by Elad Gil
What milestones will this fundraise get me to? Will those milestones fundamentally change the perception of my company’s worth?
What sorts of exits are possible for my company? Are there likely acquirers above the valuation I am raising at? Do I plan to go public? If not, is it wise to raise at this valuation? If so, will my IPO be at a higher valuation then my private market fundraising?
Secondary stock sales
As your company’s valuation continues to rise, early employees or investors may want to sell a subset of their stock in the company. A “primary” investment in a company is when you give a company money in exchange for its shares. A “secondary” investment is when you buy shares from someone besides the company (basically a previously owned share). In both cases, the shares could either be common stock or preferred stock. In other words, secondary stock is defined by who you are buying shares from versus the type of shares themselves.
For current or former employees, selling stock they hold may be driven by personal issues such as an expensive hospital bill for a family member, wanting to buy a house for themselves or their family, or an interest in diversifying what may be most of their net worth.
Early investors may be motivated to sell stock early by a need to return money to their funds’ LPs (especially if they are in the process of raising another fund and want to show returns), or they may simply be looking out for their own financial interests and the need to generate “carry” on their funds.63
Founders may also want to sell secondary stock to diversify their net worth, which is likely dominated by company stock. For that reason, founder sales, if done correctly, tend to align founders to focus on the long-term success or outcome of the company by taking away worries they may have about their personal financial future.
$500 million to $1 billion tends to be a transition point
In general, a $500 million to $1 billion valuation is usually where founders and/or employees might start to consider selling stock. This shift in behavior is due to three factors: (1) It take two to five years to get to a $1 billion valuation. During that time life events (children, family illness, and the like) may have occurred and there is a financial need; (2) the market cap of the company is large enough that most of an individual’s net worth is tied up in the company, 1% of the company may be worth $5 million or $10 million, diversifitcation starts to be meaningful. (3) Employee belief in the remaining multiple upside to the company may start to diminish. Almost all high-growth companies are chaotic and messy, and competition always increases when something is working well for a startup. Most early employees interpret this as a limit on the upside of the company, which increases their interest in selling. Moreover, the value of small amounts of stock at that valuation is sufficient to motivate employees to sell.
Founder sales
Founder secondary sales have become increasingly acceptable as a way to ensure that leaders continue to focus on the long-term potential of their companies, rather than sell early.
As an active founder, you may want to sell up to 10% of your holdings (or up to $5 to $10 million, whichever is lower) in a secondary transaction, as part of a round, a stand-alone sale, or a tender (more on each of those below). If you sell more than 10% (especially if you’re still operationally involved with your startup), it will be perceived as a negative signal about your belief in the future of the company.
Most founder secondary sales occur once a company reaches a multi-hundred-million-dollar valuation. (There are some circumstances where smaller sales occur in the mid-to-high tens of millions if there is a specific founder need. In general, these earlier-stage sales amount to sales in the hundreds of thousands of dollars in order to pay off school debt or provide a small financial cushion for founders.)
Most founders I know are happy they took some amount of stock off the table to relieve financial pressures as the time to IPO keeps lengthening.
If you do not regulate secondary sales early, it may backfire on you
There are a number of issues that can come up if you do not create a framework for secondary sales for your company: large transactions impacting your 409A valuation, misbehaving investors ending up on your cap table, or even the random dentist buying stock from an employee at a premium and then harassing your company for information. (The “random dentist” is real—I saw this happen at one company.) There are also secondary funds that may act badly in these opaque markets—for example, Facebook ended up with an SEC inquiry into their company stock sales due to issues with Felix Investments.64
Ways to get ahead of these problems include modifying your charter or other agreements to prevent secondary sales, ensuring you have a ROFR on all shares, and in some cases contractually preventing people from selling without board approval. Having a preferred buyer or tender program will also help create liquidity while ensuring stock doesn’t actively trade in a secondary market.
Types of secondary sales
In general, secondary sales begin as one-off sales—for example an employee needs to quit the company to take care of a sick parents and wants to sell some stock to pay for better medical care. As market cap grows and with it the demand to sell stock, the company realizes that random people are buying their way onto the cap table, or the demand to sell grows to significant levels as the company gets older and more employees and investors hold illiquid stock for multiple years. At this point, many companies switch to a “preferred buyer” or “tender” approach. I review the different types of secondary sales below:
1. One-off sales
In this scenario, the seller is executing a one-time transaction with either an existing cap table investor (i.e., someone who already owns company stock) or a new entity that is not already involved with the company. In general, the company has an incentive to push the stock seller to a buyer it already knows well.
There are ways to incentivize a seller to work with a known buyer. That includes everything from a simple request (especially if the seller is still active with the company as an employee or investor or wants to maintain a good relationship with the company) to making life difficult for the seller via the exercise of rights of first refusal (ROFRs) or other moves that delay the transaction and may destabilize it for the buyer and seller.
In general, one-off sales can backfire on a company as new, non-savvy, or potentially badly-behaved investors come on board. It is beneficial to the long-term health and stability of the company to establish a set of “preferred buyers” early to soak up secondary sales and demand for selling stock. This may be an informal relationship with trusted investors already on the cap table who want to buy more secondary. In parallel, the company should start to institute programs detailing how much employees or early investors can sell, and under what circumstances. Holding out the promise of a tender or other program will often cause potential sellers to wait for the company to initiate a formal secondary program. Most people want to do the right thing for the company, and are willing to wait 6–12 months, or more, for the opportunity to sell in a company-sanctioned manner.
2. Selling as part of a funding round
A straightforward time to sell—as a founder, early employee, or early investor—is during a funding round. Most financing rounds for late-stage breakout companies tend to be oversubscribed. The extra demand for company stock means that an investor who could not get a full primary allocation may be willing to take in a blend of preferred (as part of the round) and common stock (acquired from an employee or founder), or early-stage preferred stock (from an early investor).
Most late-stage investors will be okay with buying some secondary common stock alongside a preferred funding round, as the preferred stock helps protect the overall investment in a blended manner. Alternatively, investors who could not get a piece of a round may be willing to buy only common stock instead, depending on the structure of their funds. (Some funds cannot have a large portion of common stock in their portfolios due to LP agreements or the need for additiona
l SEC filings.)
Most investors tend to discount common stock 20% to 30% relative to the preferred stock price—i.e., they will want to pay less for common stock since preference does not exist and will not protect them in a downside scenario. For example, when DST purchased secondary stock in Facebook it did so at a $6.5 billion valuation—a 35% discount on the $10 billion preferred price at the time.65 However, if the company is hot enough, or the buyer hungry enough, investors may pay the same amount for common and preferred.
The company will likely want to take an arm’s length approach to the common stock sale to avoid 409A implications (more on this below). A large, company-sanctioned stock sale (and 409A re-analysis) could cause a repricing of common stock for the entire company (and future employee options), which is worth avoiding if possible. Talk with your lawyers about this.
Usually no more than 20% of the funding round will take place as secondary. The venture capitalists may not want to take the risk of buying too much common stock (which lacks the financial and control protections of preferred stock). There are also regulatory limits on the percentage a venture capital fund can invest in secondary versus primary stock.
3. Preferred buyer programs
In a preferred buyer program, one or more funds are given preferred access to purchase secondary stocks. These programs may be informal (e.g., the company suggests that potential sellers talk to a small number of funds) or formal (e.g., the company assigns a secondary ROFR, or right of first refusal, to these funds).
In a formal preferred buyer program, a fund may sign a term sheet, LOI, or binding agreement with a company to provide dedicated funds to soak up secondary stock. As part of this agreement, the fund can generally purchase stock in a pre-defined range (e.g., at a 10% discount to last round) and may be assigned a ROFR by the company.
The ROFR may become important: In many cases, the company has a 30-day right to purchase stock from a seller at a price the seller has negotiated with another buyer. When a ROFR is assigned to a fund, this may add a second 30-day period; if the company passes, the fund has another 30 days to purchase stock at the price the buyer has agreed to. The net effect is a 60-day—or more—delay between the statement of intent to sell and the time when a transaction can actually occur. This two-month timeframe can make buyers and sellers quite nervous, as market and other conditions may change during this time, destabilizing a secondary transaction.
In addition, a ROFR provides a source of sanctioned liquidity for a stock under a certain valuation, driving certain buyers out of the market: they cannot close a transaction, as the preferred buyer will take the sale from them. Effectively, the ROFR creates too long a wait and too high a price for many sellers, driving down market demand for secondary. You should talk to your legal team about ROFR assignments to preferred buyers.
Preferred buyer programs can be of special help when acquiring other companies. In this case, the founders or investors of the acquired company may want to sell a subset or all of the stock they receive in the transaction. A preferred buyer may help facilitate this transaction (and hence the actual acquisition) without the company itself needing to pay out cash as part of the purchase. This can also be handled via a tender, where the acquired company’s investors can sell into a tender instead of a preferred buyer program.
4. Tender offers
A tender is basically a large coordinated event in which one or more buyers buy secondary stock in your company at a preset price.
Tender offers typically follow this pattern:
1. The company tries to estimate demand for a secondary stock sale. This determines the rough size of the tender. The company may also put in place paperwork to further restrict stock sales by people who participate in the tender.
2. The company signs a term sheet with a buyer or set of buyers to purchase stock in a tender offering. The buyers set a single price for all sellers.
3. The company determines who can sell into the tender. Often, prior and current employees, investors, and founders can participate in tenders. In some cases, the size of the tender is preset, and who can sell is set in an order determined by the company. For example, if there is a $50 million tender offering (in other words, $50 million of stock is sold in aggregate), the company may say that current and past employees get first dibs on selling up to 20% of their holdings each. If there is enough demand from employees to cover the full $50 million, then investors and founders do not get to sell into the tender.
4. An administrative institution is hired to administer the tender, as there may be hundreds or thousands of eligible sellers. That institution will deal with all the mechanics and paperwork to cover the sale of the stock by employees and other sellers. Banks or other institutions, such as Deutsche Bank, are often hired to run tenders, even though they are not the actual buyer of the stock. The cost of hiring these administrators is typically at least partially covered by a transaction fee paid by the sellers into the tender pay (e.g., 1% of their sale).
5. The set of people who can sell into the tender is notified that the tender is open, and told the price set for the stock purchase. They are also informed of the window of time in which eligible people can notify the administrator how much they want to sell and fill out the paperwork for a sale. The selling window may be open for 20 or 30 days.
6. Once the selling window closes, the transaction occurs and the stock and cash change hands.
Typically, buyers in a tender are large institutional buyers from the hedge fund, private equity, or late-stage VC worlds, such as BlackRock, Goldman Sachs, DST, Fidelity, and others.
Tender offers may range from the tens of millions into the hundreds of millions or billions of dollars in size.
Information sharing and secondary buyers
In general, you should share basic financial information with large secondary buyers who are on your preferred buyers list or who run tenders for you. All of these types of buyers will be willing to sign an NDA at this stage. These buyers are making large investments in the company and in some cases will be long-term shareholders. Treating them well and providing them with basic information to make their decisions is important.
For small, random additions to the cap table (especially ones without strong company sanction), you can restrict information access unless it is something you are legally obligated to share with every shareholder (e.g., some changes to your legal documents).
If you end up with a $5 billion valuation or higher, that’s the point at which you will need to hire someone whose job (at least part-time) will be to regulate secondary transactions and the secondary ecosystem, unless you are able to lock it down up front and early.
How much stock should employees be able to sell?
There are three common models for secondary stock sales by employees: (1) a percentage limit, (2) a dollar limit, (3) hybrid approach.
Percentage limit on secondary sales
Some companies choose a percentage of total holdings that employees can sell—e.g., up to 10% to 20% of each individual’s holdings. This range is typically chosen so that most of the employees stock continues to be held—incentivizing them to focus on the long term value of the company and its stock. For companies that have truly broken out and are worth many billions, or for very early employees, these amounts may add inWto the tens of millions of dollars. Sales of this magnitude create a potential disincentive for employees to continue to work. Moreover, they can lead to a two-class system within the company before a true liquidity event occurs (e.g., an IPO or large sale). This two-class system can be culturally jarring.
Dollar limit on secondary sales
Alternatively, some companies allow employees to sell up to a certain dollar amount. For example, Facebook allowed employees to sell up to $1 million in stock. This meant that, irrespective of the overall net worth of the employee due to Facebook stock, all employees could cash out a common amount that was life-changing but not distracting. In some cases a dollar limit may cause some ear
ly employees to leave the company if doing so unlocks their ability to sell larger amounts of stock. In reality, people who leave solely to sell may not have stuck around much longer to begin with.
Hybrid approach: percentage up to a maximum dollar amount
A recent middle ground is to take a “whichever comes first” approach—that is, employees can sell up to 10% or 20% of their holdings or $1 million in stock, whichever comes first, over the course of their secondary sales. If an employee holds $20 million in stock, they can sell up to $1 million, even though that does not trigger their 20%. Alternatively, if an employee holds $1 million in stock, they can only sell 20%, or $200,000. This ensures that employees continue to hold the majority of their stock as a motivator to keep building the value of the company.
Whichever model they choose, companies generally place the following limits on employee sales:
1. Employees need to be with the company at least one year and/or hit their cliff. If an employee has not hit her vesting cliff, she does not yet truly own her stock. It is very hard to try to claw back cash if that employee leaves before her cliff date.
2. The amount of secondary sold is limited to, at most, what the employee has vested. Companies can alternatively limit secondary sales to a proportion of what the employee has vested (e.g., “no more than 20% of what has vested”) in official programs such as a tender.
In general, refresher grants that occur later in the lifetime of a company are a fraction of the grants employees receive upon joining (with rare exceptions for true outlier performers or people who, for example, advance from an individual contributor to a VP and get a larger refresher grant to reflect this heightened position and impact). This means that most of the value employees get in stock tends to derive from the earliest grant; that will be their primary financial incentive to contribute to the long-term success of the company.