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Founder Liquidity: Key Considerations in Secondary Sales

As a founder starts and grows a company, the founder may consider selling her shares in the company prior to an exit via a sale of the company or an initial public offering.  Such sale, typically called a secondary sale, helps a founder meet needs for necessary expenditures or reduce her risk tied to the company.  In the past, the founder’s sale of her shares was viewed as signaling lack of confidence and misaligning the founder’s interests, and therefore, investors often blocked the founder’s sale of her equity. However, in the recent years, investors are increasingly open to founders’ needs for liquidity prior to the sale of the company or an IPO.

Typical Buyers of a Founder’s Shares

The company itself, new or existing investors in a priced equity financing or a third party purchaser can all be potential buyers of a founder’s shares.

  • Company.  The company may buy back the founder’s shares using the cash of the company, thereby increasing the relative ownership share of all other stockholders in the company in the process.  Sometimes, a portion of proceeds from a financing round is earmarked to repurchase shares from certain common stockholders.

  • Investors in a Priced Equity Round.  The founder may sell her shares to new or existing investors as part of a priced equity round.  This strategy is especially useful if there is demand for the company’s shares beyond the company’s financing needs.  Instead of making the company issue more shares, interested purchasers can buy additional shares from the founder that is looking for some liquidity.

  • Third Parties.  Certain funds specialize in purchasing shares directly from founders.  There are also platforms that match interested investors with potential selling founders, such as NASDAQ Private Markets and Micro Ventures.

Potential Difficulties in a Founder’s Secondary Sale

Finding an interested purchaser, however, is merely the first step in a founder’s secondary sale.  Typically, a startup’s corporate documents and financing agreements contain various restrictions that make it difficult for the founder to obtain liquidity without consent from the board and other key investors.

  • Transfer Restrictions.  Before the founder can transfer her shares, the company and/or the existing investors will typically need to approve such transfer and the transferee.  This makes it more difficult for the founder to shop around for the highest bidder for her shares.

  • Board Approval. If the company is repurchasing the founder’s shares,  board approval will be necessary.  Additionally, if the company has borrowed any money, the financing documents would typically require that the lender approve any repurchase of shares by the company.

  • Right of First Refusal.  If the company has already undergone a financing round, the company will typically have the right of first refusal, which requires the founder to offer her shares  for sale to the company before offering them to any other potential purchasers.  If the company chooses not to purchase the shares, the existing investors typically have the secondary right to purchase the shares on a pro rata basis before the founder may offer them to third parties.  If certain of the existing investors choose to buy the founder’s shares, depending on the number of shares sold and which of the existing investors participate, the sale may lead to unintended changes in voting.

  • Co-Sale/Tag-Along Right.  Along with the right of first refusal, existing investors will also often have a co-sale/tag-along right, which gives the existing investors an option to sell their pro rata share of holdings alongside the founder’s sale.  If existing investors elect to invoke this right and participates in the sale, the founder may not be able to sell the full number of shares that she hopes to sell.

  • State Corporate Laws.  Additionally, state laws may prohibit a company from repurchasing its shares if the company does not meet certain statutory requirements.  For instance, under the Delaware General Corporation Law, a Delaware corporation may not repurchase its shares unless its net assets exceed its capital (i.e., the aggregate par value of all of its previously issued shares).

  • Impact on 409A Valuation.  If a founder sells her shares at a valuation higher than the current 409A valuation, this will likely increase the company’s subsequent 409A valuation.  Since 409A valuation sets the strike price for options granted to employees and advisors, depending on the price at which the founders sold her shares, the strike price for the company’s option grants may increase materially, thereby impairing the company’s ability to compensate its employees with low-priced options.

In order to ensure a smooth secondary sale process, it is important for a selling founder to begin communicating early with the board and key investors to create buy-ins.  Additionally, a founder may plan in advance for a sale by ensuring that restrictive provisions in the corporate documents and financing agreements contain carve-outs for a founders’ sale of shares so long as the shares being sold fall below a specified percentage threshold.

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About this Author

Associate

Soobin focuses her practice on mergers and acquisitions, joint ventures and other corporate agreements, and the regulatory aspects of deals and agreements. She has represented clients in the financial services, fintech, technology, and other industries. Soobin has experience with counseling clients on the Dodd-Frank Act, payments industry regulations, and antitrust laws.

Prior to joining Mintz, Soobin was a corporate associate and a summer associate at a New York-based international law firm, where she worked on M&A deals and matters...

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