Primer for Founders on the Tech Secondary Market

Successful venture-backed technology companies are remaining private for longer periods of time. This leads to many potential consequences, one being liquidity challenges for founders, employees, and early investors.

EDIT: I released this back when I was a registered representative. For my unfiltered essays, check out: https://medium.com/@jonathan.lonsdale

Why does it matter?

Secondary noise can create negative signaling for a company. Any resource that is scarce is perceived as more valuable. This goes for your stock as well. If your stock is everywhere in the market and you try to raise a late stage round, investors may think your company is struggling or opt to purchase discounted secondary stock instead of participating in your primary round, thus hindering your ability to raise a round at the price you want.[1]

You should treat the people who built your company fairly. Besides it being the right thing to do, it’s a positive signal for other potential employees that you’ll do well by them. Attracting top talent is critical to the long-term health of any company.

Some shareholders look to the secondary markets for liquidity via one-off brokered transactions, which can bring some downsides for a company:

• Few secondary buyers have current issuer performance data so secondary shares often trade at steep discounts. This can lead to pricing confusion in the marketplace
• Brokered secondary transactions tend to be slow with a low hit rate leading to high fees and wasted cycles for finance teams processing RoFR notices and dealing with individual shareholder issues/document requests
• Executed transactions may bring unwanted cap table complexity and a loss of voting power as large and small blocks trade and new shareholders join the cap table
• It invites the misperception of an overabundant supply of shares. One shareholder selling may go to multiple brokers creating the perception of an excess supply of shares, e.g. an early employee wants to sell 10M USD of stock, and she goes to three different brokers. Each of those brokers ask two other brokers for assistance in finding buyers. In the market, there’s now the appearance of 10M+30M+(30M*2)= 100M of supply when in reality there’s only one 10M USD block for sale
• Dishonest brokers make noise. There are brokers who go to companies with fake demand attempting to get real supply, and brokers who go to buyers with fake supply attempting to get real demand

When does it come into play?

It depends on the time that has passed since founding, the number/size of funding rounds, and valuation. As a rule of thumb, it comes into play 5+ years after founding and/or post-Series C. Secondary noise generally occurs when early investors and/or employees/ex-employees want to liquidate to diversify their holdings. Employees/ex-employees may want to buy a house or pay for other expenses.

It’s up to the founder to take care of the people who helped build their company.[2]

How do you deal with it?

If you block all transactions, you’re screwing over the people who helped build your company. They will not be complacent. Employees and investors have started resorting to the secondary derivatives market using newly invented, legally dubious securities such as the “Forward Purchase Contract.” With a FPC, an equity holder can sell their shares to someone else without notifying the company or changing the cap table. Its legality might be dubious, but the use is widespread in companies that block all secondary transactions. Billions of dollars of these types of transactions occur every year in late stage tech companies. You will have no idea who truly owns your company, and your shareholders will be paying even higher fees to sell their shares (~10% where typical secondary transaction fees are ~5%).

If FPCs or similar securities are outlawed by the company, and employees do them anyway, the legal repercussions are unclear. This has already happened, but there haven’t been any lawsuits or cases here yet.

The ideal response is to put processes in place.[3] The following methods have been used.

1) Company approved third party tender offer every 6–12 months

A company organized process where employees and investors can all sell their shares at a set price.

The company sends notice to employees and early investors that they can cash out X% of their total shares at Y stock price. You can set X to anything, but X is usually 10–25%.[4] Even with full information, common stock is generally a discount to the last preferred pricing. The discount should depend on the market, which takes cues from financial performance to size of preference stack to the general perception of the company, etc. You can speak with existing investors and trusted bankers to get a sense of the appropriate discount.

Select a trusted banker and/or existing investors to buy the stock. The company sets allocations, e.g. with 100M of sell interest, one could allocate: 20M to existing investor A, 15M to existing investor B, 45M to trusted banker, and 20M to a helpful new investor you want on the cap table who may participate in the next round. Preferred shares, common shares, and common shares with co-sale rights will all trade at the same price.

Pros

• Transparent to employees and investors, so everyone gets the same price
• Company maintains tight control over information
• Company controls the process[5]
• Forces company to get its books in order. Some even say doing a tender offer is good practice for an IPO or acquisition

Cons

• If the price is set too low, it could be seen as ripping off employees in favor of investors, especially if the company typically blocks secondary transactions. It’s even worse if the founders find their own deals at higher prices, while employees get a lower price
• Leans heavily on the company’s finance team, auditors, and legal
• Time consuming on the company side (you’ll need to check with auditors, update financials, manage process, etc.). Some compare it to a mini version of going public
• Meant to target employee retention and trimming of positions. Tenders don’t work as well when an early investor needs to sell a larger block for reasons such as end of fund life

2) Company approved SPV (Special Purpose Vehicle)

Company allows a group to get info and raise money into an SPV. The SPV calls capital as necessary and buys up secondary shares via open market operations or when the company exercises their RoFR. The SPV limits the noise in the secondary market and is a clean solution as long as the company knows and trusts the SPV managers to be long term investors and not abuse their power.

Pros

• Little to no work on the company side
• Dealing with one buyer streamlines processes and contract redlines
• Takes care of one-off transactions that create noise and waste company cycles
• Company maintains tight control over information
• Reduces cap table complexity
• Can be done in lieu of or in conjunction with a tender offer

Cons

• Company does not control the process
• SPV managers can abuse their power by being bad market makers, e.g. using selective pricing and selling in and out of their SPV
• SPV managers could spam company information widely, thus creating more noise and nuisance to the company
• The SPV can attain significant voting rights and attempt to influence the company against company management

3) Share Buybacks

The company purchases shares using cash from their own balance sheet.

Pros

• Employees get a better price
• Simple process
• Company has maximum control
• If the company has a large cash position, is profitable, and no longer needs to raise, then this option could be the easiest
• Can be done in lieu of or in conjunction with a tender offer

Cons

• If stock is bought back at a premium to the 409a price, the delta over the 409a price is treated as a compensation expense to the company, which can hit company EBITDA
• The employee pays ordinary income tax on the premium over the 409a price[6]
• Raising primary financing to do stock buybacks adds to the preference stack, which negatively impacts existing preferred and common shareholders. This can be especially harmful to common shareholders (founders and employees) in a sale of the company
• If the company selects common sellers based on a criteria (i.e. buyback not open to all common holders), then that can blow the 409a if the trade happens above the 409a price

As a founder, there are many different options to choose from. They can each be good depending upon the circumstances and incentives you want. Creating a process will provide clarity and reduce the workload on you and your management team.

Notes

1. There are cases where investors feign interest in the primary so they can acquire data from the company, which enables them to purchase secondary shares with full information at a discount instead.
2. If employees/investors want to sell because they are spooked and it’s for good reason, then you probably want to spend your time addressing the reason vs helping them liquidate. However, there are cases of difficult investors who destroy value and pester the company. In these cases, especially early on in the lifecycle of a company, you could attempt to find another existing investor to buy them out at a discount.
3. Secondary offerings are best done after a primary offering has recently closed. Pricing expectations are clearer and the company has a relatively up to date data room. When a company does a secondary offering before a primary, investors tend be suspect.
4. In a tender, you can also set max absolute dollar amounts for how much shareholders can cash out. Ex-employees and early investors are often times only given the option to cash out 100% of their shares or nothing. Tender offers are generally customizable, but auditors have different views on how customizable tender offers can be so defer to them for what you are allowed to do here.
5. Some auditors do not want the company controlling the process, hence the need for arm’s length transactions. This is why the company needs to trust whomever they put in charge of the process.
6. Depending upon your auditors, the company may have to count some/all of the purchase against EBITDA as a compensation expense.

Fideras is a boutique investment advisory firm that partners with top issuers to create solutions to their unique capital raising and shareholder liquidity challenges. We operate in the best interests of our partners and with the highest levels of discretion.

We are FINRA registered agents and securities are offered through SF Sentry Securities, Inc., a FINRA registered broker dealer based in San Francisco, CA.

About the author

Jonathan Lonsdale, co-founder of Fideras, has extensive experience advising technology companies both in the United States and Asia, concerning investment opportunities and primary and secondary financings. During the course of his career, Jonathan has helped companies raise hundreds of millions of dollars, and serves as an advisor to companies, management, and boards concerning market trends and financing opportunities throughout the world.

Jonathan is a Partner at Sway Ventures, an early stage venture capital firm where he sources and leads investments in Seed and Series A companies.

In his spare time, Jonathan writes and produces film content, most recently as executive producer of the horror comedy feature film PATCHWORK.

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