Secondary Market Explained

When thinking of the secondary market most people will typically consider this to be the “stock market”. This is because the secondary market is where investors who already own securities can buy and sell them.

Prime examples of secondary markets are the NYSE (New York Stock Exchange) and the NASDAQ (National Association of Securities Dealers Automated Quotations) although when stocks are first issued they are sold on the primary market.

However, there is secondary market activity that is of interest to startup founders and investors. This is through the increased activity in the pre-IPO secondary market because it is a vehicle that allows liquidity to be received much earlier in a startup's life cycle than ever before.

With startup founders, key early employees, and investors in mind, let us take a look at what this secondary market is all about, how it can benefit those involved, and how founders, in particular, can make the most of a secondary opportunity

Liquidity is Often Seen as an Issue for Stockholders

It is clear that stockholders in the majority of startups and privately-held companies see liquidity as an issue. This is because no open market exists to allow them to sell shares. On top of that, there can also be transfer restrictions in place which prevent any sale.

This is where secondary stock transactions (also known as ‘secondaries’) come into play. They offer a work-around solution to resolve this problem.

What are Secondaries?

These are transactions that existing stockholders can carry out. This is achieved by selling their stock for cash to either a third-party or back into the company itself before the company goes through an exit.

When discussing an exit this traditionally refers to an IPO (Initial Public Offering), acquisition, or merger.

It is becoming more prevalent for VCs (Venture Capitalists) to offer secondary transactions to founders. This ‘tool’ helps them win deals.

Founders - Why Would you Consider a Secondary Sale?

At first glance, founders selling equity before an IPO can be interpreted as having a lack of faith in the company. This is certainly not always the case. Indeed, in reality, such a transaction can turn out to be beneficial for the company.

Here’s why….

The vast majority of founders put everything (and a little bit more!) into the company they are starting. Because it takes a number of years to reach an exit, that journey can be an extremely testing time both mentally and financially.

This makes it little wonder that founders will consider entertaining offers which will provide them with a significant short-term gain. One that will not typically result in the potential gains to be received in a future exit when their company becomes more developed.

It is also clear that VCs, other stockholders, and board directors all want founders to be focused on big exits rather than an easier path to quick liquidity. This is where secondaries can help bridge that gap.

That is achieved through providing compensation that will allow and encourage founders to remain at the company's helm for the years it generally takes them to lead into an IPO, larger merger, or acquisition.

But there is a counter-argument….

While the above is seen as a very tempting proposition for founders, some industry insiders feel there is a downside. This is because if a secondary payout cash windfall is taken it could change a founder's motivation to push as hard for an exit as they would do without that secondary payment.

Meaning, that if a founder already has cash in the bank why should they put everything and a lot more into the exit process?

The fact is, each situation comes with its own set of unique circumstances. There are many factors that can affect a founder's thought process if they are given the opportunity to consider a secondary sale.

To give an insight into secondary transactions and common structures let’s take a look at:

How Secondary Transactions Work & 3 Most Common Structures

It is generally acknowledged that secondaries for Series A through startups classed as being ‘mid-stage’ in their life cycle happen during financing rounds. This is how the three most common secondaries are structured:

• The founder's shares are purchased by the company itself. This can be as a buyback or a repurchase. The cash used from the venture financing is completed with the lead investors' agreement.
• An existing or an outside investor makes a direct purchase of the founder’s shares.
• An existing or an outside investor makes a direct purchase of the founder’s shares followed by a conversion of such shares to preferred stock.

Note: Around two-thirds of all completed secondary transactions involve the third structure above. This is mainly down to the tax considerations applicable to early-stage companies.

At What Price do Founders Tend to Sell Their Common Shares?

This is obviously down to negotiations but in practice, founders tend to sell their common shares for between 70% and 100% of the preferred stock price being sold during the financing round.

To give a basic example: If it is the lead VC fund that is purchasing preferred stock at the per share price of $1.00, founders can generally expect to sell their common stock for between $0.70 to $1.00 per share.

Again, using the third structure described above, this is often carried out by common stock being “flipped” (changed) to preferred stock.

There are two major reasons for this. First, investors want the advantages and importantly, the liquidity preference of preferred stock. Second, founders clearly want to sell their common shares for the highest possible price.

How to Prepare for a Secondary Transaction Before Fundraising

This is something that all founders should consider when establishing their startup. In the early days of a fledgling business, secondary transactions and exits may seem a long way away but in this instance, forethought is most definitely foresight.

Here are 5 ways in which a founder can maximize the leverage of a secondary transaction before fundraising rounds and negotiations even begin:

Consider your preferred stock

When initially incorporating your company, research, understand, and consider issuing founder’s preferred stock. This is because there are structural advantages to having founders' preferred stock.

Create investor demand

From the very beginning of your startup journey, founders should place their fundraising process as a major milestone. The need is to establish a competitive fundraising process. One that serves to create demand among investors with the goal of obtaining multiple term sheets.

Without the proper negotiating leverage that multiple term sheets can bring, founders may receive a negative response (often termed “pushback”) when they request a secondary transaction. On the other hand, VCs could well look more favorably at offering a secondary transaction if it helps them to secure a winning deal.

Seek out likely investors

If, as a founder, you feel a secondary transaction is important you should research and identify particular investors who have a track record of participating in secondaries.

In that respect, you can look at investors who have always been supporters of your venture but have yet to commit to any funding or investors who are outside of your usual network.

Go the extra mile

It stands that investors are more likely to agree to a secondary transaction if the founder in question has already developed a great company. One that they are keen to buy more of. This means that full focus is needed to build your company as opposed to simply concentrating on a quick exit.

The benefits of putting that extra mile in will likely be reflected in two ways. First, during term sheet negotiations there is a good chance you will achieve a higher company valuation. Second, the knock-on effect will be a higher price per share on your common stock shares or your preferred founders' stock.

Be smart - Maximize experienced leverage

Startup founders have more than enough on their plate without trying to reinvent the wheel. Of course, a smart startup founder will make it their business to get a broad understanding of everything that encompasses building a growing and sustainable venture.

However, there is no doubt that leveraging assistance from those in the know will be of huge benefit to founders.

In this respect, WOWS Global is on hand to assist, advise, and direct you on all aspects of your startup's journey.

We have built a secure, digital ecosystem that is second-to-none. Our user-friendly tools will leave you and your investors best placed to have a clear picture of your company’s progress and onward progression.

In respect of helping you to understand secondary market benefits and ensure you receive favorable terms, we are ready to maximize your gains.

Any startup founder that would like to learn more should contact WOWS for an initial, no-obligation discussion at:

contact@wowsglobal.com