In general, secondary sales begin as one-off sales—for example an employee needs to quit the company to take care of a sick parents and wants to sell some stock to pay for better medical care. As market cap grows and with it the demand to sell stock, the company realizes that random people are buying their way onto the cap table, or the demand to sell grows to significant levels as the company gets older and more employees and investors hold illiquid stock for multiple years. At this point, many companies switch to a “preferred buyer” or “tender” approach. I review the different types of secondary sales below:
1. One-off sales
In this scenario, the seller is executing a one-time transaction with either an existing cap table investor (i.e., someone who already owns company stock) or a new entity that is not already involved with the company. In general, the company has an incentive to push the stock seller to a buyer it already knows well.
There are ways to incentivize a seller to work with a known buyer. That includes everything from a simple request (especially if the seller is still active with the company as an employee or investor or wants to maintain a good relationship with the company) to making life difficult for the seller via the exercise of rights of first refusal (ROFRs) or other moves that delay the transaction and may destabilize it for the buyer and seller.
In general, one-off sales can backfire on a company as new, non-savvy, or potentially badly-behaved investors come on board. It is beneficial to the long-term health and stability of the company to establish a set of “preferred buyers” early to soak up secondary sales and demand for selling stock. This may be an informal relationship with trusted investors already on the cap table who want to buy more secondary. In parallel, the company should start to institute programs detailing how much employees or early investors can sell, and under what circumstances. Holding out the promise of a tender or other program will often cause potential sellers to wait for the company to initiate a formal secondary program. Most people want to do the right thing for the company, and are willing to wait 6–12 months, or more, for the opportunity to sell in a company-sanctioned manner.
2. Selling as part of a funding round
A straightforward time to sell—as a founder, early employee, or early investor—is during a funding round. Most financing rounds for late-stage breakout companies tend to be oversubscribed. The extra demand for company stock means that an investor who could not get a full primary allocation may be willing to take in a blend of preferred (as part of the round) and common stock (acquired from an employee or founder), or early-stage preferred stock (from an early investor).
Most late-stage investors will be okay with buying some secondary common stock alongside a preferred funding round, as the preferred stock helps protect the overall investment in a blended manner. Alternatively, investors who could not get a piece of a round may be willing to buy only common stock instead, depending on the structure of their funds. (Some funds cannot have a large portion of common stock in their portfolios due to LP agreements or the need for additional SEC filings.)
Most investors tend to discount common stock 20% to 30% relative to the preferred stock price—i.e., they will want to pay less for common stock since preference does not exist and will not protect them in a downside scenario. For example, when DST purchased secondary stock in Facebook it did so at a $6.5 billion valuation—a 35% discount on the $10 billion preferred price at the time. 1 However, if the company is hot enough, or the buyer hungry enough, investors may pay the same amount for common and preferred.
The company will likely want to take an arm’s length approach to the common stock sale to avoid 409A implications (more on this below). A large, company-sanctioned stock sale (and 409A re-analysis) could cause a repricing of common stock for the entire company (and future employee options), which is worth avoiding if possible. Talk with your lawyers about this.
Usually no more than 20% of the funding round will take place as secondary. The venture capitalists may not want to take the risk of buying too much common stock (which lacks the financial and control protections of preferred stock). There are also regulatory limits on the percentage a venture capital fund can invest in secondary versus primary stock.
3. Preferred buyer programs
In a preferred buyer program, one or more funds are given preferred access to purchase secondary stocks. These programs may be informal (e.g., the company suggests that potential sellers talk to a small number of funds) or formal (e.g., the company assigns a secondary ROFR, or right of first refusal, to these funds).
In a formal preferred buyer program, a fund may sign a term sheet, LOI, or binding agreement with a company to provide dedicated funds to soak up secondary stock. As part of this agreement, the fund can generally purchase stock in a pre-defined range (e.g., at a 10% discount to last round) and may be assigned a ROFR by the company.
The ROFR may become important: In many cases, the company has a 30-day right to purchase stock from a seller at a price the seller has negotiated with another buyer. When a ROFR is assigned to a fund, this may add a second 30-day period; if the company passes, the fund has another 30 days to purchase stock at the price the buyer has agreed to. The net effect is a 60-day—or more—delay between the statement of intent to sell and the time when a transaction can actually occur. This two-month timeframe can make buyers and sellers quite nervous, as market and other conditions may change during this time, destabilizing a secondary transaction.
In addition, a ROFR provides a source of sanctioned liquidity for a stock under a certain valuation, driving certain buyers out of the market: they cannot close a transaction, as the preferred buyer will take the sale from them. Effectively, the ROFR creates too long a wait and too high a price for many sellers, driving down market demand for secondary. You should talk to your legal team about ROFR assignments to preferred buyers.
Preferred buyer programs can be of special help when acquiring other companies. In this case, the founders or investors of the acquired company may want to sell a subset or all of the stock they receive in the transaction. A preferred buyer may help facilitate this transaction (and hence the actual acquisition) without the company itself needing to pay out cash as part of the purchase. This can also be handled via a tender, where the acquired company’s investors can sell into a tender instead of a preferred buyer program.
4. Tender offers
A tender is basically a large coordinated event in which one or more buyers buy secondary stock in your company at a preset price.
Tender offers typically follow this pattern:
1. The company tries to estimate demand for a secondary stock sale. This determines the rough size of the tender. The company may also put in place paperwork to further restrict stock sales by people who participate in the tender.
2. The company signs a term sheet with a buyer or set of buyers to purchase stock in a tender offering. The buyers set a single price for all sellers.
3. The company determines who can sell into the tender. Often, prior and current employees, investors, and founders can participate in tenders. In some cases, the size of the tender is preset, and who can sell is set in an order determined by the company. For example, if there is a $50 million tender offering (in other words, $50 million of stock is sold in aggregate), the company may say that current and past employees get first dibs on selling up to 20% of their holdings each. If there is enough demand from employees to cover the full $50 million, then investors and founders do not get to sell into the tender.
4. An administrative institution is hired to administer the tender, as there may be hundreds or thousands of eligible sellers. That institution will deal with all the mechanics and paperwork to cover the sale of the stock by employees and other sellers. Banks or other institutions, such as Deutsche Bank, are often hired to run tenders, even though they are not the actual buyer of the stock. The cost of hiring these administrators is typically at least partially covered by a transaction fee paid by the sellers into the tender pay (e.g., 1% of their sale).
5. The set of people who can sell into the tender is notified that the tender is open, and told the price set for the stock purchase. They are also informed of the window of time in which eligible people can notify the administrator how much they want to sell and fill out the paperwork for a sale. The selling window may be open for 20 or 30 days.
6. Once the selling window closes, the transaction occurs and the stock and cash change hands.
Typically, buyers in a tender are large institutional buyers from the hedge fund, private equity, or late-stage VC worlds, such as BlackRock, Goldman Sachs, DST, Fidelity, and others.
Tender offers may range from the tens of millions into the hundreds of millions or billions of dollars in size.
Information sharing and secondary buyers
In general, you should share basic financial information with large secondary buyers who are on your preferred buyers list or who run tenders for you. All of these types of buyers will be willing to sign an NDA at this stage. These buyers are making large investments in the company and in some cases will be long-term shareholders. Treating them well and providing them with basic information to make their decisions is important.
For small, random additions to the cap table (especially ones without strong company sanction), you can restrict information access unless it is something you are legally obligated to share with every shareholder (e.g., some changes to your legal documents).
If you end up with a $5 billion valuation or higher, that’s the point at which you will need to hire someone whose job (at least part-time) will be to regulate secondary transactions and the secondary ecosystem, unless you are able to lock it down up front and early.
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