Today I’m answering the question, “what is a secondary stock transaction?”
As you know, right now, the stock market and venture capital market are very frothy and on fire. So there are a lot of secondary transactions happening. Meaning, a lot of venture capital firms are buying the founder shares or previous VC investors shares in the company.
So, think of a secondary transaction as the opposite of a primary share which is when a venture capitalist puts money into the company immediately, directly buying primary shares. Primary shares are the shares the company created to sell to VCs and founders when the company was established.
Definition: Secondary Stock Transaction (or Secondary)
A secondary stock transaction is when an investor buys shares in a company directly from an existing stockholder (typically a founder, employee or existing investor). The funds paid go to the seller, not to the company. This contrasts with a primary transaction, where the company sells shares to the investor and the cash goes onto the company’s balance sheet for the company to use for business purposes.
When they resell those shares, that is a secondary transaction. And so you might say, “why are people doing secondaries right now with the market being so hot?”
Well, there are a couple of reasons:
First, for founders or employees, it can be a nice source of liquidity. Maybe if you have a super successful company you can buy a house, put a down payment on something. For VCs, they want to get into these companies, and maybe they can’t buy any preferred stock because the round is oversubscribed. And so the only option is to buy secondary shares, from the founders or maybe a VC firm that wants to sell out. Although that is a lot rarer.
Second, VCs will sometimes do a small secondary of the founder shares to give the founder some money and so they are more risk-seeking. This means that the founder feels financially secure and can take bigger risks and go for a bigger outcome.
Venture capitalists value the big outcomes. For instance, with the IPO; this is what returns their fund and makes them money. They want to be aligned with the founders. So they let the founder take a little bit of money off the table, as I said maybe buy a house, do something so they feel secure. They actually align the risk-reward paradigm for the VCs and the founders.
Many think, “hey, I can just go in and buy some secondary shares?”
Well, it turns out there is something called a ROFR, or right of first refusal. Most VC firms get this in their stock purchase agreements and the articles of incorporation with the company; this means, the internal venture capitalists get the first bite of the apple. They have to waive their right to buy those secondary shares before an outside VC firm or individual can come in.
Now that’s not always the case. I believe back in the day Twitter and Facebook didn’t have that right. Or maybe, their VCs just always waived the right of first refusal; but, there were really big secondary markets in those stocks.
So remember, you typically have to get the internal VC’s permission to do a secondary sale.
The other thing to think about, is people typically think secondary sales are always the common stock of the founders, which could be your management team. However, there are a lot of secondary sales of funds, especially for very old funds, where the fund life is winding down. There is an entire market for fund sales called secondaries where a fund just sells all their ownership positions, all their stock, and then cashes out.
So, a lot is going on in secondary sales, but it’s becoming more and more prevalent. I think partly because the market is so hot, but also, investors and founders and managed teams are just getting more sophisticated.
They realize unlocking a little bit of liquidity for the team can help and align everyone for the big outcome.
I hope that helps. If you have any more questions feel free to reach out. We are here to help your startup succeed! And if you are getting ready to raise funding, get our vc due diligence checklist - it’s got the most common questions we’ve seen as we’ve helped our clients raise billions in venture capital funding!