Congratulations, you now own stock in a private company… but can you sell any of it?
The considerations that go into answering this question have changed over time as the process for selling private company shares in the secondary market has become more restrictive. In the nascence of the secondary market, companies imposed fairly limited restrictions on these types of sales.
The formula to sell shares was relatively straightforward, in that you could simply find a buyer, memorialize the price and terms in a purchase agreement and the shares could be sold. However, as the market has grown in terms of both buyers and sellers, private companies have mandated an increasing number of restrictions, with each handling secondary share sales differently.
In order to better appreciate what has changed in terms of process, it is essential to understand a private company’s possible goals related to secondary sales.
A primary goal of private companies allowing secondary sales is to protect their corporate information — financials, key customers, valuation, etc. As a result, the quality and reputation of the proposed buyer is very important as companies and existing investors have become increasingly reluctant to allow “just anyone” onto their capitalization tables.
In concept, private companies are not necessarily opposed to secondary share sales, as they have come to recognize the HR benefits associated with possible employee liquidity. With the mean time from funding to exit for a private company increasing from 2-5 years in the early 2000s to an average of 6-10 years today, an employee may hold illiquid private company stock for quite some time while undergoing major life events such as marriage, the birth of a child or a home purchase.
Hence, private companies have come to realize that the allowance of secondary sales can be a powerful tool for talent recruitment and retention, as it allows employees with more financial flexibility, thereby allowing employees to maintain focus on growing company value (see Employee liquidity — good for private companies?)
However, handling these one-off processes requires significant internal resources, as secondary share sales are an additive agenda item for the already resource-constrained CFO and/or General Counsel. Companies try to limit the administrative demands involved in these processes by creating standardized protocols related to transfer documents or approval processes.
Minimal Corporate Involvement
Private companies are wary to limit any perception of asymmetric information related to these transactions, and want to ensure that both the buyer and the seller have similar information sets. As a function of this, companies are reluctant to get involved, as they want to limit the impact of secondary sales on their 409A valuation process and common stock option issuance price.
Secondary transactions were once largely ignored in 409A valuations by companies, valuation firms and auditors. In recent years, however, increased SEC scrutiny on 409A valuations has prompted the American Institute of CPAs (AICPA) to create guidelines that specifically recognize secondary transactions.
Therefore, private companies have started to become more cognizant with the factors that may influence this value, including but not limited to: (i) whether a third-party buyer was involved in the transaction and how much information they had, (ii) how broad the process was and how many counterparties were involved and (iii) the type of security that was sold, transferred or redeemed in the transaction (see The New Normal: Secondaries and the 409A Valuation Process).
Prior to selling shares in a private company, an investor must first determine what type of stock is held (i.e., preferred versus common), then refer to the company bylaws (specifically, a section oftentimes called “Transfers of Capital Stock”), which contain the governing conditions and requirements for that class of stock.
Beyond this, there are several key questions that will help determine how to sell part or all of your shares:
Does the company allow share transfers? Many private companies today, notably some of the “unicorn” companies, have included specific restrictive sale provisions in their bylaws that limit or inhibit the ability for shareholders to sell or transfer their shares under any circumstance. Most of these companies control who can sell and when by managing and restricting external sale processes (existing investors or the company itself are the buyers).
Which buyers has the company “approved” to be shareholders? Many private companies have asked our firm and a short list of others to be on “approved buyer lists.” These are typically 1-4 funds that the company and/or Board of Directors has “approved” to increase their share ownership and who specialize in secondary sales. In certain instances, a company will direct their Right of First Refusal on share sales to the buyer group so they have a short list of long-term and trusted shareholders.
Is there a company liquidity program in place already? Many private companies create organized shareholder liquidity programs with funds that specialize in secondary sales and purchases. They typically work with funds that have pre-existing relationships with the current shareholder base and management team.
In summation, while privates companies’ underlying goals relating to secondary share sales have not changed significantly, the way in which these processes are handled has. We believe that over the next three years, we may see a more fluid market for secondary sales and transfers as processes become more uniform and standardized.