Early Founder Liquidity? Risks And Upside of Secondary Sales

“If a company has reached a level of success…and you believe the company has potential to break out …then you should let founders take money off the table. It’s that simple. Only then are you truly aligned.” – Mark Suster

Over the last several years we have seen a boom in the number of secondary transactions in the startup community, both one-offs and on platforms. A secondary is any transaction in shares where the seller is not the company. Many of these are sales by founders, but also include investors who need liquidity, as well as occasionally employees who are leaving the company but where a buyback mechanism was not in place.

While these sales offer the opportunity for founders to “de-risk” their personal situation, they also raise questions about their impact. Here are three things to watch out.

1. Impact on the Company – Does Your Option Strike Price Go Up?

The primary impact on the company is the impact it can have on the pricing of common stock and thus the strike price of options.

A number of rules have been developed to provide guidance as to whether these transactions anchor value in the stock. The core test established by FASB is whether it is an “orderly transaction between market participants”.

As a simplified view, you can judge this from a few key criteria:

  • Frequency, Volume, Timing and Bid-Ask spread of the transactions
  • Buyer/Seller issues – Was the seller distressed? Did the buyer have access to historical and forward looking financial information? Is the buyer a financial buyer or did they have other motivations?
  • Were the securities marketed prior to the transaction

The tests argue by analogy from the sale of shares in public markets, and ask how closely this deal is similar to those transactions. It’s important to disclose these transactions, and provide a strong justification for the weighting they are given. Increasing scrutiny from the SEC, IRS and auditors make clear that they are ignored only at your peril.

2. Impact on the Seller – You Have to Pay Tax. Maybe a lot.

The seller of the shares must contend with tax implications, particularly if the sale price is above the current “fair market value” (FMV) of the stock (and these sales are often done at the Preferred funding round price).

If the sales are sold above FMV it creates the risk that the difference between the sale price and FMV will be taxed as ordinary income (e.g. 40%+) as opposed to capital gains tax, and the company would have a withholding obligation. The risk is greater if the company is the purchaser, and additionally in such cases a company buyback may need to be taxed and reported as a dividend.

3. Impact on Other Shareholders – You could lose the s.1202 advantage.

Where the company is the buyer, it can impact if the shares held by other shareholders are “qualified small business stock” (QSBS) under s.1202 for federal income tax purposes. This provision affords tax breaks to investors that qualify, with potential savings in the millions upon a sale of the company/stock.

Looking Forward

We expect that activity will increase going forward, particularly as more retail crowd funding platforms take off and a host of retail investors look to make secondary transactions.