Thanks initially to websites like SecondMarket (defunct) and SharesPost, and more recently to the trend of venture-backed companies electing to stay private longer, a substantial increase in the number of investors seeking pre-IPO access to private companies and the massive increase in capital available for these efforts, you have likely been hearing about secondary stock sales quite a bit recently. While it may be a generally understood term around Silicon Valley, we thought it might make sense to write a post to explain this term in a bit more detail to remove any confusion on the subject.
Primary versus Secondary Shares (for Privately-held Companies)
First off, let’s make sure everyone is clear on this. There is no difference between a primary share of stock and a secondary share. In fact, there really is no such thing as a secondary share of stock. When you hear someone say “she bought secondary shares” what they really mean is that the buyer bought shares of stock in a secondary sale. The actual shares purchased are in no way secondary to other shares of the same class of stock.
The Primary and Secondary designations refer only to how the shares were purchased. More specifically, purchasing “Primary” shares means you are buying the shares directly from the Company and the proceeds from the stock sale go to the Company. If you purchase “Secondary” shares you are buying stock from an existing shareholder instead of directly from the Company. The shares being purchased on a “Secondary” basis were at some point in the past sold as “Primary” shares by the Company. Primary shares are sold by the Company in a variety of situations. This first occurs when the founders of the business purchase their founders shares (hopefully at a very low Par Value per share). After the Company is operating, the most common situations where a privately-held Company will sell/issue primary shares are the following:
- Investors in equity financing rounds
- Employees and other option holders upon the exercise of stock options granted to them
- Warrant holders (often a venture debt lender in the case of startup companies) when they exercise the warrant
- An acquisition where the company is buying another business and paying for all or part of the purchase price with stock
Secondary Stock Sales in Angel/Venture Backed Private Companies
Secondary stock sales are by no means a new phenomenon. Every share traded on public exchanges like the NASDAQ and NYSE is a secondary share. The proceeds from the purchases go to the current holder of the shares, with nothing going to the Company.
Until around 2010 however, it was rare to see secondary sales of shares in private, venture backed companies. This was partly due to a reticence on the part of investors to buy secondary shares in private companies, and partly due to the fact that the process of handling secondary sales can be a cumbersome one. This has changed significantly in the past few years and the trend towards a more active secondary market for private, venture-backed companies is clearly up and to the right (even the SEC appears willing to play ball and allow this market to expand, at least for now).
There are some negative aspects to this trend. Some are being addressed, some are unavoidable, and others have the potential to derail this market shift. Here are a few of the key potential issues:
- Impact on valuation of Employee Stock Options. A well-defined secondary market that sets prices for common stock based on market dynamics could be used by the IRS to determine the fair market value of common stock, and as a result the fair market value of stock options. Assuming the secondary market is inflated compared to internal valuations (we think this is a safe bet for the long term in the secondary market), these secondary trades could lead to higher stock option strike prices, which will reduce the attractiveness of the options to new employees, and in turn could make it more difficult for the company to recruit top talent.
- Influx of new shareholders creates administrative headaches. Secondary stock sales bring new shareholders onto the Cap Table of a startup. This means the company now has to track a new shareholder, provide them with required notices, and seek their approval for issues where they have a voting right. In short, it adds an administrative burden that is exacerbated by the fact the new shareholder may well be completely unknown to anyone at the company, which is rarely the case with the angel investors and venture firms who purchased primary shares from the company.
- The 500 shareholder limit. There has been a lot of news about the fact Facebook surpassed 500 shareholders sometime early in 2012 (this post was initially written in 2011 but still holds true today). Going above this limit forces a company to provide disclosures in the same manner that public companies are required to disclose information. In essence, they will be a public company whether they want to be or not. There is active discussion with the SEC about changing this 500-person limit, but for the time being it stands. As an interesting aside, it is worth noting that this 500-person limit is one of the reasons venture investors insert Right of First Refusal and Co-Sale language into their financing documents. Without these terms in place, it is conceivable that a disgruntled shareholder could sell a small number of shares to a large number of people and effectively trigger the 500-person limit. We are not aware of this ever being done but include this note as one example of why venture financing documents are so damn long (if you have heard of a situation where this 500-shareholder trigger was even threatened, PLEASE add a comment below).
- One Bad Apple. The worst potential issue we see is that it only takes one “Bad Apple” to ruin this for everyone. At some point there will be a situation where secondary purchasers feel they were duped, and investigations will reveal “insiders” sold secondary shares of their private company based on information not available to the purchasers. This is really no different than insider trading issues for public companies, and if the amount of money involved is significant, and if it is proven there was fraud committed, we will see a quick backlash from both prospective secondary buyers and more significantly from the government, who rarely think of the impact of new regulations have on the startup community.
In spite of these and other issues, the Secondary Sale trend is a positive one for the startup ecosystem as it benefits most everyone involved (founders and employees of startups as well as startup investors). A strong secondary market reduces the illiquid nature of privately held companies and if founders and shareholders can “take a little off the table” along the way as opposed to having to wait for a 100% payday at some eventual company exit (acquisition or stock sales following an IPO) it will make it easier for companies to recruit talented employees who see the stock as an important part of the job offer, it will make it easier for venture investors to attract capital from LP investors who often cite the illiquid nature of venture investments as the primary issue they have with the asset class, and it will allow founders to not have all of their “eggs in one basket” and thereby make it easier for them to decide to turn down an early acquisition offer without fearing they are walking away from a personal fortune and could still lose everything if something goes wrong.
A number of companies and investors are still reluctant to embrace this secondary trend, with some companies taking steps to make it more difficult for shareholders (especially employees) to trade their shares prior to an IPO. While this is a reasonable approach to a degree (our view is that a Board of Directors should have the ability to approve or decline a secondary sale request – this could be a heated area of debate and we may cover it in a future post but for now please just trust that there are some good arguments for this that benefit founders and their companies).
One interesting potential change that we have not yet seen but believe will emerge is that the pre-IPO liquidity that secondary share purchases create could lead companies to provide a greater degree of transparency around financials and capitalization in an effort to make it easier for secondary purchasers to properly value the shares they are buying. Greater transparency will in turn increase the number of people willing to purchase secondary shares in private companies, which will only serve to support the secondary trading market for privately funded companies and create a more liquid market in a space that historically has been highly illiquid.
The process of trying to sell shares of stock you hold in a secondary transaction can be complex and will almost always be subject to terms and conditions set in the financing documents of the company you hold these shares in. This will likely include things like a right of first refusal, co-sale rights and other restrictions and may well require the approval of the board of directors. This is a whole big ball of wax we will not cover here but if there are enough requests in the comments and/or Twitter we’ll add it to the future queue.