The Case of the Secondary Showdown

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HEIDI: Welcome to The Startup Solution and “The Case of the Secondary Showdown.” I'm Heidi Roizen from Threshold Ventures.

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Today’s episode starts with not one but two unhappy people. A few years ago, I was on the board of a company that was about to close a big financing. That’s normally a very happy circumstance. But in this case, a good situation also created a dilemma. The CEO – who I’ll call Maria – and one of the earliest investors – who I’ll call Jeremy – each wanted to sell some of their shares alongside the transaction. And each of them thought the other was entirely wrong to want to do so.

MARIA: Hey Heidi, it’s Maria. I just got off the phone with Jeremy. He said that for me to take three million dollars off the table when I’ve never generated a penny of revenue is egregious. But then he has the nerve to say he wants to sell six million himself. I mean, it’s not like his fund needs the money like I do, and I think it’s a terrible signal to the new investors that he wants to sell. I’m going to try to cool off now, but we didn’t end our call in a happy place. I’d like your take.

JEREMY: Hey Heidi, it’s Jeremy. I want to get your take on this secondary situation with Maria. I think it looks really bad for her to sell millions of dollars of stock right now. I don’t think she’s really earned it.  Now she’s mad at me for wanting to sell, but we’ve been in this for five years, and we’re only taking about 10% of our holdings. So, basically, we’re at a standoff. Could you give me a call?

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HEIDI: Stock sales like the ones Maria and Jeremy were proposing are called secondary sales, and they can become surprisingly emotional issues, as you’ve just heard. Before we dive into the drama, let me give you a bit of a primer on what secondary sales are.

When a company raises money or gives stock to founders and employees, it does so by creating primary stock. That is, the company authorizes and issues stock and then either grants it to founders and employees or sells it to investors.

By contrast, in a secondary sale, the stock being sold comes from a secondary source – usually those same investors, founders, or employees. And, of course, instead of the money going to the company, it flows to those sellers instead. Because the company is private, and there’s no public market for the stock, these transactions are often combined with a company financing, with the new investors buying both primary and secondary shares.   

Secondary sales can be great things. They allow people who own private company stock to get some liquidity, which is especially helpful if the company’s timeframe to exit is long. But in my experience, secondary sales can also lead to conflicts and emotions – like what we just heard from Maria and Jeremy.

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Maria’s company was raising a 150-million-dollar D round. The company had raised over a hundred million dollars across four rounds up to this point. It was a capital-intensive, deep-tech company in the healthcare space. The company was six years old and making great progress, but because of the long R&D cycle that was necessary, it was still at least a year away from generating revenue.

Maria was feeling financially pinched, and for good reason. She had left a lucrative job six years earlier at a giant pharma company. And she had moved her family from a low-cost-of-living town to Silicon Valley. She needed liquidity not only to help her buy a house in this pricey place but also to put three kids through college.

Maria asked the board to allow her to sell about 5% of her position to take some financial pressure off. She would be selling common shares, which don’t have the added downside protection of a preference, so the new investor offered to buy those shares at a slightly discounted price from the D round. But still, the sale would gross her about three million dollars.

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Jeremy was one of the seed investors and also wanted to sell some of his shares. He had seen his original three-million-dollar investment grow on paper to about 65 million dollars at the D-round price. His shares were a combination of seed and A-round preferred shares, so the preference protection was pretty low. Still, the new investors were willing to pay close to the D-round price for those shares, which would gross him about six million dollars for the 10% of his holdings that he wanted to sell.

Maria’s and Jeremy’s reactions came as no surprise to me. In fact, I can summarize all my secondary experience in one statement: when you want to sell your shares, it’s prudent financial management. But when anyone else wants to sell their shares, it’s an insult to the company.   

And if you ask five VCs and five founders about the rationale behind secondaries, you’ll probably get ten different answers! So, here’s my disclaimer: everything I say in this episode is my personal opinion based on my own experience. I’m sharing it all so that if you are ever so lucky as to be involved in a secondary sale, you’ll at least know about some of the issues that might crop up. 

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First of all, no one should be selling secondary stock if they’re competing with the company for limited dollars – that is, if the concurrent round is under-subscribed – meaning there are not enough buyers to buy all the shares that the company itself wants to sell. Remember – a startup issues stock to attract capital; capital needs to grow. Some companies are lucky enough to have more dollars of investment available than they need, which we call an oversubscribed round – but many do not. For either founders or investors, if you’re prioritizing your own desire for cash over the needs and health of the company, I think that’s generally a bad idea.

Second, the day an investor buys stock from your company, you should expect that someday they’ll sell it because that’s the business model of investors. We have to sell your stock at some point because that’s how we generate returns for our investors, called limited partners.  

A quick side note here is that sometimes companies go public, and then we might create those returns by distributing the stock directly to our limited partners instead of selling it. But public stock is a different situation entirely, so I’m going to stick to private companies in this episode.

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When companies have a very long path to liquidity, as is the case here, it’s pretty reasonable for early investors to want to take some money off the table, like Jeremy wants to do. And as long as they’re not competing with the company’s needs, I don’t see anything wrong with that.

Also, different investment funds have different strategies and different time frames. And it’s pretty common for early-stage funds to sell their positions along the way. That doesn’t mean they don’t believe in the company; it just means they are following a harvesting strategy over the time frame appropriate to their particular fund.

And among the professionals who both buy and sell private company shares, these strategies are well understood, so this should not create any negative signals about the company – as long as the sales are in typical size ranges. But again, investors should only be selling if they’re not in competition with the company for those same dollars.   

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Now, let’s turn to Jeremy’s complaint about Maria wanting to sell shares. Every founder’s situation will be different, both for their personal reasons as well as the specifics of their company. And some teams will need to toil away years and years before an IPO or an acquisition is possible, so I think it’s reasonable to allow for sales in those cases. But, as always, only when the company is not competing for those same dollars.

Notice I said team, not just the founder. I think it’s fair to also accommodate long-term employees when it comes to secondaries. I think it’s also reasonable to limit the amount that can be sold to a smallish percent of anyone’s position, as well as include a dollar limit per person, and also to make the sales available only to those people who have served for some number of years.  

The founder usually has vastly more shares than anyone else and a much higher profile, too – and that may create a negative signal to investors if they sell too much stock. So, it makes sense to negotiate the founder’s amount separately from everyone else.

For what it’s worth, I felt Maria’s ask was reasonable. It was a small stake relative to her overall holdings; she’d been working on this for six years, and she had some personal needs that would be helpful to alleviate. Also, the round was well oversubscribed, which meant there were plenty more buyers than the company needed for its own purposes. I suggested that Maria also extend the opportunity to participate in the secondary to her team – with some constraints – like the tenure of the employee, percent of their holdings, and dollar value caps per person as well. And that she limit the total available pool so that, you guessed it, the sale would not be competing with the company for those same dollars.

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Before I tell you what ultimately happened with Maria and Jeremy, let me make one more comment on founder sales that some of you may hate, but I’ll say it anyway.

In my opinion, it’s not okay for founders to sell massive amounts of stock when that kind of liquidity isn’t available to any other shareholder or employee.  

Yes, these sales do happen. They usually come about because some big new investor wants to lead a giant round in a hot deal and offers to not only lead the round but also to buy a massive amount of shares from the founder – hoping to sway that founder towards taking their funding. But that’s not a balanced secondary market between buyers and sellers; that’s a targeted, exclusive purchase to sway a big decision-maker. And that doesn’t seem fair to me with respect to all the other investors and employees. And it’s also a really sucky thing to do if that founder wants their team to feel that they are all in this together.

For the most extreme example of this, you can tune in to either Netflix or Hulu for the story of WeWork and Adam Neumann. Neumann walked away with somewhere between $500 million and almost $2 billion dollars, depending on how you calculate his various stock sales and payouts. Meanwhile his investors poured 22 billion dollars into WeWork, which appears to now be practically worthless. And WeWork employees, some of whom worked there for ages, walked away with nothing. And I think that’s atrocious!

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Anyway, let’s get back to Maria and Jeremy. In truth, both their requests were reasonable – neither amount was a large percent of their respective holdings, and the round was well oversubscribed, so there were enough buyers for both the company’s needs and theirs. Once we talked it through, emotions aside, each could see why the other’s ask was fair, and they both made peace with moving forward.

The board, in turn, allowed their sales, plus made an additional $2 million of secondary available to any employee who had been there for four years or more, to sell up to 20% of their holdings, with a cap of $100,000 per person. In the end, the company was funded, Jeremy distributed some money to his investors, longstanding employees got some liquidity, and Maria got to buy a house and put her kids through college. 

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So, what can you learn from the Case of the Secondary Showdown?

First, secondary sales can be a useful component of the financial ecosystem for shareholders, founders, and employees of startups, but only if the secondary sellers are not competing with the company’s primary need for capital.

Second, the buying and selling of stock is the business model for pretty much all investors, so don’t be surprised, upset, or offended when your investors sell their shares over time. 

Third, secondary sales can also allow for some valuable liquidity for both founders and employees, especially when the timeframes to exit are long. But they should be right-sized to the need without creating the kind of massive payouts that are unfair to the other stakeholders. 

And finally, no matter how reasonable everything I’ve said may be, secondaries always seem to bring out emotions, and I’m sure the next one I deal with will be the same. So, if you end up dealing with a secondary someday, at least now you’re ready for the drama and prepared to think about it rationally.

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HEIDI: And that concludes “The Case of the Secondary Showdown.” The names and details of this case have been altered to protect identities, and no startups or venture firms were harmed in the making of this podcast.

Thanks for listening to The Startup Solution. We hope you have enjoyed this episode, and if you have, please pass it along to someone who could use it. I’m Heidi Roizen from Threshold Ventures.

Further Reading

Some considerations for private companies organizing a secondary sale here.

Some considerations for founders selling their shares in a secondary sale here and here.

I didn’t cover secondary sales that happen independent of a fundraise on the podcast, but that is also an interesting topic. Here’s an article about founders selling secondaries outside a fundraise. 

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