How to take money off the table before the IPO
Secondary stock sales are the real startup lottery hack
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The real startup lottery hack is selling stock before the IPO, especially in today’s markets where private valuations are extremely inflated, and it’s a little bit of a crapshoot how well your company will do on the public markets. It’s also a great way to mitigate risk. My personal risk profile is a pretty funny juxtaposition: on the one hand, I choose to work for early stage companies, where a large part of my compensation is extremely high-risk privately-held equity. On the other hand, if you look at how I invest my retirement funds (and pretty much anything that isn’t stock in companies I’ve worked for), I’m a big index fund guy, who focuses on heavy diversification (my IRAs are basically just target retirement funds). When I’m thinking about my startup equity, my number one goal is to diversify those funds as quickly as possible.
Enter: The Secondary
Markets are defined by the liquidity available for a thing. Everything has a market, if you can find the right seller and the right buyer. The trick is to find both of those things. Obviously, privately-held equity tends to be very illiquid, meaning there are very few buyers and very few sellers. The more successful a company is, and the closer a company gets to IPO, the likelier that a secondary market will exist.
Secondary markets and secondary sales are called “secondary” because the transaction is for privately-held equity, but not directly a purchase of newly-issued stock from the company (which would be a primary transaction). Usually, it’s a company employee (often a former company employee) reselling stock to some other private investor.
It’s actually become quite common for secondaries to be done towards the D and E funding rounds. At that point, the company has likely been around somewhere between 5-7 years, and some of the early employees are looking to take a little money off the table. Frequently, there will be what are called tender offers made, in which early employees can sell some of their exercised stock or vested options (if you’ve been reading my other posts, you’ll probably recognize that this is a situation where you can get different tax treatment depending on when you exercised), but these sales are typically restricted to a small percentage of employees’ total holdings (usually under 15%). It’s also very typical for founders to take money off the table even earlier (around the B or C round). The rationale here is usually that investors want to make sure that founders aren’t overly tempted to sell early in order to realize their gains. Since the venture capital industry expects that more than 50% of their investments will fail and go to $0, they need the promising startups to fly high, and need to incentivize founders to keep their eyes on the prize, which usually means giving them a small payout earlier.
I’ve had the luxury of getting to do a handful of secondary transactions, and since they’re a somewhat obscure financial transaction (at least for the vast majority of startup employees), I thought it might be interesting to devote a post to the mechanics of getting these things done. If that doesn’t sound interesting to you, the back button on your browser beckons you. On we go!
Find a broker or find a buyer
If you’re familiar with the term secondary sale, there’s a good chance you’ve come across a number of the companies that aim to create secondary markets for privately-held stock: Forge Global, EquityZen, and SharesPost are a few companies that are well known for providing this service. Carta also seems to be aiming to provide a similar market with their upcoming CartaX offering. These companies all generally operate the same way: they act as a broker for transactions. They aggregate interest from sellers and buyers, and essentially try to play matchmaker. When they find a match, they take a small cut (often 5% or so of the total proceeds). That broker fee can add up fast if you’re selling a large volume of stock, and typically these brokers don’t want to deal with small amounts. It’s unlikely you’d manage to get a deal done with less than $100K or so in transaction volume.
The cheaper option is to find a buyer directly, but that can be pretty difficult. Unless you work for a near-IPO company, and everybody is looking to own a piece of the company pre-IPO, it’s generally a non-trivial task to find buyers. It involves a ton of networking, or just knowing people who know people. There are actually quite a few venture funds that specialize almost exclusively in secondary transactions, so that may be a path of least resistance.
The bad news is that even if you find a match via a secondary market or are able to find a legitimate buyer, getting a secondary sale done is often still a pretty tough task.
The long road to a closed transaction
Secondary sales are often a surprisingly complex thing to do. If you’re used to just clicking the sell button on Robinhood, and you’re trying to complete a secondary sale, you are probably in for a world of hurt. They can be long, arduous, and suspenseful. The first step to actually getting one of these done is dusting off that Equity Incentive Plan document that you received when you got your option award, and start reading the fine print. Every agreement is going to be different, but fortunately there’s a lot of boilerplate in these things, especially since most startups use one of a few legal firms to draw up a lot of these critical documents.
While I don’t have tons of data points, the transactions generally follow this pattern:
Find a legitimate buyer, and notify the organization of intent to sell
Wait for the company to waive its right of first refusal (ROFR) and approve the transaction
Get a legal opinion
Pay a transaction fee
Send any paper certificates that are related to the transaction back to the company (for many companies using systems like Carta or Shareworks, this is a wholly digital process)
Get a new stock certificate with any remaining shares, get an incoming wire from the buyer, close the transaction, rejoice!
It’s a bunch of steps, and they can happen fast, or they can happen slow. Very slow. Let’s break it down to understand what these steps actually mean.
Finding the buyer
This is the most straight-forward step, because it’s basically just “do the thing.” You find a buyer, they offer a price, you agree that you’re willing to sell at that price, and then they basically give you a formal document stating who the buyers and sellers are, and that you’ve agreed to transact at a particular price. You deliver that to the company, and the company says: “cool, let’s get on with the show.”
The waiting game begins
The second step is the real pins-and-needles, suspense step. Usually, what you’ll see in these Equity Incentive Plans is that the company has a right, called a right of first refusal (commonly referred to as ROFR). What this means is that the company can say “no, you’re not allowed to transact with this person,” but if they exercise that right, they usually need to buy the shares at the offered price from you instead. So if you do get ROFR’d, it’s not necessarily the end of the world, but sometimes this is where secondary deals go bad. If the company doesn’t want you to sell the stock, they might go to the buyer and try to get them to back out and kill the deal. Maybe they tell them the company is crap, or something. There’s also usually a timer associated with the ROFR, usually 30 days. However, I’ve seen it as long as 120 days. The company may sit on your secondary transaction hoping that the buyer decides they’re eager to deploy the capital, and aren’t comfortable waiting around for the company to have their hand forced by the calendar.
The other tricky bit is that who actually can waive the ROFR may vary. Sometimes the CEO or founders can do it unilaterally, sometimes the entire board has to approve it. That can certainly cause trouble, since boards typically only convene once a quarter, and so you may be stuck waiting just because calendars don’t align well, and your secondary stock sale is probably not the first order of business. If you get through this step, however, the rest is actually pretty straightforward. This is far and away the hardest hurdle to get over.
Legal opinions
Legal opinions are kind of a funny thing in my mind. In the context of a secondary transaction, they typically serve as a legal way of saying “the seller owns the stock, and yes, they’re allowed to sell it.” As with literally every legal document and clause, I’m sure they exist because something went wrong at some point with some transaction, and some transaction got invalidated, and everybody was unhappy. But they sort of feel like a title insurance-y type of racket (which, if you happen to have ever bought a house, you’ll probably appreciate the analogy). These legal opinions can be a little pricey, and run somewhere between $500-$1500. Gotta spend money to make money.
Finishing out the transaction
With the legal opinion out of the way, the only real task left is to sign a stock purchase agreement which dictates all of the terms (number of shares, price being paid, and who the various parties are) that officially transfers the stock to the other party. The buyer, the seller, and a representative of the company all sign on their appropriate lines, and the money gets wired over. You may need to pay a transaction fee to get through this stage. Otherwise, you’ve done it! You’ve won the startup lottery! Make sure you set aside some of your earnings for taxes.
Some final thoughts
If you end up going through the process of doing a secondary sale, and it’s not brokered by your company through a tender offer, or some other structured mechanism, get yourself a lawyer who deals with startups. The contracts that govern stock can be fairly complex, and if you’re working through a slightly bespoke process, it’s good to have someone watching your back to make sure you don’t accidentally agree to something you don’t intend. It’s also worth mentioning that all legal negotiations are essentially a game of risk management. If you redline contracts, you may not get everything you ask for, and at some point, you may need to decide whether or not you’re comfortable moving forward in a process. Your lawyer’s job is to make you aware of the risks that you’re taking on, and what you’re agreeing to when you sign documents, but at the end of your day, it’s your decision whether to sign or walk away.