Founders guide to navigating secondary transactions

As startups mature, founders are often approached about secondary transactions.  As founders grow they often become concerned with the level of net worth they have tied up in one investment. These transactions can help provide liquidity to bootstrapped founders before an exit and also help them take a few chips off the table.

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The legal and tax mechanics, benefits, and complexities of secondary transactions are often confusing to founders who receive multiple opinions from their advisors. 

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Navigating these successfully can create win-win scenarios that help both incoming investors and the founders.  

What are secondary transactions?

Secondary transactions involve the sale of existing shares (stock) by current shareholders to other private investors. The private investor must be an Accredited Investor in most cases.  Company counsel will generally ask the investor to provide supporting documentation to prove they are accredited before they can engage in these transactions.  

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Unlike primary transactions where new shares are issued to raise capital for the startup, secondary transactions transfer ownership of existing shares, which does not impact the company's balance sheet or dilute other shareholders' stakes.  

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VC’s are often motivated by the founder’s being “all in” but they also realize they need to remove some chips from the table in order to have personal capacity to grow.  Properly aligning VCs and founders is often the crucial piece to ensuring a secondary sale can occur in an efficient manner.

Features of secondary transactions

• Non-dilutive nature: They do not dilute the ownership stakes of existing shareholders because no new shares are created or issued by the company. In many cases, approval from existing shareholders or the board will be needed.
• Liquidity: Shareholders can convert their equity into cash, providing immediate liquidity without waiting for a company exit.  However, some founders become concerned around the optics of cashing out some of their stock early and not being seen as “all in”.  This should be discussed with key investors, management and the board of directors. 
• Valuation: These transactions do not directly influence the company's market valuation since they do not involve the company's financial mechanisms. That being said, if there is a significant secondary transaction at a price that is well above or below the current valuation, this could be taken into account during the next company outside valuation.  For example, if the latest 409A has a price of $1 but a secondary sale occurs at $12 per share, this is likely a material event that must be considered. 

Benefits of secondary transactions

1. Financial flexibility for founders and employees: Startups often compensate key personnel with equity rather than high salaries to conserve cash flow. Secondary transactions allow these individuals to liquidate part of their holdings to cover personal expenses or diversify their personal net worth.
2. Cap table management: These transactions can assist with the strategic restructuring of the cap table, whether to streamline shareholder arrangements, accommodate new strategic investors, or resolve issues arising from changes in the management team or personal situations for the founders.
3. Opportunity for new investments for VCs: For late-stage investors looking to establish or increase a stake in a company they believe in without waiting for a new round of equity financing, secondary transactions can be a solution.
   

Process and challenges in secondary transactions

Valuation complexities

Determining the fair market value of shares in a privately-held startup is challenging due to the absence of a public market. Valuations must therefore rely on financial projections, recent funding rounds, and comparable company analyses, often requiring negotiation between the buyer and seller to agree on a fair price.  As aforementioned, a strong variance in the secondary price on a significant transaction could play into the future valuation(s) of the startup. 

Legal and contractual considerations

Secondary transactions are often governed by the company’s shareholder agreement, which may include rights of first refusal (ROFR) or other restrictions on share transfers between existing shareholders or an existing shareholder and an outside investor. Generally, company counsel needs to be involved in the transaction as well as outside counsel for the incoming shareholder(s) to ensure all compliance and regulations are followed. 

The role of rights of first refusal (ROFR)

Rights of First Refusal (ROFR) are commonly attached to shares in startup companies. This right allows existing investors to match the terms of a new offer on shares they do not already own, giving them the first opportunity to buy and prevent new parties from entering the cap table without their consent. This can ensure that existing shareholders can maintain or increase their stake before any shares are sold to external investors, some of whom may be looking to gain control of the company.  

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We often see the ROFR be exercised where an existing shareholder is selling shares to a key individual who does not see eye to eye with other shareholders or management. 

Tax implications of secondary transactions

Capital gains 

Sellers in secondary transactions are subject to capital gains tax on the difference between the sale price of their shares and their original purchase price (the adjusted basis). If the shareholder has held for greater than 1 year, they would qualify for long-term capital gains rates.  If the shareholder has acquired the stock in multiple tranches they should carefully consider which tranche they are selling as it will affect their ultimate federal and state capital gains tax.

Qualified small business stock (QSBS) considerations

Shares that qualify as QSBS under IRC §1202 (see our 1202 blog) may be eligible for favorable tax treatment, including exemptions from federal taxes on capital gains if certain conditions are met. 

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However, the company must be aware of the implications when companies buy back shares from founders, and then the VCs purchase directly from the company (often as preferred stock vs common stock).  These redemptions could be considered significant redemptions or related party redemptions which can upset QSBS treatment for both the parties involved and others. 

Summarizing secondary transactions

In practice, secondary transactions offer a somewhat complex but necessary strategy for providing liquidity for startup founders and key employees. We caution all founders to be aware of some of the tax traps around IRC 1202 and be aware of valuation considerations where there is a significant sale with a material price difference from the current fair market value.

However, with the right circumstances, these transactions may bring in strategic investors without a full financing round while helping founders achieve much-needed liquidity. 

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.

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