I was recently approached by several entrepreneurs who had launched successful VC-backed companies who wanted to learn more about “secondaries”. As I described my experiences, I realized that in my 20+ years doing startups, I had been part of many different types of secondaries at many stages of the startup lifecycle.

The first time was just after the first VC round I’d ever raised back in 1995. a few friends (who were doctors and such) wanted to get in on the round because our startup was “hot” and “growing”. Since the round was already completed, my co founder and I offered to sell them $10k of our shares. Today this would be a very small (actually, tiny) secondary transaction.

Since then, I’ve been on both sides — as a buyer of secondaries, usually of late stage companies prior to their IPOs (companies like Facebook, Twitter, Pinterest), as well as a seller of secondary shares of rapidly growing startups I was a co-founder, advisor, or early investor in.

What follows is a quick primer on secondaries — what they are, why you would want to do one, how you would value secondary shares, and a bit about the benefits and risks of such sales.

What is a Secondary Sale?

A “secondary” sale is when a shareholder (typically one of the founders or an early employee or an early investor) of a private company sells his or her shares to another buyer.

A “secondary” usually (though not always) happens when the startup has achieved significant revenue or traction and is seen as a “leader” in their market space, on the way to an IPO or a major sale. Since the company is already doing well, most secondaries involve sales of millions or even tens of millions of dollars.

They are distinguished from a “primary” sale, in which company issues new shares to investors, and the proceeds of that sale go directly into the company. In both cases, investors are buying stock, the main differences being 1) where the proceeds go, and 2) whether the shares are newly issued or have belonged to someone else.

Once a company is public, of course, you can buy and sell shares easily on the major stock markets (NASDAQ, NYSE, etc.). Until a company offers shares to the public, the company’s shares are considered private; there is limited liquidity for the shares, there are various restrictions on the shares, as well as SEC requirement for who can buy the shares, how many shareholders the company can have, etc.

Why secondaries have become popular in Silicon Valley

One of the main reasons why secondaries have become popular in Silicon Valley is that IPOs have been less common since the crash of 2008 (and way less common than during the dot com boom of the 1990s). Traditionally companies went public with smaller revenue/valuations than is the case today, so investors and early employees could cash out upon an IPO. Since startups are staying private longer, this means that early founders and employees can’t get liquidity for their shares, sometimes even 5 or 10 years after the company started, even if the company is doing well.

These private companies are not just raising series A or B, but private series C, D, and even series E preferred stock. Some of these companies have over $100 million in revenues and some have become “unicorns”, an informal term coined by my MIT classmate, Aileen Lee, and now tossed around in SV for private companies whose valuations are more than $1 billion.

Uber, Facebook, Twitter, Pinterest, Palantir — all of these are well known companies whose valuations were well over $1 billion before they went public.

The main factors that drive secondaries are:

1) supply and demand of the company’s stock. When a company is doing well, investors want to get stock in the company, but a startup may not need the financing or not want to dilute its existing shareholders by selling stock, so its stock may be hard to come by.

2) liquidity for early shareholders. Rarely do employees (or even founders) stay at one company for more than a few years, but it’s possible that a succesful startup may not have an IPO for 5–10 years.

These employees want to cash in on part (or all) of their holdings as a reward for their early participation and give them peace of mind in their financial affairs. Moreover, founders may find themselves suddenly multi-millionaries on paper- but trust me, it’s not fun to be a millionaire “just on paper” — anything can happen, and so founders may want to cash out enough to buy a decent home in Silicon Valley.

VCs have become more sympathetic to founders selling secondary shares recently. This wasn’t always the case. In the 1990s I remember one VC telling me she wanted to make sure that all my assets were in one place, and wanted to be sure I was mortgaging my home to put money into the startup to make sure that I was “properly motivated” (which by the way is a terrible idea!).

Who Buys Secondary Shares?

The first question I get from entrepreneurs is who they might sell their shares to. That’s like saying, who invests in startups? There are many people who want shares of successful startups. Here’s an overview of the different groups I’ve seen participate in buying secondary shares:

Existing and New Investors.

The most popular buyers of private secondaries are usually either existing investors or new investors in a round of financing. Why? Because these investors know the company well -they have done due diligence on it. If the company is doing well, then investors want to buy as much of the company as possible.

Some investors even have specific percentage thresholds they are trying to reach (or maintain) — for example, some like to keep a 20% ownership of their companies. I’ve seen term sheets that are structured like this (not actual numbers) in order to combine primary and secondary shares to get the percentage they want:

Primary: Investor X and Y will put in $18 million into the company and get new Series C Preferred stock (for 15% of the company)

Secondary: Investor X and Y will buy up to $6 million in common stock from existing founders, employees, and investors for another 5% of the company

As the numbers get larger in subsequent rounds, from series A to series B to series C or D, then the amount of money gets larger. Zynga for example, did a $490 million round in financing before their IPO, and according to press reports, this included a certain amount set aside for the founder’s shares and early employees who wanted to cash out on their shares.

Matching Websites and Micro Funds

There are a number of websites and organizations who specialize in secondary sales — three of these include Shares Post, Second Market, and Micro Ventures.

These sites usually are “matching” sites — either curated or un-curated. In the un-curated version, you post that you want to sell (or buy) shares of company X, which gets up on the board. If enough buyers (or sellers) match, then the organization puts together an LLC to buy those shares, or just introduces buyers and sellers to each other.

In the curated version, the organization selects which shares they think their investors will be interested, and will package them up and present their investors with the opportunity to be part of the secondary sales. These are of course, better for companies that are doing very well and are very well known, particularly in Silicon Valley, and usually involve investors who are putting in smaller amounts to be aggregated.

Secondary-specific funds

Thousands of startups are founded each year in Silicon Valley alone; very few of them make it to a series A, fewer to a successful series B or C, and even fewer make it to a late stage series D or E or an IPO. A few years ago, investors realized that they could reduce their risk by investing in the handful of companies that have already made it onto an IPO track. They wouldn’t make as much money as the early investors in those companies, but they would take considerably less risk. That is of course the logic of most late stage private equity/VC firms. However, in recent years, a few funds have been formed specifically for buying secondary shares of startups that are taking off, such as Industry Ventures.

Private Investors and SPV

In many cases, there are private individuals who are willing to buy your shares in a hot startup that’s doing well. In 2008, a friend approached me about buying shares in Facebook, which was still a private company. At that time, still years before an IPO, one of the early employees of Facebook wanted to sell his shares to get some liquidity. A group of private angel investors had formed an LLC, often referred to as an SPV (special purpose vehicle) for the sole purpose of buying the Facebook shares. The actual deal was a little more complicated than the employee simply selling shares to the LLC — he contributed his shares and became a shareholder of the LLC, and participated in some of the upside on those shares. While this was a complicated vehicle, the idea of forming an SPV for selling to private investors that you know is not uncommon.

Investment banks

In a special case, we once hired an investment banker to go out and sell our shares in a mobile advertising company that had grown very big. Investment banks become interested in secondaries only when the dollar amounts are large enough that their fees can be meaningful, or to build a relationship with the sellers. Some investment banks are better at helping you negotiate the sale process, others may be better at finding buyers since they have a spectrum of client. Be sure to do your background reference checks to find out what the investment bank is good at.

What is the Price of Common Stock vs. Preferred Stock?

OK if you’ve found someone who’s interested in buying your shares in a successful startup — so how much should they pay per share?

The answer, like many answers when it comes to startups, is that it depends. It depends on the the class of stock, the stage of the company, and the company’s financing.

Investors usually want preferred stock in the company — Series A preferred, Series B preferred, etc., because they want to make sure they get their money back first before sharing in the proceeds of a sale. Founders and employees (and sometimes early investors) usually have common stock, which is seen as less valuable.

If the company has had a recent financing, or is planning an upcoming financing that has been valued, then the price of the stock is usually related to that price. For example, if the company raises a series C financing at $100 million post money valuation, and has fully diluted 50 million shares, then the price in the last round was $2 per share of preferred stock.

Common stock is usually not worth as much as preferred stock. In fact, when the company does a 409a valuation for its options strike price for employees, the valuation is kept deliberately low — often from 10% to 33% of the preferred price. This is so that employees get stock at the lowest possible price and to account for the risk that common shareholders may never get any money back.

As a company matures and proceeds towards an IPO, the common stock becomes more and more valuable, approaching the value of the preferred stock, as shown in Figure 1, which provides a visual way to think about it. Once the company goes public, you can usually argue that the preferred stock and common stock are pretty much equal in value, so in Figure 1 we see the graph going from 10% (seed financing) to 100% at an IPO, with estimates for various Series A,B,C, etc. financing in between.

Figure 1: Value of Common Stock vs. Preferred Stock

I saw a series E financing term sheet recently which included a secondary sale where the price of the common stock was 80% of the value of preferred stock. This is more of an art than a science, but in most secondaries I’ve seen, 60% of the value of the last preferred round is a pretty good rule of thumb, with that number going up or down depending on what stage the company is at, how hot the company is, and the specific preferences that the different series have.

A Few Important Considerations and Gotchas

Let me wrap up with a few important considerations if you are going to be involved in a secondary sale of shares in a startup. Each of these can complicate a secondary sale. You should be aware of these items before getting into a secondary sale.

Right of First Refusal.

Most companies have a right of first refusal on any stock you may be selling in a secondary. This basically means that if you want to sell your stock to someone other than the company for $X, the company has the right to buy it back from you. While most startups (even ones that are growing towards an IPO) won’t want to use the cash they got from investors to buy back stock, it is a risk that could happen in most secondary sales. For one thing, it would reduce the number of shareholders if the company buys your stock, whereas selling some of your stock to another shareholder might actually increase the number of shareholders — and there is a limit of how many shareholders a company can have before it is forced to go public.

Breakup fee. If there is a serious risk for a buyer of your shares that the company may want to exercise its right of first refusal, then the buyer may be less likely to make you an offer on your shares. The buyer doesn’t typically want to put down an offer and then have you sell the stock to the company, so he might ask for a breakup fee. This is usually built into the price of the offer, so that you might pay them out of the proceeds if you sell to someone else.

Right of Co-Sale

Another common right that investors often ask for is the right for them to sell a pro-rata percentage of their share at the same price that you, the founder are selling for. The main reason for this clause is that they don’t want the founder getting a “sweet” deal on his stock that the investors can’t get. So let’s say someone offers to buy 1000 of your shares @ $2.00 per share. They will have the right to sell some part of the 1000. In a simple example, let’s say an investor owned 10% of the company, they might be entitled to up to 10% of the sale, or 100 shares — and you would only be able to sell 900, but the buyer would still get 1000 shares.

Company co-operation, asymmetric information, SEC rules.

Sometimes the company may not be happy that you are selling your shares, but they won’t exercise their right of first refusal either. In fact, they may stay silent and not co-operate, which means that the buyer won’t have any information about the company. This is often referred to as “asymmetric information” — because one side (the seller in this case) may know more about the company than the buyer who is a new investor. I’ve also seen “asymmetric information” go the other way — when the buyer (who perhaps is a major investor in the company with information rights, board seats, etc.) may be privy to information that the seller (who may be an early employee who is no longer with the company) doesn’t know. This is a tricky area that can run up against SEC regulations, and both sides should be really careful here. It’s also possible that the company won’t cooperate because they don’t want more shareholders, because they don’t want to run up against the SEC limits of 500 shareholders and don’t want to be “forced” to go public. Doing a transaction without the participation of the company can be difficult.

Example: A few years ago, a friend approached me about an opportunity to buy some Twitter shares before its IPO. I happened to know the counsel for Twitter at the time and I asked them what he thought of secondaries and my contact said that the company didn’t want the secondaries to happen and would try to thwart them in many ways. I ended up not buying the shares.

Restrictions onShares.

Any buyer of secondary shares should be aware that almost all private stock comes with restrictions and lock up periods for when they can sell. Let’s consider a scenario: Suppose you were approached about buying shares just before a well-known IPO was coming up. You might have a bit of a dilemma — while you might want to own some shares from the company, if you buy them before the IPO, you might get a good price, but the shares would be restricted and you couldn’t sell them for 6 months. On the other hand, you could wait and buy the shares once the company was public and have no restrictions on buying or selling the shares, but the price may have gone up considerably in the IPO. If it was Snap, then you might have wished you bought the shares since it started trading above its IPO price. If it was Facebook, it turns out that Facebook was trading below its IPO price for quite a few months before going on its meteoric rise, so you might have been better off just waiting until after the IPO, rather than just before the IPO.

Founder Series FF Preferred.

At one point, secondaries were becoming so popular that founders were creating a special class of stock, Series FF Preferred, which had preference over the common but was subordinate to any other preferred. If you were one of two equal co-founders in the company, each of you normally starts with 50% of the company. But you might have 10% of your shares (or 5% of the company) in FF Preferred and the rest in common. Why? Because investors usually want preferred stock, and this gives you, the founder, the ability to sell them preferred stock if the company is doing well and the stock is in demand, but the shares aren’t yet liquid. This seems like it’s not as common now as it was a few years ago, but it’s something to keep in mind.

Conclusion

Secondary sales can be great for entrepreneurs and early investors and employees because they provide liquidity when a company is doing well but there is no exit in sight.

While traditionally, most VCs didn’t want entrepreneurs to take any money off the table until an IPO or m&a exit, in recent years secondaries have become more and more popular, particularly for startups whose stock is in demand. There are many different buyers for secondaries, but the most common are investors that are already in the company because they know the company and can get comfortable easily. There are any number of ways for a secondary sale to get complicated, so be sure to know the specifics of your company’s shares, investor rights agreements, etc. before committing to a secondary sale of shares.