At some point, your startup’s early investors may want out. This isn’t necessarily a vote of no-confidence in the company but rather may be a result of the investor’s own fund requirements and legal obligations for liquidity on investments. The most common ways to provide early investors liquidity is through a secondary sale or a buy-back.
Secondary Sale
A secondary sale is where an existing shareholder sells his or her shares to a third party, with the proceeds going to the selling shareholder. This approach has become increasingly common as startups are staying private longer and these investor-to-investor sales provide an attractive liquidity prospect.
Buy-Backs
Companies also provide liquidity to early investors by using available cash or, more commonly, proceeds from a recent equity financing round, to “buy-back” the shares. In a buy-back that follows an equity financing round, the company uses a portion of its proceeds from the equity financing to repurchase shares from its shareholders. For example, if the company sells $50 million of shares of Series D preferred stock, it may ultimately earmark $30 million for general operations of the company and use the remaining $20 million to repurchase shares of stock from its existing shareholders.
Pros of a Secondary Sale or Buy-Back:
No Dilution: Secondary sales provide other investors an opportunity to increase their ownership of the company without any dilution to the company’s existing shareholders. No new shares are issued and the existing equity pool is not diluted, preserving founder and employee equity stakes. In a buy-back, the company will have “reverse dilution” where the total outstanding capitalization of the company is actually reduced thus leading to increased ownership for all equity holders.
More Nimble: Secondary sales and buy-backs are more nimble than other liquidity options for investors such as acquisitions or IPOs and can be easier to execute in challenging market climates.
Reduced Pressure: Secondary sales and buy-backs can reduce pressure to rush to a large-scale liquidity event, such as an IPO or acquisition, by giving early investors access to liquidity.
Cap Table Consolidation: Secondary sales often provide an opportunity for small, legacy investors to transfer shares to larger, institutional investors which can streamline governance and future fundraising, especially if such institutional investors are more strategic or have follow-on capacity. Buy-backs offer companies an opportunity to take certain shareholders off the cap table without increasing the ownership of any single shareholder.
Cons of a Secondary Sale
Vetting Buyers
A secondary sale may be to a new investors selected by the selling shareholder. In those cases, such new investor may not be as well-known (generally or to the company specifically) and bring with them different ideas for the company’s direction.
Morale Risk
If only a select group of investors are offered liquidity, either through a secondary sale or buy-back, employees and later-stage investors may feel excluded.
Company Limitations
Both secondary sales and buy-backs may require board approval and, in certain instances, shareholder approval. Furthermore, the seller may need to give the company and/or certain shareholders a right of first refusal. The seller, the company and the buyer (if not the company) should review the company’s bylaws, certificate of incorporation and shareholder agreements, and review the company’s insider trading policies, to determine what approvals and/or waivers are needed.
Consolidation of Cap Table
While in some instances, companies may appreciate consolidating shareholders on the cap table, in other situations, such consolidation may give certain investors greater than intended control of the company.
Secondary Sales and Buy-Back Structures
Both secondary sales and buy-backs can be structured as private, individually negotiated transactions or complex tender offers involving a broad group of shareholders with specific pricing and deal terms.
Private Secondary Sales
The simplest secondary sale involves an existing shareholder directly selling his or her shares to a third party. These one-off, individually negotiated, transactions allow for time-constrained early investors to realize quicker returns, but may be limited if the company has implemented a right of first refusal or other transfer restrictions that require advance notice and/or approval by the board and shareholders.
Investors will sometimes participate in private secondary sales in connection with a company financing transaction, particularly where investors in the financing have an appetite for more shares than the company intends to sell. Secondaries can provide an opportunity for the new investors to acquire more shares without dilution to the company. When these secondary sales are done in connection with, or close proximity to, a financing transaction, the company can fold any requisite approvals or waivers into the transaction consents to streamline the approval process.
One-off or limited Company Buy-Backs
Similar to private secondary sale transactions, investors may sell shares in one-off, individually negotiated, buy-back transactions. Again, these transactions can be more cost and time efficient for both parties; however, both the company and the seller need to be mindful of any consents or waivers required in connection with the transaction. Furthermore, companies engaging in buy-backs must pay careful attention to applicable laws which may limit the company’s ability to use its funds for a buy-back.
Structured Tender Offer Secondary Sales and Buy-Backs
While private secondaries and buy-backs are negotiated transactions between an individual seller or a small group of sellers and buyers or the company, offers made by a buyer or the company to a broader group of potential sellers may be deemed to be a “tender offer.” Under a tender offer, a broad group of shareholders are offered the opportunity to sell their shares at a predetermined price under uniform terms. If a transaction is treated as a tender offer, it will have to comply with additional regulatory obligations, including, but not limited to, the following:
- The buyer must prepare detailed offering materials which include detailed terms of the offer, material facts about the company and the buyer (if the buyer is a third party), and risk factors related to the company and the offer.
- Offer must stay open for at least 20 business days from officer’s announcement date.
- Certain additional timelines must be complied with if the terms of the offer are changed or amended.
- Extra scrutiny is given to any material misstatements and omissions, particularly by the buyer.
- Offeror must make prompt payment of the purchase price after the offer’s close, typically conducted through a paying agent.
Legal Hurdles
Whether sellers decide to proceed with a secondary or a company buy-back, there are a number of tax and legal considerations that all parties should take into account. For example, secondaries with respect to a significant number of shares may impact the company’s eligibility to qualify shares as Qualified Small Business Stock (QSBS). The company should speak to its counsel regarding its withholding obligations and any negative QSBS implications in connection with a secondary. Investors should speak to their advisors regarding capital gains and QSBS implications for their personal holdings.
Furthermore, as noted above, both private transactions and tender offers often require consent for the transaction or notice of the transaction to certain parties. While buyers and sellers are responsible for their own due diligence to ensure they are complying with any agreements to which they are bound, it is prudent for the company to conduct its own review to ensure that all approvals and waivers are properly obtained. For example, sellers may be bound by rights of first refusal which require that the company and/or the stockholders be provided notice of any sale and such notice period must either lapse or be waived before the transaction is effected. More recently, many companies are imposing blanket transfer restrictions which require board approval before any transfer of shares to a third party. Preferred investors often negotiate for a veto right over any repurchases by the company of shares of its capital stock outside of a typical vesting arrangement. Accordingly, parties should review the company’s certificate of incorporation, bylaws, applicable stock agreements and investor agreements (such as the “right of first refusal and co-sale agreement” and the “investors’ rights agreement”) before effecting any sale of shares.
Acquisition
An acquisition offers a startup a decisive liquidity event where all or a portion of its equity is sold for cash, stock, or a combination thereof, but with easier execution than an IPO. The key drivers for pursuing an acquisition include a lack of other liquidity options (including a lack of opportunity for going public), inability to raise further capital or an attractive acquisition offer has arose. Here are the pros and cons of choosing an acquisition as an exit strategy:
Pros of an Acquisition
Full or Partial Liquidity
Converts all or a portion of equity into cash for all shareholders.
Speed
Can happen quickly and faster than an IPO. Process could be three to six months if negotiations are smooth.
Avoids Regulatory Burdens of IPOs
While fiduciary obligations and shareholder approvals will still be required, an acquisition avoids the burdens associated with navigating regulations related to IPOs.
Mitigates Risk
Reduces long-term execution risk on finding a liquidity event.
Cons of an Acquisition
Loss of Independence
Founders may have to report to a new corporate hierarchy and the company’s strategic direction and vision may be modified to the acquiror’s wishes.
Unfavorable Deal Terms
Purchase price, forms of consideration (cash, stock, earnouts, etc.), treatment of equity awards, warranties and indemnities, holdback provisions and other deal terms may be unfavorable to existing investors.
Lower Upside Potential
Compared to IPOs, an acquisition may yield smaller returns and the absence of the public market’s competitive pressures gives acquirors leverage to demand discounted pricing.
Preparing for an Acquisition
If the startup decides to be acquired, there are several things that need to be prepped for the acquisition. Here are key items that should be in order ahead of a potential acquisition:
- Organize Financial Records: Collect and prepare GAAP-compliant financial statements so that they are ready for review. This will include revenue, expenses, cash flow, debt and other historical financial information.
- Clean up Corporate Records: Board minutes, charter, bylaws, stockholder consents, cap tables, equity grants and other documents need to be organized and updated as they will be closely scrutinized.
- Compile Due Diligence: Compile all major contracts, including those relating to customers, vendors, leases, NDAs, employment, licensing,
- Identify Contract Triggers: Identify change-of-control and assignment provisions to determine if any key customers, suppliers, lenders, service providers or investors have termination, consent or notice rights in the event of an acquisition.
IPO
The IPO represents the most well-known path to liquidity, as well as the most uncertain. When a startup goes public, its shares become tradeable on public markets, allowing investors to exit, but market volatility and lock-up periods pose unique challenges. Here are the pros and cons you need to know when it comes to pursuing an IPO:
Pros of an IPO
Access to Public Capital
Enables the company to raise significant amounts of capital for operations and execute follow-on offerings to establish a long-term fundraising channel.
Liquidity for Investors
Enables access to the public market for investors and founders to sell and realize returns.
Potential for Greater Returns
An IPO has the potential to elevate the valuation of the company much more than private funding rounds.
High-Profile Arrival and Brand Recognition: Enhanced recognition from being a public company can increase visibility and credibility, aiding in business development, sales and marketing and talent acquisition.
Cons of an IPO
High Cost and Time Burden
IPO preparation can take 12 to 18 months and costs millions in fees and expenses, as well require significant time from the executive team.
Short-term Market Pressure
Public companies face quarterly earnings expectations.
Loss of Privacy
Must disclose detailed financials, risks, governance and compensation.
Lock-up Periods
Founders, employees and investors typically cannot sell for 6 to 12 months after the IPO.
Compliance and Reporting Complexity
Must comply with Sarbanes-Oxley, SEC reporting, audits, etc.
