“I’ll get liquidity in the secondary market.”

Please see my Disclaimer.

As previously mentioned, venture-backed companies are getting much older before their exit. But the percentage of $100M+ exits grew by 18.7% when comparing the last 365 days with 2013. The increasing share of larger exits is good news for VCs — if they can get liquidity! Because the percentage of venture-backed companies older than nine years at exit jumped by 16% in 2018 when compared to the average of the previous five years 2013 to 2017. And we are seeing more zombies (companies that are just-so cash-flow positive with flat revenue growth… but that’s another blog post).

So naturally, venture capital firms are looking for earlier liquidity. Especially pre-seed and seed firms increasingly mention that they intend to start selling off some of their shares once the 10x+ return hurdle is met. I like early liquidity. Especially at a 10x. But there are a few complications to keep in mind.

Pre-IPO Companies usually Establish Control over Secondary Sales.

When companies come into the range of potentially going public, they start establishing rigorous controls over secondary shares. In a recent Wilson Sonsini Goodwin Rosati event on Initial Public Offerings, some partners presented numbers where the weight of secondary shares were 75%, 80%, or even 100% of the Fair Market Value and thus made it necessary to price the shares at a lower range than expected. Because companies would like to avoid that, they usually start enforcing strict limits on secondary transactions.

409A and Options Pricing.

Similarly, your secondary transaction will be considered as a factor for options pricing. Recently, we have seen a rather radical weight on secondary transactions. That can have an undesirable effect on options pricing of your employees — which could become a problem if your board does not authorize the transaction in fear of getting sued for neglecting their fiduciary duty (yes, it happened).

Insider Trading.

I have seen some secondary transactions fall through where an institutional venture firm had no board or observer seat but the buyer, an existing investor who had led a late-stage round, did have a board seat or observer seat.  I’ve also seen deals fall through the other way round (big guy sells to smaller guy who could not get the desired allocation in a later round). In both scenarios, the question was whether the board member had material information about imminent good news (or imminent bad news).

Fiduciary Duty.

Similarly, as a board director your loyalty is first and foremost to the company, then the share class, then your firm, then your personal gains. If you or your firm profits in any way from the transaction you have to make sure that there are no negative effects to other classes that hold a higher interest. That could be tricky. I’ve seen a situation where the investors were divided over an issue, and one of them thought it adequate to simply bow out and step off the board. However, the combatant situation did not help and it got ugly.

Co-Sale Agreements — you might end up selling less than you thought.

if the share class or the company has co-sale agreements, other investors might want to sell their shares as well. If the buyer does not have more appetite or the company reaches its maximum limit of shares it can sell, you might end up selling less than anticipated, or the sale falls through.

SEC Rules 144 and 144A might require disclosure.

Under certain circumstances, these SEC rules require disclosures about the startup or the venture capital firm. But startups and VCs are mostly private entities, they have no interest in disclosing internal, confidential information.

Section 7704 of the Internal Revenue Code (it’s complicated).

Together with Treasury Regulation 1.7704, the IRS increases the tax burden for so-called “publicly traded partnerships”, or “PTPs”. Venture Capital firms are usually Limited Partnerships and qualify for flow-through taxation. There are two ways a partnership can become a PTP: (1) the partnership’s interests are traded on an established securities market; (2) the partnership’s interests are readily available on a secondary market. To avoid that negative tax impact, two so-called “safe harbors” are available: (1) trade less than 2% of the total interest in partnership capital or profits during any taxable year. So that’s not helpful. (2) make the trade through a so-called “qualified matching service”, or “QMS”, which then allows up to 10% of the total interest in partnership capital or profits during any taxable year.

Negative Signaling.

If you are willing to sell your shares, potentially at some discount, in the secondary market, what signal does that send about your confidence in the startup or its current valuation? Are you worried that the liquidity stack of later rounds is too high? is there perhaps material information you know about that makes you sell the stock? Will you no longer be supportive of the company in the future?

Voting Risks.

Really a minor problem, but there is some risk that depending on the acquirer this might change the voting rights of a series. That can have rather dire consequences: Imagine an investor who is holding several rounds and acquires a Majority of stock from an earlier round and now tries to waive pro-rata rights in a new financing (yes, it happened).

500 Shareholder Limit.

This one also rarely plays a role. If a private company has more than 500 shareholders, the SEC considers the company a de-facto public company.  Usually, VC firms sell their shares to existing investors or new investors in a round that want more ownership (while the private company wants less dilution), so that is rarely a problem.

Antitrust Regulations.

We are living in interesting times. In the past, this has been rare. If you are selling shares to an investor that is already holding a large number of shares in the company, you might be required to file a “Hart-Scott-Rodino” antitrust filing with the U.S. Federal Trade Commission and Department of Justice. That is costly, lengthy, and substantially punitive if you missed it.

Thoughts? Opinions? Comments? Corrections?