In our September article “Exploring Founder Liquidity Options”, we described some ways that founders are gaining liquidity from their private company shares. This article examines the role secondary markets play in gaining liquidity, for both founders and other constituents. There are many options when trying to achieve liquidity for private shares; however, it is important to understand the pros and cons and which strategies best fit a particular situation.
Consider these questions to help you achieve your personal financial goals.
Why am I selling now?
A critical first step is to get clarity on the motivation and goals of the liquidity event on the secondary market as these will determine the best strategy. Here are a few scenarios that may be true to your goals:
- Personal financial situation, e.g. buying a home or diversifying your portfolio
- Employee concerns, if some employees are leaving or their options are expiring
- Corporate uncertainty on when/if company will be sold
- Corporate strategy to retain/motivate employees
- Clean up the cap table, realign investor interests
For example, if the founder is trying to solve the issue of expiring options for employees and perhaps also raise enough to buy a home, it may make sense for the company to offer loans instead of buying back shares. On the other hand, if there are a number of people who truly need liquidity, tapping a secondary market may be the most prudent action.
Who might buy my shares?
- You might sell to existing or new shareholders, or to the company. One strategy frequently used is, after raising a round, the company may use some of the proceeds to repurchase common shares. For more information, see below.
- There are matching websites that link sellers with interested qualified buyers. This approach is best suited for late-stage company shares. Matching websites include NASDAQ Private Markets, SharesPost, and EquityZen.
- Another option is secondary specific funds, which purchase common shares directly from multiple holders but align incentives with the board and executives. Some examples of these are Founders Circle Capital (FCC), Saints Capital, 137 Ventures, Akkadian Ventures, Delta-V Capital and ESO.
- Private investors and SPVs (special purpose vehicles) are willing to buy shares directly or work with an investment banker who may locate buyers and act as a facilitator.
What should I be aware of in the secondary market?
Entering the secondary market can be complicated and there are many factors to consider that could help you reach or derail your goals. Among key things to consider:
- How do I value my shares?
- How should I address tax implications?
- What corporate accounting issues may impact a sale?
- What are the regulatory and legal requirements?
- How might a founder sale impact employee retention and morale?
Tailoring a liquidation isn’t always in your control.
What are some of the possible risks?
- Most shareholders of private company shares are subject to a Right of First Refusal (“ROFR”) by the issuer. This complicates things from a buyer’s perspective because there is a risk when the buyer makes an offer yet the issuer repurchases the shares instead.
- Shares subject to co-sale rights have a risk to the seller because they typically entitle other shareholders the right to sell pro-rata with the seller. In other words, the seller may only be able to sell a portion of the amount that the buyer is willing to purchase.
- It might be impossible, especially if the ROFR is not exercised, for a seller to force the company to transfer the ownership of shares to a new owner.
What is the benefit of a secondary offering as part of raising a round?
Many founder-initiated secondary transactions today are being done in conjunction with raising a round of financing. To get the biggest benefit, we recommend you consult with tax and legal experts. Here are some questions to consider regarding tax impact:
- If the company is going to raise a round, is it a good idea to use some proceeds to repurchase common shares from select individuals? Be aware, the sellers might face an unintended tax impact. If the company is going to raise a round, will some company investors be buying common stock directly from current holders? This may have a different type of tax impact on the sellers.
- Who is setting the price for the common stock and how much of a say does the board of directors have? This, too, leads to tax implications for the sellers.
- If the company is purchasing the shares, then QSBS (the Qualified Small Business Stock exemption) is not available for selling shareholders and may impact other shareholders’ eligibility to use the exemption.
Here are some questions to consider regarding other impacts
There could be implications to the 409A value depending on many factors surrounding the sale.
- If the company is purchasing the shares above the current 409A price, sellers may receive a bifurcated tax treatment - capital gains up to the 409A price and ordinary income for proceeds above the price. (This may hold true even if the investor purchases the shares directly, depending on the facts and circumstances.)
- Depending on the number of shares repurchased by the company, there could be implications to other holders’ shares purchased from the company a year before or year after the transaction.
- Consider the implications on employees and investors who are not included in the sale.
- If the company goes public within three years, the secondary transactions may have to be publicly disclosed.
How SVB can help
Choosing the right investment partner is key to successfully reaching your liquidation goals. Also, prior to any transaction, consult company accountants, the company’s 409A value provider, legal counsel and seller’s personal CPA -- in addition, of course, to the company’s board of directors. Here at SVB Private Bank, we are happy to work with you to determine the best liquidity solution to fit within your needs.
One of the more unique structures is a combination of a secondary sale with a loan structure. Although it can be difficult for banks to loan against private stock holdings, a loan guarantee by an investor with the right to purchase shares in the future can provide founders with the biggest benefits. SVB has structured such loans in partnership with Founders Circle Capital.
Another example using SVB Private Bank and FCC is to structure a delayed sale. This may be a loan between the seller and SVB, including an option agreement between the seller and FCC. With FCC backing the loan, it is considered a non-recourse solution to the seller with favorable borrowing terms. Benefits of this structure may include further appreciation in value, retention of voting rights and possibly tax advantages related to long-term capital gains or a qualified small business tax exemption (based on holding period). FCC’s alignment of interests among the seller, company and existing investors may make this a strong solution for everyone.