Slippery When Wet: Secondary Sales

At Point Nine, we are always in it for the long run :) When we invest, we are betting that a company can become very large and eventually go public, and we do our best to partner with founders that share this long-term mindset. But this doesn’t mean that we think founders shouldn’t be able to sell some shares along the way to take some risk off the table — something which investors frequently do. As a result, the sale of existing shares (commonly referred to as a secondary sale, in contrast to the primary shares issued in a funding round) is generally dealt with quite extensively in the shareholders’ agreement.

Secondary sales are especially common in the context of later stage funding rounds. For founders, selling some shares can make a lot of sense at this stage to help them be more comfortable “swinging for the fences” as we say (it may sound mundane, but swapping a flat share for one’s own four walls can really make a difference here). Likewise, a secondary sale that allows employees to monetise some of their (vested) options helps underpin the value of the ESOP. Last but not least, secondaries may encourage existing investors to sell some shares to consolidate the cap table and give new investors a larger stake without additional dilution of other shareholders. Early investors often find such an option attractive given their comparatively low entry valuation and limited involvement at this more advanced stage of the company’s journey.

In this post we’d like to focus on secondary sales outside of traditional funding rounds or a full exit (change of control). Such sales pose particular challenges to founders and investors alike given the parties involved often have conflicting interests. These are relatively easy to deal with if the secondary happens in connection with a funding round where everything is agreed as part of the overall transaction and primary and secondary investors are (mostly) identical, but in a separate secondary things tend to be more complicated.

In general, shareholders want

• maximum flexibility to sell their holding without constraints on timing and terms;
• to retain control over the shareholder structure, sometimes to prevent a competitor from joining the cap table;
• not be “left in the rain” while others, in particular the founders, sell out.

To address these conflicting positions, there is a standard set of rules in most shareholder agreements that seeks to strike a balance between them. A simplified version of these rules looks as follows:

• Because the founders are a key reason for investors to invest in the first place, they face quite far-reaching sale constraints: only vested shares may be sold (economically unvested shares haven’t been “earned” yet), and there may even be an investor veto on share sales beyond, say, 10% of a founder’s holding. If founders do sell, investors have a right of first refusal (“RoFR”) and co-sale rights.
• Investors can sell more freely, although there may nonetheless be an approval requirement by the board and a right of first refusal of other shareholders. In some jurisdictions, co-sale rights on investor shares are also quite common, e.g. in Germany.

While this kind of framework is mostly uncontroversial and straightforward, the devil is in the details, in particular the practical implementation of the secondary. Given that no company, shareholder structure, and contractual framework is the same, any generalisation must be handled with care. Still there are three basic scenarios that seem worth distinguishing and drawing a few generic conclusions from:

The company-driven sale

This is the most straightforward case and very similar to what happens if the secondary is organised as part of a funding round. In this case, the company (= active founders or management) organises the sale for the shareholders, often as part of an initiative to allow employees to monetise some of their stock options. Because the sale is centrally managed, investor interest and discussions with potential buyers can be channeled efficiently. Likewise, the control of the sale process by the (active) founders gives them substantial sway over the matching of buyer interest with willing sellers.

This approach can be problematic for some (mostly earlier) investors, particularly as it concerns their co-sale rights. At the later stages where these secondaries typically occur (generally in the wake of series C or D rounds), co-sale rights may no longer be available to all investors and are frequently reserved for only the largest ones, who sometimes demand this limitation during funding rounds for efficiency and confidentiality reasons. While such a setup is not illegitimate, especially if the shareholder base is already large and heterogeneous, founders should honour their early commitment to and support of small investors by keeping them in the loop where appropriate.

The process in a company-driven sale clearly offers maximum control and efficiency, but it’s less obvious that it always maximises value and volumes. The company may not be willing or able to approach a sufficiently large number of potential investors to find the keenest ones with the deepest pockets. This may incline some potential sellers to ask for a greater level of participation in the process, which can raise other concerns.

The “rogue” sale

The opposite to the company-driven sale is one initiated and run solely by the shareholder(s) wishing to sell. These cases are rare, as they face numerous obstacles, both legally and commercially. The transfer of the shares may be subject to a RoFR or approval requirement, substantially reducing the likelihood that the transaction actually happens and hence impacting the willingness of potential investors to engage. Even if there are no legal obstacles, the scope and depth of due diligence can be extremely limited without access to management, in which case the parties rely mostly on desktop research and maybe some basic KPIs available to the seller. Still, such “rogue” transactions do happen occasionally if the relevant stock is hot or if there is a benchmark price from a recent funding round that can be used as a reference point for valuation.

As a matter of principle, founders should push back against rogue sales. There are intermediaries, first and foremost investment banks with specialised trading desks, which might offer the stock to an excessively large number of potential investors. Even with confidentiality in place, such wide marketing can quickly create an impression of oversupply and spook investors.

Of course, reputable investors will not even pursue such an approach against the will of founders, or at a minimum coordinate closely with them. But even if the risk of unwelcome sale attempts is low, founders should keep a lid on them by legal and procedural means too. This leads us to the third sale scenario:

The hybrid case

Occasionally companies seek to find a compromise between the first two approaches: Allow investors to approach potential buyers directly while keeping tight control over terms, timing, and process. Besides helping to push up the purchase price in certain circumstances, the main benefit of this approach is the generation of additional demand where the company is already highly valued and significant volumes are needed even for small sale percentages.

Because the most active sellers are rewarded with the greatest sale volumes, such a “you eat what you kill” approach risks spooking the market (see above). It’s therefore key to implement some precautionary shackles: The number and identity of potential investors should be channeled and controlled by the company (or an intermediary reporting to the company) and approaches only happen after sign-off by the company or its adviser. The information provided to potential buyers should be controlled, and in a best case prepared by, the company. There should be a minimum price to avoid dumping by potential hitch hikers. The company should also seek to implement certain sales windows rather than allowing an “evergreen process.”

All of the above can be implemented by a board resolution defining guidelines for the exercise of the board’s discretion when deciding upon the approval of a sale request. If a board approval requirement does not exist or if there are rights of first refusal or co-sale rights to be managed, a secondary sale policy might be the right way forward. Following approval by the requisite investor/shareholder majority, such a policy might function as a voting agreement obliging shareholders to waive RoFR and/or co-sales rights on a sale which happens in accordance with the policy.

What to make of it

It’s difficult to give “one size fits all” tactical advice for founders on how to approach secondaries given the myriad of conceivable situations and interests. But some broad principles, alluded to already before, seem worth reiterating:

• Maintain maximum control and don’t encourage investors to pursue their own agenda;
• Where possible, combine secondaries with primary funding rounds for optimal control and efficiency;
• Consider implementing board guidelines or a secondary sale policy at the appropriate time, setting strict rules on timing, process, volumes, and terms. Any good legal venture adviser will be able to help you find the right balance here; and
• Accommodate investors who (legitimately) request to find their own buyers by strictly controlling the approach of, and discussions with, potential buyers.