The secondary stock sale: The employee perspective

The previous few sections have focused on how to regulate secondary sales from the company perspective. The focus of this section is the employee perspective: How to sell your stock on secondary markets.

1. Understand if you can sell stock.

Check your stock option plan, company charter, or other company documents to see whether you can sell secondary stock. If your company has a general counsel, you can also ask her about the details of what you can or cannot do. Alternatively, some later-stage companies have a person on the finance team dedicated to secondary transactions; even the CFO may be the right point of contact.

From a process perspective, most companies will have a 30- or 60-day right of first refusal (ROFR). This means that once you’ve negotiated a price with a potential buyer, the company can decide if it wants to purchase your shares at that price, instead of the buyer. If the company declines, existing investors in the company may also have a ROFR and will be asked if they want to buy your shares. If everyone passes, then the original buyer can purchase the shares from you. If the company or its existing investors want to exercise their rights of first refusal to buy the shares, they will pay you the same price you negotiated with the buyer. So even if a ROFR is invoked, you will be able to sell your shares.

It typically takes about 30 days for your company (and investors, if applicable) to waive their ROFR. But in some cases it can be longer, so you need to plan for this when selling stock.

Remember, right before an IPO, a company will often halt trading in its shares—which means you may not be able to sell for a few months before the IPO and then another six months after the company is public.

2. Decide how much to sell.

The decision on how much to sell may be driven by a few factors including:

Employment status. Most companies require you to exercise your stock options within 90 days of leaving your job with the company, or you lose all the options you worked years to obtain. In this case, you need to start thinking of how to do a secondary sale shortly after leaving the company. You will need to decide whether to sell enough to just cover taxes on the full set of options you exercise, or if you want to sell more to take some money off the table as well.
Diversify your portfolio. If 99% of your net worth is tied up in company stock, you may want to take some money off the table to protect yourself from a black swan event that would cut your net worth dramatically all at once. I know a number of people from, for example, Zynga who saw their net worth drop 70% with the stock price.
Cash needs. Even if your company is close to going public, you may want some short-term liquidity to buy a house or car, pay for your kid’s school, or the like. Remember: Just because your company files for an IPO does not mean it will quickly go public, and even after it goes public you will probably be prevented from selling your stock for six months, which means half a year of uncertainty.
Taxes. There may be large tax considerations to selling your stock, depending on the timing. For instance, a number of people sold secondary stock in 2012 to avoid the tax hikes of 2013. Talk to an accountant before making any sales.

Many people end up selling 20–50% of their stakes pre-IPO for the reasons above. If you really need the cash or just want security, you may be able to sell your entire stake in a secondary transaction. Of course, that limits your potential upside if the stock does go up after the IPO. But that’s the trade-off you are making with an early sale: the security of cash now, or the possibility of a larger return later.

3. Find a legitimate buyer.

Buyers of secondary stock are diverse. There are dedicated secondary funds, hedge funds, family offices, angels, dentists, and a random assortment of yahoos (aka individual investors) who operate in this opaque market. (See the previous section on secondary sales for more on this.)

In general, you want to find a buyer who:

Has the funds available. If you are doing a large transaction, ask for proof of funds or make sure the person or entity is a well-known investor.
Will move quickly. Avoid situations where there are multiple decision-makers between the purchaser and the person offering to buy the shares. For example, some secondary funds will have a decision-making committee that only meets periodically.
Has invested in private securities before. If you are dealing with high-net-worth individuals (versus funds), make sure the buyer understands the secondary process, the risks involved, and the various steps needed to close a transaction quickly.
Won’t be a pain in the butt to the company. Adding a dentist from Ottawa to the company’s list of shareholders may do your employer a disservice. The dentist may be willing to pay more for your shares than a professional buyer would. But random buyers may also have volatile properties (e.g., they may sue your company for no good reason). This can hurt the value of any remaining stock you don’t sell, and it will certainly hurt your relationship with your employer. Only transact with random people if you don’t mind burning bridges with your employer.
Your company will approve quickly. Optimally, you want buyers your company knows or is willing to add to the cap table quickly. Some funds have had problems with the SEC in the past around secondary purchases, which means your company may not want them to buy your stock. ¹

4. Figure out the price you want.

Private market transactions are highly illiquid and volatile. ² There are always rumors that somebody got higher or lower prices on their stock. Or, illegitimate buyers may suggest prices for stock that they can’t or won’t really pay to test the market. Often these transactions don’t go through, and they muddy perceptions of real market prices.

To get a sense of the market for the stock, ask colleagues what they are getting for their shares in transactions that have actually gone through. That means transactions that actually closed, versus offers they have received. Unclosed transactions are often meaningless.

Don’t be too greedy. Focus on speed of closing at a price you are comfortable with. Unless you are selling a very large block, a difference of five cents a share won’t make much of a difference if the stock is at $18 a share.

A few rules of thumb:

Common stock is often discounted from the last preferred stock price. ³ This is on the order of 30%. For example, if your company just raised at a $240 million valuation, you can expect to sell your common stock at a price based on a $160 to $200 million valuation. If the round took place many months before your sale, and the company has made progress since then, you can typically sell at the preferred stock price. ⁴ You should by all means ask for the last preferred valuation, but investors may not be willing to pay that much. As the company matures and gets more valuable/later stage, the spread between common and preferred stock will disappear.

IPOs breed volatility.

There is typically a sharp run up in secondary prices in the weeks before a company halts secondary transactions, which is directly before an IPO. In some cases, those secondary prices will be higher than the post-IPO stock prices (see, for example, the first year of Facebook’s public stock price ⁵ ). If you want to sell, don’t get overly greedy during this period. Prices are rising so quickly that you might be tempted to hold out for an even better one. Remember, though, the price is moving quickly because the company is about to stop all secondary trades. If you over-optimize and don’t sell, you may be prevented by the company from doing so for an uncertain period of time.

The root of this uncertainty is that not every company that intends to go public will do so immediately. After filing for an IPO, a company may wait for many months (or quarters) before going public, due to market conditions. Once the company does go public, you will be locked up for another six months. If the IPO gets delayed, you can end up with a bunch of illiquid stock and ongoing market risk.

Expect things to move up and down in a semi-random fashion.

In a market with limited numbers of buyers and sellers, prices may move all over the place. For example, if one of your company’s founders dumps a large block of stock at a low price to diversify, it can depress prices for everyone.

Don’t forget taxes.

Talk to an accountant. Selling in one year versus another may impact the taxes you pay. Similarly, if the company was a qualified small business when you bought your stock/exercised your options, there may be very large benefits to holding the stock longer, or there may be future tax breaks depending on how you reinvest the money you just made.

5. See if the company wants to have their legal counsel run the transaction.

Many companies will have a stock purchase agreement (SPA) they want you to use to sell their shares. If not, you can use one of the major Silicon Valley firms to put together the paperwork.

Regardless of who does the paperwork, you will need a stock purchase agreement. Sometimes, you may need additional paperwork such as a third-party legal opinion that you legitimately own the shares you are selling. (This is usually only needed if there is a large secondary market for a company’s shares, with lots of buyers and sellers. At some point you can get people acting badly in the market and selling shares that don’t exist, which creates the need for this extra layer of legal work.)

6. Terms to include.

You want to make sure the paperwork for your secondary transaction includes basic items such as:

The buyer is obligated to fund the shares within X days of being able to do so. For example, if she does not wire money to you within a week of the sale closing, you can void the transaction.
The seller is obligated to sell the shares and can’t back out.
If the company blocks the transaction or exerts its right of first refusal (ROFR), the contract is voided.

I am not a lawyer and am completely unqualified to give legal advice. So talk with your lawyers about this.

7. More complex transactions.

Some secondary funds will offer more complex transactions that allow you to benefit from the upside of your stock in the future while cashing out today. In some cases, you take a loan out against your shares and then split the upside of the stock with the lender. Alternatively, you outright sell them the shares, but have a contract in place that if the stock goes above a certain dollar amount you split the upside. For example, you might sell your stock for $25 per share, but then split any appreciation of the stock above $30 per share. So if the stock sells for $32, you end up with $26 a share ($25 plus ($32–$30)/2). ⁶

See link at eladgil.com.[https://dealbook.nytimes.com/2012/03/14/charges-filed-against-brokerage-firms-that-trade-privateshares/?_r=0]
There are always rumors that a stock is selling for much higher and much lower prices. In my experience, these rumors often turn out to be false. Focus on closed transactions, where money actually changed hands, versus “a friend of a friend was offered $X but did not sell.”
The reason for this discount is that preferred stock gets paid out first if the company exits at lower than its last round’s valuation. So while preferred stock has “insurance” that makes it more likely to get paid in full, common stock does not, hence the discount. As a company gets more valuable and has more traction, the risk of a low exit goes down, and the gap in price between common and preferred shrinks and eventually disappears. In some cases, as part of a financing round, a venture firm will buy common shares from founders at the same time it buys preferred stock from the company. In this case, the venture firm will pay the same price for preferred and common, as (1) it wants to help the founders partially cash out, and (2) the percentage of common stock it owns is low enough to not be material versus its preferred stock position.
If you work for a super-hot company that has made a ton of progress since its last round, and a lot of time has passed since the funding, then you can demand a premium to the last round of funding. Companies also track their own internal valuation at board meetings and via 409As, so you can ask the company what price they think the company is now worth in order to set a price.
I know a number of investors who stopped buying secondary shares after they got “burned” by speculating on Facebook pre-IPO.
Thanks to Naval Ravikant for reviewing and providing feedback on this chapter.