Friday, January 3, 2014

How To Sell Secondary Stock

A number of early employees at startups have recently pinged me to ask about how to sell secondary shares.  Below is a short primer.

A Short Guide To Selling Secondary Stock
0.  Understand if you can sell some stock.
Check your stock option plan or other company documents to see whether you can sell secondary stock.  If your company has a general counsel, you can also ask them about the details of what you can or can not do.  Alternatively, some later stage companies have a person on the finance team dedicated to secondary transactions or the CFO may be the right point of contact.

From a process perspective, most companies will have a 30 or 60 day Right of First Refusal (ROFR).   This means the company can decide if it wants to purchase your shares instead of the buyer you negotiated a price with.   If not, the existing investors in the company also often have a ROFR and are asked if they want to buy your shares.  If everyone passes, then the original buyer can purchase the shares from you.  If the company or its existing investors want to exercise their right of first refusal to buy the shares, they will pay you the same price you negotiated with the buyer.  So even if a ROFR is invoked, you will be able to sell your shares.

Waiving the ROFR typically takes about 30 days but in some cases can be longer, so you need to plan for this when selling stock.

Remember, right before the IPO a company will often halt trading it is shares - which means you may not be able to sell for a few months before the IPO and then another 6 months after the company is public.

1. Decide how much to sell.  
The decision on how much to sell may be driven by a few factors including:
a. Are you leaving the company and need to exercise options?
Most companies require you to exercise your stock options within 90 days of leaving or you lose all the options you worked years to obtain.  In this case you need to start thinking of how to do a secondary sale shortly after leaving the company.  You will need to decide whether to sell enough to just cover taxes on the full set of options you exercise, or if you want to sell more to take some money off the table as well.

b. Diversify your portfolio.
If 99% of your net worth is tied up in company stock, you may want to take some money off the table to protect from a black swan event that will cut your net worth dramatically all at once.  I know a number of people from e.g. Zynga who saw their net worth drop 70% with the stock price.

c. Get cash you can use today.
Even if your company is close to going public, you may want some short term liquidity to allow you to buy a house, car, pay for your kid's school, or the like.  Remember, just because your company files does not mean it will quickly go public, and even after it goes public you may get locked up for 6 months of uncertainty.

d. Taxes.
There may be large tax considerations depending on the timing of selling your stock.  A number of people sold secondary stock in 2012 to avoid the tax hikes of 2013.  Talk to an accountant before making any sales.

Many people end up selling 20-50% of their stake pre-IPO for the reasons above.  If you really need the cash or just want security, you may sell your entire stake in a secondary transaction.

2. Find a legitimate buyer.
Buyers of secondary stock are diverse.  There are dedicated secondary funds, hedge funds, family offices, individual investors and angels, dentists, and a random assortment of yahoos who operate in this opaque market.

In general, you want to find a buyer who:
a. Has the funds available.
If you are doing a large transaction, ask for proof of funds or make sure the person or entity is a well known investor.  Some secondary funds will offer you a price, and then go raise money AFTER you sign a contract with them to fund the transaction.  Don't get stuck waiting for them to raise a fund to buy your shares.

b. Will move quickly.
Avoid situations where there are multiple decision makers between the purchase and the person offering to buy the shares.  E.g. some secondary funds will have a decision making committee that only meets periodically.

c. Has invested in private securities before.
If dealing with high net worth individuals (versus funds) make sure the buyer understands the secondary process, the risks involved, and the various steps needed to close a transaction quickly.

d. Won't be a pain in the butt to the company.
Adding a dentist from Ottawa to the company's list of shareholders may do your employer a disservice.   They may be willing to pay more for your shares than a professional buyer would.  But random buyers may bring volatile properties (e.g. they may sue your company for no good reason).  Only transact with random people if you don't mind burning bridges back to your employer.

e. Your company will approve quickly.
Optimally, you want buyers your company knows or is willing to add to the cap table quickly.  Some funds have had problems with the SEC in the past around secondary purchases, which means your company may not want them to buy your stock.

3. Figure out the price you want.
Private market transactions are highly illiquid and volatile[1].  There are always rumors of higher and lower prices somebody got on their stock.  Or, illegitimate buyers may suggest prices for stock that they cant or wont really pay to test the market.  Often these transaction don't go through and muddy the perception of the real market price.

To get a sense of the market for the stock:
-Ask colleagues selling stock what they are getting for their shares in transactions that have actually gone through.  This should be what transactions actually closed, versus offers they have received.  Unclosed transactions are often meaningless.
-Don't be too greedy.  Focus on speed of closing at a price you are comfortable with.  Unless you are selling a very large block, 5 cents a share won't make much of a difference if the stock is at $18 a share.

Rules of thumb:
-Common stock often has a discount to the last preferred stock price[2].  This is on the order of 30%.  E.g. if your company just raised at a $240 million valuation, you may expect to sell your common stock at $160 to $200 million.  If the fundraise took place many months before your sale, and the company has made progress since then, you can typically sell at the preferred stock price[3].  You should by all means ask for the last company preferred valuation, but investors may not be willing to pay[2].  As the company gets more valuable/later stage, the spread between common and preferred stock will disappear.

-IPO volatility.  There is typically a sharp run up in secondary prices you can get in the weeks before a company halts secondary transactions directly before an IPO.  In some cases these prices will be higher then the post-IPO stock price (see e.g. the first year of Facebook)[4].  If you want to sell, don't get overly greedy during this period.  Prices are rising so quickly you keep trying to hold out for an even better price.  Remember, the price is moving quickly because the company is about to stop all secondary trades.  So if you over optimize and don't sell you may prevented by the company from any selling for an uncertain period of time.  The root of uncertainty is that not every company that intends to go public will do so immediately.  I.e. post filing a company may wait for many months (or quarters) before going public due to market conditions.  Once the company does go public you will be locked up for another 6 months.  If the IPO gets delayed, you can end up with a bunch of illiquid stock and ongoing market risk.

-Expect things to move up and down in a semi-random fashion.  In a market with limited numbers of buyers and sellers prices may move all over the place.  If one of the founders dumps a large block of stock at a low price to diversify, it may depress prices for everyone.

-Don't forget taxes.  Talk to your accountant.  E.g. selling in one year versus another may impact the taxes you pay.  Similarly, if the stock when you bought it was a qualified small business, there may be very large benefits to holding the stock longer, or future tax breaks depending on how you re-invest the money you just made.

4. See if company wants to have their legal counsel run the transaction.
Many companies will have the Stock Purchase Agreement (SPA) they want you to use to sell their shares.  If not, you can use one of the major Silicon Valley firms to put together the paperwork.  Typically you will need a stock purchase agreement.  Sometimes, you may need additional paperwork such as a third party legal opinion that you legitimately own the shares you are selling (this is usually only needed if there is a large secondary market for a company's shares with lots of buyers and sellers.  At some point you can get people acting badly in the market and selling shares that don't exist).

5. Terms to include.
You want to make sure the paperwork for the secondary transaction includes basic items such as:
a. The buyer is obligated to fund the shares within X days of being able to do so.  I.e. if they do not wire money to you within a week of the sale closing you can void the transaction.
b. The seller is obligated to sell the shares and can't back out.
c. If the company blocks the transaction or exerts its right of first refusal (ROFR) the contract is voided.

I am not a lawyer and completely unqualified to give legal (or frankly, any other) advice.  So talk with your lawyers on this.

6. More complex transactions.
There are some secondary funds that will offer more complex transactions that will allow you to benefit from the upside of your stock in the future while cashing out today.  In some cases you take a loan out against your shares and then split the upside of the stock with the lender.  Alternatively, you outright sell them the shares, but have a contract in place that above a certain dollar amount you split the upside.  An example of this would be selling your stock for $25 per share, but then splitting any appreciation of the stock above $30 per share.  So if the stock sells for $32 you end up with $26 a share ($25 plus ($32-$30)/2).

Thanks to Naval Ravikant for reviewing and providing feedback on this post.

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Notes
[1] There are always rumors that a stock is selling for much higher and much lower prices.  In my experience, these rumors often turn our to be false.  Focus on closed transactions where money changed hands versus "a friend of a friend was offered $X but did not sell".

[2] The reason for this discount is that preferred stock gets paid out first if the company exits at lower then its last rounds valuation.  So while preferred stock has "insurance" that makes it more likely to get paid in full, common stock does not, hence the discount.   As a company gets more valuable and has more traction, the risk of a low exit goes down, and the gap in price between common and preferred shrinks and eventually disappears.

In some cases, as part of a financing round, a venture firm will buy common shares from founders at the same time it buys preferred stock from the company.   In this case, the venture firm will pay the same price for preferred and common as:
-It wants to help the founders partially cash out.
-The percentage of common it owns is low enough to not be material versus its preferred stock position.

[3] If you work for a super hot company that has made a ton of progress since its last round, and a lot of time has passed since the funding, then you can demand a premium to the last round of funding.  Companies also track their own internal valuation at board meetings and via 409(a)s, so you can also ask the company what price they think the company is now worth in order to set price.

[4] I know a number of investors who stopped buying secondary shares after they got "burned" by speculating on Facebook pre-IPO.