This Week in Startups
Understanding Secondary Market Transactions with Becki DeGraw | Wilson Sonsini Startup Legal Basics
Thu Jul 13 2023Description
The episode covers the rise of secondaries in the startup industry, founder liquidity and selling restrictions, considerations in structuring liquidity transactions, Pari Pasu and stock status, the role of the board of directors in transaction participation, transfer restrictions and secondary transactions, qualification and benefits of Qualified Small Business Stock (QSBS), and working with startups and deferral programs.
Insights
Secondaries have become more common in recent years
Secondaries in the startup industry have become more common in recent years, especially during the funding frenzy from late 2020 to early 2022. Previously, secondaries were rare and usually reserved for later stage companies at a discount.
Founder liquidity decreases as the company matures
Founders are allowed to sell a percentage of their total holdings, typically around 5% or less. The percentage decreases as the company matures.
Considerations in structuring liquidity transactions
Different players have different considerations when structuring liquidity transactions, including tax implications and impact on stock status. The amount of money available for the company itself to increase its value is an important consideration.
Pari Pasu and stock status
Pari Pasu is a concept that relates to early investors, employees, and founders. Investors may prefer preferred stock over common stock due to liquidation preference and other benefits. As companies get closer to an exit transaction, investors become less hesitant about holding common stock.
Role of the board of directors in transaction participation
The board of directors plays a role in deciding who can participate in secondary transactions and what is in the best interest of the company. Honesty and transparency are considered best practices when it comes to involving interested parties in transactions.
Transfer restrictions and secondary transactions
Transfer restrictions in LLCs and contracts determine if secondary transactions can occur. Investor shares usually have fewer transfer restrictions than common stock shares. Buy laws may include transfer restrictions that require board approval for any share transfers. Stockholders must approve bylaws amendments for transfer restrictions to apply.
Qualified Small Business Stock (QSBS) qualification and benefits
Qualified Small Business Stock (QSBS) has specific requirements, including acquiring stock directly from the company and holding it for at least five years. QSBS benefits mainly apply to early-stage investors. Holding stock for more than five years can result in a percentage-based exclusion from federal income taxes, up to $10 million.
Working with startups and deferral programs
Working with startups at various stages is preferred, but very early ideas may not be feasible due to funding limitations. Deferral programs and automation are available to make working with startups more affordable and efficient.
Chapters
- Overview of Secondaries in the Startup Industry
- Founder Liquidity and Selling Restrictions
- Considerations in Structuring Liquidity Transactions
- Pari Pasu and Stock Status
- Board of Directors and Transaction Participation
- Transfer Restrictions and Secondary Transactions
- Qualification and Benefits of QSBS
- Working with Startups and Deferral Programs
Overview of Secondaries in the Startup Industry
00:00 - 07:26
- Secondaries in the startup industry have become more common in recent years, especially during the funding frenzy from late 2020 to early 2022.
- Previously, secondaries were rare and usually reserved for later stage companies at a discount.
- During the funding frenzy, secondaries started appearing as early as series A and were often priced the same as preferred stock rounds.
- Currently, secondaries are less common due to the slowdown in later stage financing.
Founder Liquidity and Selling Restrictions
00:00 - 07:26
- Founders are allowed to sell a percentage of their total holdings, typically around 5% or less.
- The percentage decreases as the company matures.
- There is no specific dollar amount for founder liquidity, but it is often around a million dollars or higher.
- The upper bound for founder liquidity tends to be around three to five million dollars.
- Excessive selling by founders can be seen as a distraction and may affect their motivation to grow the company.
- Some transactions involving large amounts of founder selling have resulted in negative outcomes for investors.
Considerations in Structuring Liquidity Transactions
06:57 - 14:30
- A company sold $200 million worth of shares to a buyer, but the money went into the founder's personal bank account instead of strengthening the company.
- The amount of money available for the company itself to increase its value is an important consideration.
- Different players have different considerations when structuring liquidity transactions, including tax implications and impact on stock status.
- When a company raises $100 million at a $1 billion valuation, if $20 million goes towards secondary sales and $80 million goes into the company, it means 20% of the round goes to secondary sales and 80% goes to new shares issued by the company.
Pari Pasu and Stock Status
06:57 - 14:30
- Pari Pasu is a concept that relates to early investors, employees, and founders. Investors may prefer preferred stock over common stock due to liquidation preference and other benefits.
- As companies get closer to an exit transaction, investors become less hesitant about holding common stock.
- In some cases, founders are allowed to sell their shares before an IPO while employees miss out on potential gains if the stock price drops after IPO.
Board of Directors and Transaction Participation
06:57 - 14:30
- The board of directors plays a role in deciding who can participate in secondary transactions and what is in the best interest of the company.
- Honesty and transparency are considered best practices when it comes to involving interested parties in transactions.
- While rare, off-the-cap table transactions can occur where shareholders create LLCs or sell their shares outside of official channels.
Transfer Restrictions and Secondary Transactions
14:05 - 21:11
- Transfer restrictions in LLCs and contracts determine if secondary transactions can occur
- Investor shares usually have fewer transfer restrictions than common stock shares
- Buy laws may include transfer restrictions that require board approval for any share transfers
- Stockholders must approve bylaws amendments for transfer restrictions to apply
- Early investors often have more freedom to sell and transfer shares compared to later investors
- Venture firms sometimes allow early investors to sell their interest at a discount
- Large endowments may offer liquidity to early investors in exchange for their shares as collateral
- Tender offers provide a way for shareholders to sell their shares, with additional disclosure and a minimum open period of 20 business days
- Secondary transactions can be done through the NASDAQ secondary platform or with the help of a lawyer, depending on the number of participants involved
- Qualified Small Business Stock (QSBS) has specific requirements, including acquiring stock directly from the company and holding it for at least five years
Qualification and Benefits of QSBS
20:50 - 24:43
- Shares bought from the company are not QSBS eligible.
- Significant repurchases can make stock ineligible for QSBS treatment.
- QSBS doesn't apply to companies with more than 50 million in assets.
- QSBS benefits mainly apply to early-stage investors.
- Holding stock for more than five years can result in a percentage-based exclusion from federal income taxes, up to $10 million.
- Attorneys and tax advisors should be consulted for proper QSBS qualification.
Working with Startups and Deferral Programs
20:50 - 24:43
- Working with startups at various stages is preferred, but very early ideas may not be feasible due to funding limitations.
- Deferral programs and automation are available to make working with startups more affordable and efficient.