Secondary stock sales

As your company’s valuation continues to rise, early employees or investors may want to sell a subset of their stock in the company. A “primary” investment in a company is when you give a company money in exchange for its shares. A “secondary” investment is when you buy shares from someone besides the company (basically a previously owned share). In both cases, the shares could either be common stock or preferred stock. In other words, secondary stock is defined by who you are buying shares from versus the type of shares themselves.

For current or former employees, selling stock they hold may be driven by personal issues such as an expensive hospital bill for a family member, wanting to buy a house for themselves or their family, or an interest in diversifying what may be most of their net worth.

Early investors may be motivated to sell stock early by a need to return money to their funds’ LPs (especially if they are in the process of raising another fund and want to show returns), or they may simply be looking out for their own financial interests and the need to generate “carry” on their funds. ¹

Founders may also want to sell secondary stock to diversify their net worth, which is likely dominated by company stock. For that reason, founder sales, if done correctly, tend to align founders to focus on the long-term success or outcome of the company by taking away worries they may have about their personal financial future.

$500 million to $1 billion tends to be a transition point

In general, a $500 million to $1 billion valuation is usually where founders and/or employees might start to consider selling stock. This shift in behavior is due to three factors: (1) It take two to five years to get to a $1 billion valuation. During that time life events (children, family illness, and the like) may have occurred and there is a financial need; (2) the market cap of the company is large enough that most of an individual’s net worth is tied up in the company, 1% of the company may be worth $5 million or $10 million, diversifitcation starts to be meaningful. (3) Employee belief in the remaining multiple upside to the company may start to diminish. Almost all high-growth companies are chaotic and messy, and competition always increases when something is working well for a startup. Most early employees interpret this as a limit on the upside of the company, which increases their interest in selling. Moreover, the value of small amounts of stock at that valuation is sufficient to motivate employees to sell.

Founder Sales

Founder secondary sales have become increasingly acceptable as a way to ensure that leaders continue to focus on the long-term potential of their companies, rather than sell early.

As an active founder, you may want to sell up to 10% of your holdings (or up to $5 to $10 million, whichever is lower) in a secondary transaction, as part of a round, a standalone sale, or a tender (more on each of those below). If you sell more than 10% (especially if you’re still operationally involved with your startup), it will be perceived as a negative signal about your belief in the future of the company.

Most founder secondary sales occur once a company reaches a multi-hundred-million- dollar valuation. (There are some circumstances where smaller sales occur in the mid-to-high tens of millions if there is a specific founder need. In general, these earlier-stage sales amount to sales in the hundreds of thousands of dollars in order to pay off school debt or provide a small financial cushion for founders.)

Most founders I know are happy they took some amount of stock off the table to relieve financial pressures as the time to IPO keeps lengthening.

If you do not regulate secondary sales early, it may backfire on you

There are a number of issues that can come up if you do not create a framework for secondary sales for your company: large transactions impacting your 409A valuation, misbehaving investors ending up on your cap table, or even the random dentist buying stock from an employee at a premium and then harassing your company for information. (The “random dentist” is real—I saw this happen at one company.) There are also secondary funds that may act badly in these opaque markets—for example, Facebook ended up with an SEC inquiry into their company stock sales due to issues with Felix Investments. ²

Ways to get ahead of these problems include modifying your charter or other agreements to prevent secondary sales, ensuring you have a ROFR on all shares, and in some cases contractually preventing people from selling without board approval. Having a preferred buyer or tender program will also help create liquidity while ensuring stock doesn’t actively trade in a secondary market.

1. Carry is the percentage of a fund’s return on investment that a VC earns in exchange for managing that fund. No capital returned=no carry, which greatly limits what the individual VC takes home.
2. See article linked on eladgil.com. [https://www.law360.com/articles/516967/sec-settles-with-firms-over-pre-ipo-facebook-trading]