What is a Secondary Stock Transaction?

Today, we’re exploring the concept of secondary stock transactions. Despite a general slowdown in VC activity, we are still seeing some founders successfully sell shares in secondary transactions - particularly among AI companies experiencing rapid sequential funding rounds. Secondary transactions involve the sale of shares from existing shareholders, such as founders or early investors, to new or existing investors, without injecting new capital into the company itself.

Definition: Secondary Stock Transactions (or Secondaries)

A secondary stock transaction occurs when an investor buys shares directly from an existing shareholder rather than the company, contrasting with primary transactions where new shares are issued to raise capital for the company’s growth. This setup provides liquidity for shareholders while not diluting the ownership through the issuance of new shares. 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.

Secondary: no money onto the company’s balance sheet, cash goes to an existing shareholder who sells their shares to an investor in exchange for the cash.

Primary: money goes onto the company’s balance sheet to fund operations etc., and additional shares are created and given to the investor.

Motivations behind secondary transactions

Secondary transactions offer several advantages, including providing early liquidity for founders or employees and allowing VCs access to invest in companies when new share issuance isn’t possible. These sales can also rebalance the risk and reward for founders, enabling them to secure financial stability and pursue ambitious growth strategies.

Why founders may want to do a secondary transaction

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. Many founders don’t draw that much salary (see our founder salary report and our startup ceo salary report). So selling secondary shares can help a founder manage their costs and lifestyle, which is a totally normal thing to want to do in a high cost area like San Francisco or NYC.

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. It’s not uncommon for a founder to get a startup to a certain size, and then for them to realize that 100% of their net worth is tied up in the stock of that company, which can sometimes lead to risk aversion. The founder becomes afraid of messing it up, so stops taking as much risk. And since VCs love risk since it (hopefully) drives growth, letting a founder sell some secondary stock can put that founder back into a risk taking move.

Third, and this is not a great thing to have to talk about, but when a founder gets divorced this can cause issues where there is a strong desire to change up the capitalization table by letting the divorced spouse sell out of the business.

Fourth, a co-founder may depart a startup and the investors want to remove them from the cap table. Note that this really only comes together when a company is doing really well. If a company is doing poorly, then the business may get recapped in a downround, which effectively crams down the departed founder’s shares.

You also see some very late stage companies (Stripe being the most famous) who allow employees to do secondaries at the point where the employees’ stock options are going to expire.

Why VC may want to buy stock in a secondary purchase

Again, we mentioned the VCs may want to give a founder some liquidity in the hopes that it makes them more open to high risk, high reward strategies.

Secondly, a venture round may be over subscribed. In this case, a VC may be willing to purchase shares directly from an existing shareholder to get more ownership in the company - or even as a way to sneak into a round.

And, finally, there are some moments when a VC may want to sell some shares in a round - so the VC sells secondary shares to another VC! There are a few reasons for this. One is to drive DPI, which means the VC can return cash to their investors. Additionally, 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.

Understanding rights of first refusal (ROFR)

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.

This right ensures that existing investors have the chance to maintain or increase their stake in the company under the same conditions offered to outside investors.

QSBS and redemptions

Transactions where companies buy back shares from founders, followed by VCs purchasing new preferred stock, need careful handling to maintain QSBS status, affecting the tax treatment of the shares. This can happen more often that you’d think in a secondary - the VC may ask the company to purchase common from the seller, then the VC buys shares from the company. Again, talk to your tax team, as redemptions can cause QSBS issues.

Selling founder shares in funding rounds

While direct sales of founder shares to VCs during funding rounds are less frequent today, they provide an essential liquidity option. This process allows founders to realize some financial gains without waiting for a company exit or public offering.

How to approach your vc about selling shares

Engaging in a conversation with your VC about selling shares requires tact, transparency, and timing. Here’s a guide to navigating this discussion:

  • Preparation: Understand the terms of your existing agreements, particularly any clauses related to share sales or ROFR.
  • Reasoning: Clearly articulate your reasons for wanting to sell shares, whether it’s for personal financial security etc..
  • Timing: Choose an opportune moment, usually best when you are pulling together a hot funding round or after a significant company milestone, to show continued commitment to the company’s success.
  • Proposal: Present a structured plan on how many shares you wish to sell, ensuring it doesn’t signal a lack of confidence in the company’s future.
  • Negotiation: Be open to feedback and ready to negotiate terms that align with both your interests and those of the VC and the company. Remember that common stock is usually worth less than preferred shares!

In the current venture capital climate, understanding and leveraging secondary stock transactions is more crucial than ever for startups looking to navigate financial complexities. For personalized assistance and to ensure your startup is well-prepared for venture capital engagement, consider leveraging our VC due diligence checklist, crafted from extensive experience in aiding clients through their funding processes.