A Founder's Toolkit: Navigating the Surge in Startup Secondaries

This article delves into the reasons behind the surge, how stakeholders—including selling and buying investors—can capitalize on it, the legal and regulatory frameworks governing these transactions, and best practices for companies and investors.

Understanding the Rise in Secondary Market Activity

Delayed Liquidity Events

Traditionally, startups aim for an initial public offering (IPO) or company sale within five to seven years of inception. However, companies now stay private longer, often exceeding a decade before going public or being acquired. This extended timeline delays liquidity for investors and employees holding stock options or shares. For example, Stripe (founded in 2010), has yet to announce IPO plans. Instead, Stripe actively facilitates secondary sales to provide liquidity to employees and investors.

New Investor Appetite for Private Secondaries

Institutional and accredited investors are eager to invest in high-growth private companies. Secondary markets offer access to equity in firms that might be otherwise inaccessible due to closed funding rounds or high minimum investment thresholds.

“Democratization” of Venture Capital

The rise of secondary markets is also a byproduct of venture capital’s “democratization” trend. By providing broader access to private company investments, secondary markets are enabling a wider range of investors to participate in venture capital opportunities that were traditionally reserved for a select few.

Opportunities for Companies and Investors

For Companies

Talent Attraction and Retention – By facilitating secondary sales, companies can offer employees a pathway to liquidity, enhancing job satisfaction and retention. Instacart offered secondary sales opportunities to employees before its IPO, helping retain talent by providing financial rewards.

Controlled Share Distribution – Companies can manage who acquires their shares, maintaining control over the cap table and ensuring strategic alignment with new shareholders.

Market Valuation Insights – Secondary transactions can provide insights into the company’s market valuation between funding rounds.

For Investors

Opportunities for Selling Investors:

• Liquidity Without Waiting for Exit Events: Early investors and employees can realize returns without waiting for an IPO or acquisition.

• Portfolio Rebalancing; Facilitating LP Returns: Selling shares allows investors to rebalance portfolios, mitigate risks, or invest in new opportunities. Venture capital firms are increasingly using secondary sales to manage fund lifecycles and return capital to limited partners.
• Capitalizing on High Valuations: When market valuations are favorable, selling investors can seek to maximize returns.

Opportunities for Buying Investors:

• Access to High-Growth Companies Pre-IPO: Investors can acquire equity in promising startups before they go public.
• Portfolio Diversification: Secondary markets enable investors to diversify portfolios with private equity investments across various industries. Family offices and high-net-worth individuals are leveraging secondary markets to gain exposure to startups in which they did not have the opportunity to make a direct investment.
• Potential for Negotiated Terms: Buyers might have the opportunity to purchase shares at discounted prices from existing investors seeking liquidity or if the market experiences a general downturn.

Legal and Regulatory Considerations

Securities Laws Compliance – All secondary transactions must adhere to federal and state securities laws. The Securities Act of 1933 requires that any offer or sale of securities be registered unless an exemption applies.

• Accredited Investors – Sales are often limited to accredited investors to qualify for certain exemptions.
• Regulation A+ and Crowdfunding Exemptions – However, some companies are exploring exemptions that allow non-accredited investors to participate. The use of Regulation A+ and Crowdfunding exemptions are some examples. Still, these often come with heightened disclosure and regulatory requirements.

Company Level Restrictions – Company bylaws, stockholder agreements or investor rights agreements may restrict the transfer of shares.

• Right of First Refusal (ROFR) – The company or existing shareholders may have the right to purchase shares before they are sold to third parties. For example, Airbnb enforced ROFR provisions during secondary transactions before its IPO.
• Consent Requirements – The company may require prior written consent for any share transfer.

Best Practices for Navigating Secondary Sales

For Companies

• Establish Clear Policies – Develop a secondary sales policy outlining the company’s stance, approval processes and restrictions.
• Engage Legal Counsel – Work with attorneys to ensure compliance with securities laws and internal agreements.

For Selling Investors

• Review Legal Agreements – Understand any contractual obligations that may affect the ability to sell shares.
• Assess Market Conditions – Evaluate the timing of the sale to maximize returns.
• Seek Professional Advice – Engage financial and legal advisors to understand tax implications and compliance requirements.

For Buying Investors

• Conduct Due Diligence – Verify company information, financial health and growth prospects before purchasing shares.
• Understand Transfer Restrictions – Be aware of any limitations or conditions associated with the shares.
• Evaluate Investment Risks – Consider factors like liquidity, market volatility and potential dilution.

Conclusion

The rise in secondary market sales of private company stock presents both opportunities and challenges. For founders, it is a tool to manage shareholder expectations and maintain control over equity distribution. For selling investors, it offers a chance to realize returns and rebalance portfolios. For buying investors, it provides access to high-growth companies and potential for substantial gains. Moreover, the growth of secondary markets is democratizing venture capital, allowing a broader spectrum of investors to participate in private company investments.

However, navigating the legal and regulatory landscape is complex and requires careful planning and professional guidance. Challenges like valuation discrepancies and information asymmetry necessitate thorough due diligence and strategic negotiation. By staying informed and proactive, all parties can leverage secondary markets to their advantage while minimizing risks.

Whether you are a founder looking to manage secondary sales of your company’s stock, an existing stockholder seeking liquidity or an investor looking to purchase stock in a secondary, our team is here to assist. We can help you establish appropriate procedures, navigate the regulatory requirements and negotiate and document the transaction.

Author Jason Acevedo is a partner in the Venture Capital & Emerging Growth practice group in the Corporate and Securities Department at Klehr Harrison.

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