Secondary Transactions – Issues and Challenges

August 31, 2017

By Howard Lee and Rob Ackerman

The potential slowdown in venture funding for private companies in all stages of development will lead to uncertainty for all stakeholders – founders, employees, and investors. The notion of providing any partial liquidity for any of the “life events” reasons described in the previous blog post may be impractical for some potential buyers, such as the existing investors or VCs. These traditional primary investors cannot always meet the needs or demands for internal liquidity because their capital may be outside of their deployment cycles, or that their capital is already earmarked as “dry powder” for future rounds of funding. In addition, some primary investors may be reluctant to internally price shares in an existing investment.

There remains some hesitation among startup executives to pursue secondary transactions in more mature, pre-IPO companies, as a result of the challenges and difficulties that Facebook and Twitter encountered in the run-up to its IPO. In 2012, the pre-IPO rounds of funding for these two companies highlighted the strong demand in secondary transactions and the importance of a controlled transaction environment.  The resulting large swings in pricing in Facebook shares prior to its IPO illustrated the negative impact of an uncontrolled and unregulated secondary market on the public offering process.

Another important consideration is the impact of any secondary transaction on the company’s 409A valuation, which is used to determine the fair market value (FMV) of a company’s common stock. Generally, the impact is minimal if it is not a related party transaction, where information is potentially limited or restricted to the buyer or investor. Later stage, more mature companies that are closer to an IPO, will have common share pricing that will ordinarily converge to the preferred price, potentially lessening the significance of any 409A valuation increase. The relatively smaller transaction size compared to a primary round combined with a single counterparty may also result in a minor impact, if any, on the 409A valuation. As in the all sales of securities, the seller must be made aware of the tax implications.

The number and types of shareholders in a company are critical dimensions to the corporate structure of a company. This capitalization table management becomes even more important when there are secondary transactions contemplated by the company. The management team and the board of the company both desire a small and limited number of investors to ease the communications and investor relations burden for the management team. Adding new investors to a startup, who are not a part of the VC ecosystem introduces both complexity and business risk.  New potential investors who do not share the same long-term view as the existing VC investors bring different expectations on company development and exit, as well as the potential for trading of the shares on a frequent or short-term basis. This in turn can impact the 409A valuation adversely for the company, potentially driving the 409A valuation higher (and compressing the upside for new employees) and thus making it more difficult to attract quality talent to the company. If a company is considering secondary transactions for its founders, executives, or employees, it is strongly recommended that the new investors or buyers of the common stock be investors who are part of the VC ecosystem or “insiders.”

A secondary transaction for a VC-backed startup affects three key stakeholders in a company: the founders and employees, the VC investors and board, and the company itself. The alignment of interests of these key stakeholders is essential for the success of any secondary transaction within the company. For the founders and employees, there is access to partial liquidity of their shares in working with a buyer that is efficient, experienced, and professional. For the VC investors and the board, these secondary transactions, if done properly, minimize distraction for management from the operations of the business and improve executive retention. The company improves its standing with employees by providing an employee benefit through a structured liquidity program that greatly enhances employee retention.  The company benefits from bringing aboard a new investor through this secondary transaction who can contribute immediate value, since the new investor is part of the VC ecosystem and ideally has decades of experience in bringing value to management teams as a VC. The company gains a controlled and managed investor base. Finally, all of the key stakeholders, including the new investor, must work to maintain this alignment of interests.

The actual process by which a secondary transaction takes place must also bring the key stakeholders in a coordinated manner. The management team and/or the board help determine the right direct secondary investor.  The most important characteristic of direct secondary investor is that they are considered a trusted counterparty. Startups and VC investors cannot tolerate any risk in terms of the capitalization table, the investor base, the 409A valuation and employee retention, or the business operations itself that would result from closing a secondary transaction with investors who are not considered trustworthy. This trustworthiness is developed and cultivated by working closely among the VC investors in the VC ecosystem for a long period of time. These investors should know the VCs and be known by the VCs as long-term investors.

The case of a secondary trading market poses a particularly challenging situation for the company. The potential fluctuation of the stock prices in this type of private market brings the significant risk of demotivating employees. For example, Fidelity marked down several later stage investments in companies such as Cloudera and Dropbox.  On the other end of the spectrum, a private market comprised of many third party transactions of a company’s shares can impact the 409A valuation in an adverse manner by increasing the 409A valuation and limiting a company’s ability to attract new employees. This further reinforces the need for professional and trusted secondary investors to “partner” with the company to address the concerns described above.

What other possible options are available to employees to accomplish a partial liquidity effectively and efficiently? In many ways, the secondary market in the recent past has resembled the “wild west” in terms of regulation and transparency.  In 2015, the SEC began investigating groups and individuals acting as broker who were offering derivative transactions to employees of private companies that were in violation of the Dodd-Frank Act of 2010. The use of derivatives by these groups to allow employees to receive cash in exchange for a future promise to sell their shares was also typically not permitted by companies.  These restrictions and unpermitted transactions have led to buyers and sellers to work together and in tandem with the companies to ensure that the transactions pass scrutiny and are executed properly. Most importantly, the companies should work with trusted groups who are known in the VC community and who understand the regulatory environment.