Using secondaries strategically
Why startups should look at secondaries more favorably
Investing in private companies is quite different than investing in public companies. In private companies, a typical investment involves the issuance of new shares by the company, which are then sold to the investor (often involving the creation of a new tranche of preferred stock). This is a primary transaction, and it is the vast minority of stock buying that happens in public markets. Most public market trading is called “secondary” because you are buying it from an existing shareholder. In private companies, secondary transactions are the vast minority instead. Secondary sales in startups are more common than they used to be, but they are still rather rare. The majority of such sales happens through a private market like Forge Global.
Startups and investors look down on secondary transactions. Secondaries are viewed as lower status because they don’t provide capital to the company, so they are a purely financial transaction — they don’t give fuel for the company to grow.¹ Companies have other concerns as well. They worry about losing control of who is on their cap table, they worry about disincentivizing employees from working too hard by giving too much liquidity or making the stock price so dynamic that it becomes a distraction, and they worry about unnecessarily setting a price in anticipation of the next round. There is also always the looming threat of regulation.² These are all valid concerns, and for that reason all startup shares contain a right of first refusal, or ROFR, to control who gets the stock.³ Top firms like Andreessen Horowitz and Sequoia are doing more secondaries, but it is just to get even more exposure to their favorite companies as they desperately search for more ways to deploy their dry powder.
Despite the validity of these concerns, private companies and their boards should look at secondary sales differently. By tackling these concerns head-on and being thoughtful about them, they can actually use secondary sales strategically to better manage their investors and manage their employees.
First, let’s tackle investors. The most common reason for an investor to be turned away is not that they won’t be helpful but because of fears of concerns surrounding dilution or investor size. Secondary shares solve that problem instantly. Instead of diluting by expanding the issuance, you can just sell existing shares and get this person on the cap table. Because secondary transactions don’t require amending the Investor Rights Agreement, you can also do these transactions off-cycle when someone great comes along. From that perspective, secondary investors are not interlopers but partners. Today it would be unheard of to give an observer or board seat to someone who buys common stock, but if the buyer is strategic, it should be treated like any other investing decision.
Secondary transactions can also be used to set favorable terms. Secondary transactions are usually common stock or early investor stock, which sits at the bottom of the preference stack; the investors who want those stock (1) will be your most enthusiastic investors willing to take on the most downside risk, so they will usually pay a premium; and (2) are lower in the preference stack, so they will set a floor, not a ceiling. In formal financing rounds, secondary and primary can be combined to allow a great investor to come in at buzzy headline number while still having a good blended valuation.⁴ This can lubricate the deal to make it go through.⁵ Plus not all secondary sales need be common stock from employees — sometimes secondary sales are preferred stock from past investors, which still achieves those goals.
The other issue is employees. Companies need to tightly control this because premature secondary sales have become a big problem. Especially with founders, some have recently been allowed to sell either too early or too much stock before an exit.⁶ It is all too common today to see a secondary sale for a company that is still only has the mere promise of scale. The founders of startups like Clubhouse and Hopin sold lots of secondary stock before they’d proven that their business was mature and stable, and not surprisingly the companies have since fallen way behind. At some companies, like Bolt, secondary sales have even triggered suspicions of bag passing because they were funded in part by loans. The solution is not to prevent secondary sales but to limit them. The best way to handle this is to take control of the situation and broker limited secondary transactions. This can be highly motivating to employees who deserve liquidity, and is done by companies like SpaceX⁷ and, recently, Brex.
Rather than demotivating employees, as long as it is a small amount, the company is sufficiently late-stage, and the employee has sufficient tenure, secondary sales can be motivating. In today’s market, companies remain private for long periods of time and employees do deserve to be able to, say, buy a home.⁸ Plus, just like with investors, secondary sales can be used to manage the cap table on the employee side by cleaning out old employees. Employees who are underperforming or who have departed have an outsize presence on the cap table; reducing it is a good move. Allowing those employees to right-size their equity packages, or even sell once they leave, is a great way to remove “dead” equity that is not actually incentivizing anybody, particularly if it can be sold to someone strategic.
Realizing that secondary transactions can be used strategically should cause the startup world to view secondary transactions as high-status, even though it will never be the same as a pure primary venture investment. But everything can be used as a tool, and secondary transactions are no different. It’s time to start using them that way.
[1] Ironically, secondary shares are viewed as lower status partially because they suggest a lack of access, but startups still need to sign off on secondary transactions, so a significant level of connection is still required.
[2] There is also some motivated reasoning here. Venture capitalists are only allowed to invest up to 20% of their dollars in secondary transactions, so it is somewhat self-interested to make those transactions second-class to keep larger financial investors out.
[3] In some cases of extreme leverage, like Uber, the restrictions can be even more onerous.
[4] In 2010, DST Global invested in Facebook by buying both primary preferred stock and secondary common stock from insiders. The common stock was valued lower for the reasons discussed above, but this allowed DST to offer the highest valuation for the preferred round, allowing DST to both give Facebook the highest headline valuation while investing at a reasonable blended valuation.
[5] Another kind of lubrication used by larger investors is to use secondary sales to give liquidity to investors to persuade the company to take them on as investors. The biggest user of this technique is Softbank, which used bought out old investors when it invested in its deals with WeWork, Uber, and others.
[6] One particularly egregious example is Clubhouse, where the founders were allowed to sell $10 million of stock in secondary while the startup was still in beta, had no revenue, and was valued at a mere $100 million.
[7] SpaceX is an extreme case. They have a biannual employee liquidity event.
[8] Roelof Botha, the Sequoia partner who used to be the CFO at Paypal, explained that in the summer of 2001 Paypal did a secondary prior to their IPO, and that it was essential for giving them fuel to go in because it allowed them to stop living in squalor.
