalls that might derail the transaction or create future complications.

Tax treatment differs for founders and employees. Founders who have held shares for more than a year often qualify for long-term capital gains rates, while employees may face alternative minimum tax (AMT) rules on incentive stock options. The timing of your sale and the type of equity you hold determine your actual tax burden, making professional tax advice critical.

Securities laws also limit who can buy secondary shares. Buyers must meet accredited investor requirements for income or net worth, and companies are responsible for verifying status and maintaining proper documentation to remain compliant.

409A valuation

A 409A valuation sets the fair market value of a company’s common stock for tax purposes. This independent appraisal prevents undervaluing stock options, which could trigger penalties and extra taxes. Most companies update their 409A annually or after major events like funding rounds.

Secondary transactions must follow 409A pricing rules to stay tax compliant. Selling below the 409A value can create issues for buyers and option holders alike. The valuation also provides a baseline for sale negotiations, though final prices often reflect broader market conditions and investor demand.

Recent valuations carry more weight than older ones. If the last appraisal is more than six months old, buyers may request an update. Significant business changes can also render previous valuations less relevant during negotiations.

Qualified small business stock (QSBS)

Qualified small business stock (QSBS) can allow founders to exclude up to 100% of capital gains on eligible stock sales under Section 1202. The benefit applies to gains of up to $15 million (as of Jul 4, 2025) or 10 times your adjusted basis, whichever is greater. To qualify, you must hold C-corporation stock for at least 5 years and meet specific company-level requirements.

At the time you acquired the stock, the company must have had gross assets under $50 million. It must also use at least 80% of its assets in an active trade or business, excluding most professional services and financial firms. These requirements apply for your entire holding period, not just at acquisition.

Founders often lose QSBS eligibility through preventable mistakes. Early secondary sales, restructuring from a C-corp to an LLC or S-corp, or the company crossing the $50 million asset threshold before the 5-year mark can all disqualify shares. Careful tracking is essential, since the tax savings can reach millions of dollars.

How secondary transactions work

Secondary transactions let existing shareholders sell equity to new or current investors without the company issuing new shares. According to Jefferies, the global limited partner and general partner secondary markets grew from $112 billion to $162 billion between 2023 and 2024, a 45% increase, with continued growth expected in 2025.

Here’s how a typical transaction unfolds:

Private equity secondaries create liquidity for shareholders while preserving the company’s cash position and avoiding stock dilution for existing stakeholders.

Due diligence considerations

Both buyers and sellers need to complete thorough due diligence before closing a secondary transaction.

For buyers:

• Review the company’s latest financial statements and performance metrics
• Analyze recent funding rounds and valuation trends
• Check for pending litigation or regulatory issues
• Verify the seller’s ownership rights and share restrictions
• Assess the company’s growth trajectory and competitive position

For sellers:

• Confirm the buyer’s financial capability to complete the transaction
• Verify compliance with company transfer restrictions
• Review the tax implications of the sale, such as capital gains treatment
• Understand any holdback or escrow requirements
• Check for pending events that could affect share value

Legal counsel ensures compliance with securities laws, drafts agreements, and manages transfer restrictions. Financial advisors provide valuation analysis, identify qualified buyers or sellers, and negotiate terms to optimize tax outcomes.

Right of first refusal (ROFR)

A right of first refusal (ROFR) gives the company and existing investors the option to buy shares before they’re sold to outside parties. Most stockholder agreements include this provision as a way to control who joins the cap table.

When a shareholder wants to sell, the shares are first offered to the company at the proposed price. If the company declines, they are offered to existing investors on a pro-rata basis. Only if both pass can the seller move forward with an outside buyer.

The ROFR process usually takes 30–90 days. This window gives companies time to evaluate whether the prospective buyer aligns with their investor base and long-term goals.

Accredited investor requirements

Securities laws restrict most secondary transactions to accredited investors. This rule is meant to protect less experienced investors from the risks of buying illiquid, unregistered securities.

An accredited investor is generally someone who meets at least one of the SEC’s financial thresholds:

• Income: $200,000 in annual income ($300,000 jointly) for each of the past two years, with the expectation of the same in the current year
• Net worth: Over $1 million in net assets, excluding a primary residence

Buyers must provide documentation to prove their accredited status before completing a secondary sale. This requirement can limit the pool of eligible buyers but helps ensure compliance with securities regulations. Some exemptions exist for employees and existing shareholders.

A secondary transaction in action

Here’s a simple example of how a secondary transaction might play out:

Sarah joined XYZ Tech as employee #8 in 2019, receiving 0.5% equity in the company. By 2024, XYZ Tech had grown to 200 employees and raised a Series C financing round at a $500 million valuation. Sarah wanted to buy a house but didn’t want to leave the company she helped build.

The company allowed employees to sell up to 25% of their vested shares each year. Sarah chose to sell 20% of her holdings, worth roughly $500,000 at the recent valuation. The company exercised its right of first refusal but passed, and an existing institutional investor bought the shares at the Series C price.

The process took 45 days from request to closing. Sarah got her down payment, the investor increased their position, and XYZ Tech retained a motivated employee with 80% of her original equity stake intact.

Best practices for navigating secondary transactions

Secondary transactions work best when managed strategically to balance employee liquidity with company growth and investor alignment. Founders can set themselves up for success by following these practices:

• Negotiate volume caps: Limit the percentage of shares eligible for sale in each window to maintain stability and prevent over-concentration of influence among new investors
• Communicate proactively: Share your transaction policy with the board early, give regular updates on timing and volume, and explain how sales support retention and liquidity goals
• Preserve culture: Position secondary sales as rewards for early contributions, keep employees invested with meaningful ownership, and celebrate liquidity while reinforcing long-term commitment to the mission

These practices help you provide meaningful liquidity while keeping control and alignment intact.

Common mistakes to avoid

Avoiding pitfalls will help you navigate secondary transactions without damaging relationships or creating unintended consequences:

• Ignoring transfer restrictions: Skipping a review of stockholder agreements can cause legal conflicts, violated contracts, and tension with investors expecting certain protections
• Poor timing: Scheduling secondary sales right before a funding round or major announcement can create valuation confusion and signal misalignment to new investors
• Inconsistent policies: Treating shareholders differently without clear reasons breeds resentment, creates perceptions of favoritism, and harms morale
• Overlooking tax impacts: Failing to account for seller tax consequences, such as AMT on exercised options, can turn liquidity events into financial setbacks

Thoughtful policies and clear communication prevent most secondary transaction headaches.

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The information provided in this article does not constitute accounting, legal or financial advice and is for general informational purposes only. Please contact an accountant, attorney, or financial advisor to obtain advice with respect to your business.