As your valuation rises, early investors may want to sell all or a subset of their stock in your company. For example, an early angel may want to diversify or sell her stake, as your company’s stock may be her biggest financial holding. Alternatively, a venture fund may want to sell part or all of its stake to return money to LPs, especially if they are raising their next fund and want to ensure the participation of those same LPs.
“In general, you should view investor secondary sales as an opportunity to claw back rights and clean up governance in a manner that is positive and mutually beneficial for all parties involved. ”
– Elad Gil
An investor’s interest in selling stock also presents a key opportunity for you, an opening to renegotiate prior terms with that investor. Some key items you may want to revisit include:
Information rights. As an investor’s stake diminishes, you can argue that they should no longer receive information rights if they have them. In some rare cases I have seen the biggest sources of leaks for companies have been early investors, rather than employees, trading favors with TechCrunch. Cleaning up early investor information rights can make a difference.
Board participation. Board representation is supposed to reflect ownership. Further, some early-stage investors are great advisors for a small ten-person company, but have no operating experience or insights for later-stage companies. As part of a secondary sale by a venture fund, you can ask that their board member step down, or you can convert her board seat into an independent seat from a preferred one. This returns control to the company and its founders and allows you to remove people from your board who are no longer helpful (or, in some cases, may be actively destructive). A large secondary sale to a preferred buyer or a tender is a unique opportunity to clean up the board, at least partially.
Cleaning up your cap table. A secondary tender may be an opportunity to clean up your cap table. For example, you can go to all your small, early angels and offer an “all or nothing” sale, where they can sell their entire stake or none of it. This may allow you to remove multiple line items from your cap table at once and consolidate them by selling their stock to a single investor with a bigger ownership stake.
In general, you should view investor secondary sales as an opportunity to claw back rights and clean up governance in a manner that is positive and mutually beneficial for all parties involved. The funds get to sell part of their stake and return money early to LPs, and the company gets to remove board members or information rights that have existed past their prime.
Any secondary sale is also an opportunity to prevent that same individual or fund from selling again without explicit company say-so. This is most important for the many companies that had sloppy initial structures in place for secondary sales (in some cases having no restrictions at all on early employees, not even a ROFR—Fenwick & West is notorious for leaving this out of their standard docs).
Whenever any party sells its stock, you should ask them to sign a contract that will prevent future sales without company sanction. Similarly, you may change your bylaws and general employee docs to create a situation that still allows for employee sales, but avoids long-term harm to the company via random cap table additions or bad actors buying stock. Ask your legal team to draft documents that help with both approaches.