Secondary Rounds

Updated: Aug 1, 2020 at 11:55pm
Created: Jul 17, 2020 at 12:29am

This is an article on secondary rounds. Some still consider secondaries as a taboo, which really shouldn't be. Secondary round is a form of transfer of ownership and exchange the risk of their portfolio.

When does it happen?

Secondary opportunity usually happens around series-B/C and after, when the business gets to a point of creating a meaningful business value through revenue and customer base. When there's enough demand in the market from investors who'd like to become (partial) owners of the business, it will create opportunity for the existing owners (shareholders) to transfer the portion of their ownership to someone else, through a form of a secondary transaction. During the process, their financial risk is alleviated as they exchange their illiquid asset (private stocks) into cash, and the buyer trades cash into form of a stock, with a hypothesis that the value of the stock will go up faster than their opportunity costs and with the right level risk appetite.

Secondary transaction is non-dilutive for the shareholders, because the company is not issuing new stocks, and the transfer happens from existing shareholder to another (whether another existing or new investor). So it does not dilute the existing shareholders, although when the shares are gathered the in the wrong hands, such owner's exercised influence as a shareholder can become disruptive to the organization.

How does this directly help the shareholders

As private market valuation can fluctuate without a lot of liquidity in between, private market can be more riskier than most public market where the information is more transparent (hence "public") and there is a marketplace to buy and sell shares with greater liquidity.

So to de-risk your position in the company, when there's an opportunity to liquidate a portion of your position, to realize the gains (if any), will give the opportunity of the owners to derisk their position.

Also for the shareholders who have not yet gained any capital gain that is significantly larger than their ordinary incomes (such as salary), this gives an opportunity for the shareholder to gather wealth that's materially greater than savings from regular incomes, and potentially changing their life's expectations and trajectory.

How does this indirectly help the shareholders

What's more interesting is the psychologial impact this has on the seller, especially those of the founders and employees, and this is where most investors would be very sensitive to. More experienced investors understand the benefits of secondary, if done right, so can plan this along the growth of the company, while many inexperienced investors will have negative reactions to secondaries.

Where secondary can be helpful to the investors (and the sellers)

When the seller (founder) has cash constraints that are creating a lot of concern to maintain and focus on the business. For example, medical costs, family dependents that need financial aid, marriage/housing/kids, any form of existing financial liabilities, can derail founders from being able to focus on the business for a long time.

As startups take a long-time (any meaningful startup usually takes 10+ years to build), the life stage of founders will likely change during the period. Typically founders are paid materially less than market, and especially in the early stages, they might be on a very minimal payrol. So even though some founders start their business when they are single and have low personal burn that's manageable with low pay, they may eventually have to move out of their parent's home, get married, settle down, have kids, and also experience many situations where financial constraints creating a lot of stress.

Through secondary rounds, such financial stress can be relieved, giving the time/attention/energy resources back to focus on the company building. According to some survey, many founders throughout their journey have considered second jobs & alternative source of income to sustain their role as a founder. This is a severe distraction for the company, and where secondary can make material difference to the trajectory of the company.

Think of it as adding an oxygen tank to a diver, who used to swim deep seas only holding their breaths.

Where it can potentially backfire for the shareholders

Sometimes, founders & management get burntout and want to give up. This is one of the primary reasons founders sell their company short. Although on the press release, you might read about the synergies and the rationale on why such an acquisition is a good deal for the buyer, when the company has meaningful resources but the outcome is selling at a lower price than expected, it usually means founders are simply tired, which rarely gets covered by the stories.

But this can happen along the way as well. Sometimes, founders simply get tired and want to move on, but due to their sense of responsibility and/or reputational risks, they may simply choose to get a meaningful secondary and plan a transition. If not done with coordination with the board of directors, this can create a slow (or fast) death of a startup. As the moment the sellers get a way out, they may care less as they have crossed the minimum threshold of exit value.

This can actually be a real case, where many investors have experienced heart burns. The founders may worry about not being able to get liquidity or the company value going down significantly if they announce their departure, or risk their reputation all together, so sometimes they may even sell through secondary and nudge the company unconsciously towards a slow death situation to relieve themselves from the responsibility and lower their reputation risk.

The key here is to form the partnership when the founders are hitting the end of their journey. Start the search to level up their management team, and create a transition plan. Assist in bringing in the best management team they can possibly find and continue to grow the business. Sometimes there are fundamental shift in the market (e.g. large public companies offering a competitive product for free and wiping out the market, new regulations that prohibit the existance of the company, etc.) that triggers such fire sell. This is a different problem, but the recommendation is to partner with the board of directors and build a transition/exit plan and lowering the expectations.

The ultimate guideline is to do right by the customers, the employees, and the shareholders.

So how does secondary happen / work?

Secondary can happen as part of a primary round ('fundraising'), or sometimes a secondary-only round. There are roughly 1% of startups who offer liquidity to employees, but I believe this will be an increasing trend over time.

Usually, when there's enough demand from the investors, and the market valuation is material enough, either company gets the leverage to sell portion of their ownership to other investors though secondary (where investors will want the shares). Sometimes to drive the demand for secondary (as the share classes can be different - earlier preferred shares with less protective provisions, or common shares), seller can put a discount on the secondary shares.

Typically, secondary shares will have 15-30% discount compared to the primary, but in the case of a high-demand, or if redemption (repurchase by the company) is an option (there are tax implications to this), sometimes secondaries do get traded at the same value as primary.

Example case of a $50m round.

For example, a $50m round can be created with $40m primary and $10m allocated to secondary. Unless the company is very mature (so the enterprise value is more "real"), secondary-only round will be rarer, as investors worry about the degradation of company value, when founders sell their shares.

Sometimes, secondary round can be designed outside of the main round. So all of $50m round becomes primary, and based on sell supply, company can create a market for the buyers and provide a standardized purchase agreement to facilitate the exchanges, and the total amount of secondaries can become more flexible.

The $10m secondary can (and should) be allocated to existing investors and employees. Most companies only offer this to existing investors (and sometimes management), but I'd encourage everyone to think about creating a simple employee liquidity program for employees — such as being able to sell 10-20% of their vested amount.

The key challenge with having more than 10~ish people selling is (in the U.S.) SEC/security rule on tender offer will become relevant. This is a whole different process than having a few existing investors sell to the new investor, where you need to work with legal to prepare the docs and create disclosure packets for the potential sellers (e.g. employees) and have to give those fokks 20 days to make a decision whether to sell, and once gathered, have to run the process. So it could take 2-3 months from start to finish, and can be costly from legal perspective. And if done through a platform (e.g. NASDAQ Private Market or Carta) they will also ask for a fee as well. Most of the legal/transaction fees are spread across the sellers (given that sellers are the ones getting the money), but navigating all this can be time consuming for the company and may involve a lot of communications as most employees will not have experienced this before.

Of course, some investors will have rights to sell first (e.g. liquidation preference) or even buy them first (e.g. right of the first refusal), so the employees may not get the allocation to sell, but if the relationship is managed well and the company is doing relatively okay, then it becomes easier to create an equitable plan for everyone to opt-in to selling and gauge the demand, and then the amounts get allocated proportionally based on the sell demand.

Tax implications are real

There are many tax implications when it comes to selling, and the sale impacts your [[409a Valuation]] which impacts your exercise price of your stock options as well as tax, so make sure to have the sellers discuss with their tax accountants of the implications.

High-level wise, secondaries will have something along the range of long-term capital gain tax, short-term capital gain tax, or compensation/ordinary income tax. If the stocks qualify for QSBS(Qualified small business stock), then it could mean good things to the sellers quite dramatically.

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