What the heck is a “Secondary Sale of Stock” anyways?

Thanks to a combination of websites like SecondMarket and SharesPost, large Web 2.0 companies electing to stay private, venture firms deciding that purchasing “secondary” shares at billion dollar plus valuations still counts as venture investing, and the general fascination of the startup press (and community) around valuations and wealth creation (which is perfectly understandable), 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, lets 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 “he 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
Now that all of these different entities have shares of stock in the Company, they have some level of flexibility to sell those shares to third parties through a “Secondary sale” of stock. This flexibility will depend on a number of factors, first and foremost on whether there are any restrictions on their ability to sell shares of stock prior to a public offering of the companies shares.
Restrictions can include fixed prohibitions on the sale of shares (usually requiring the approval of the board of directors), Rights of First Refusal that give the company (and sometimes other shareholders) the right to purchase the shares instead of these being sold to a third party, and Rights of Co-Sale that allow other shareholders to sell some of their stock alongside the shares being sold in such a way that the purchaser is required to buy shares from a variety of sellers.
In addition to these restrictions, there will often be voting agreements in place that direct how the shares in question are required to vote on a variety of issues such as the election of the board of directors, approvals of new financing rounds, and approvals for acquisitions. For Preferred Stock there will be a Stock Purchase Agreement that outlines a whole range of terms and conditions that apply to that class of stock, regardless of whether it is held by the primary purchaser or sold to a secondary buyer.
There are also restrictions for sellers and buyers based on their level of sophistication as investors and their financial situation (buyers must be “Accredited Investors“). Both of the websites mentioned at the start of this article do a good job of outlining all of these potential restrictions on the shares and the process of buying and selling them.

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 recently 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 four to five 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 emerging 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 expects to surpass 500 shareholders sometime early in 2012. 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, we generally see the Secondary Sale trend as 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 will reduce the illiquid nature of privately held companies. If 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 natural reaction to a potentially disruptive new trend, we expect it to shift over time as startups that secondary trading of their shares have an easier time recruiting employees to the business based on the flexibility these employees have in terms of selling some of their shares as the business grows and founders see the value of being able to sell some of their ownership position along the way. This could lead to a greater degree of transparency by startup companies as they start to provide information related to financial results, equity capitalization and other important diligence items 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 emerging secondary trading market for privately funded companies.