Liquidity Options for Private Shares in the Secondary Market

There are many options available when seeking to gain liquidity for private shares. It's important to understand the pros and cons of each and to consider which strategies best fit a particular situation. The secondary market can play an important role in gaining liquidity, both for company founders and other stakeholders.

Start by thinking about these important questions—and the issues they identify—to help you achieve your personal financial goals as a company founder or stakeholder.

Why should you consider a small liquidity event now?

A critical first step is to be clear about your motivation and goals for a secondary market liquidity event. Understanding key factors can help determine the best strategy. Here are several scenarios that may be driving your decision:

• Your personal financial situation, such as buying a home or diversifying your portfolio
• Employee concerns, such as expiring options or requiring liquidity for everyday needs
• Uncertainty of full liquidity event timing
• Implementation of corporate strategy to retain or motivate employees
• A refinement of the cap table, realigning investor interests

For example, when trying to solve the issue of expiring options for a limited number of employees while raising enough to buy a home, it may make sense for the company to offer loans instead of buying back shares. Alternatively, if there's a healthy demand for the shares, a direct sale may make more sense for all parties.

Who might buy your shares?

You might sell to existing or new shareholders or arrange a company repurchase. One frequently used strategy is for the company to use some of the proceeds from a recent raising round to repurchase common shares.

For example, the secondary market for private company shares has become increasingly robust. There are websites that match sellers with interested qualified buyers. This approach is best suited for late-stage companies and is simply a function of market demand.

Another option is secondary-specific funds. These funds purchase common shares directly from multiple holders and may align incentives with the board and executives. There are also providers that engage with the company to provide nonrecourse loans across the employee base, as well as companies providing derivative products such as prepaid variable forward contracts.

If the share amount is large enough, an individual could also consider engaging an investment banker specializing in facilitating these types of sales.

What should you be aware of in the secondary market?

Deciding to sell shares through secondary market transactions requires engagement with professionals to help avoid legal and tax issues, as well as negative perception from stakeholders. It may help to ask yourself the following questions:

• How do I value my shares, and how are others valuing them?
• How should I address tax implications?
• What corporate accounting issues may impact a sale?
• What are the regulatory and legal requirements?
• How might a founder sale impact employee retention and morale?
• How will existing investors view founders or employees getting liquidity?

What are some of the possible risks?

Most holders of private company shares are subject to a right of first refusal, or ROFR, by the issuer. This can complicate the situation from a buyer's perspective. There's a risk when the buyer makes an offer to a shareholder but then the issuer can exercise their right to repurchase the shares.

Shares subject to co-sale rights carry a risk to the seller because they typically entitle other shareholders to the right to sell pro rata with the seller. In other words, the seller may only be able to sell a portion of the total shares the buyer is willing to purchase.

It might be impossible—especially if the ROFR isn't exercised—for a seller to force the company to transfer ownership of shares to a new owner.

Exploring a secondary offering as part of a financing round?

Many of today's founder-initiated secondary transactions happen in conjunction with a round of financing. To navigate the range of tax implications and realize the greatest benefit, it's a good idea to consult with tax and legal experts. Here are some elements to consider regarding tax impact:

• Is it prudent to use some proceeds to repurchase common shares from select individuals? Be aware that the sellers might face an unintended tax impact.
• Will some company investors be buying common stock directly from current holders? This may have a different type of tax impact on the sellers.
• Who's setting the price for the common stock, and how much of a say does the board of directors have? This may also lead to tax implications for the sellers.

If the company is purchasing the shares, then the qualified small business stock exemption, or QSBS, isn't available to the selling shareholders and may impact other shareholders' eligibility to use the exemption.

Here are some things to consider regarding other financial impacts.

• There could be implications for the 409A value, depending on many factors surrounding the sale.
• If the company is purchasing the shares above the current 409A price, sellers may receive a bifurcated tax treatment. This may apply even if the investor who sits on the board purchases the shares directly, depending on the specific facts and circumstances.
• Depending on the number of shares repurchased by the company, there could be QSBS implications for other holders' shares purchased from the company a year before or after the transaction.
• Consider the implications for employees and investors who aren't included in the sale.
• If the company goes public within 3 years, the secondary transactions may have to be publicly disclosed.

Choose a partner to help you navigate secondary market liquidity options

Choosing the right investment partner is key to reaching your liquidation goals. Prior to any secondary transactions, consult company accountants, the company's 409A value provider, legal counsel and seller's CPA—in addition to the company's board of directors.

Whatever secondary market liquidity solution you choose, employing professional support to analyze your specific situation and identify relevant issues and implications can be invaluable.