A Primer on the “Secondary”
In the venture world, a secondary offering refers to the sale of outstanding (and previously issued) shares by a company’s shareholders to a group of investors.
There are a couple of reasons for the trend. Sure, founders are generally happy with the early liquidity, and there is a school of thought that it encourages them to really swing for the fences. More often, though, secondary offerings permit our startup stars to make room for the clamour of investors beating down their door without swamping the cap table in any financing round.
With this in mind, how do you get a “secondary offering” done, and what do you need to know at the term-sheet stage to make it happen?
First of all, do some scoping prior to term sheet negotiations. Boards have a pretty wide berth in structuring the terms of any secondary offer, and so founders should consider a wide range of factors before jumping headlong into the warm, liquidity pool. Who will participate, and to what extent of their holdings? Will optionholders have the opportunity to participate? How will the liquidity affect the startup’s culture? How might it affect the option pricing and the resulting recruiting wedge following the completion of the secondary offering? How will the company communicate with the sellers, and what will the timing of its closing be relative to the primary offering?
Second, you should get the key secondary terms included in the term sheet.
In our view, they are threefold: (i) the price, and whether any discount will apply to secondary price, (ii) whether the secondary buyers will be getting “pulled up” into the financing round shares (ie. typically a new and often senior class of shares), and (iii) lastly, if the secondary investments are not to be “pulled up”, the syndicate’s relative contribution to secondary offering, relative to the primary.
Why would a discount apply at all?
Well, theory goes that it represents the appropriate risk premium for investors providing early liquidity rights for the secondary offering sellers. But don’t fret too much, the discounts are generally in the 10-25% range (if they apply at all), and they definitely do not approach the type of discounts we see to common share prices in connection with your typical post-financing round 409A valuation (or Canadian equivalent). As importantly for senior management, our experience has been that the greater direct founder participation in the secondary offering, the less likely there is to be a discount. We can only suppose it violates even the (admittedly low) standards of VC politeness to ask for material discounts from their founders as they’re looking to squeeze into a round.
Alright then, with price established, how do you structure the secondary transactions?
On the one hand, it can be pretty easy – investors acquire shares from the sellers, and the investors keep those shares (and accept whatever place in the liquidation priority stack they get as a result).
However, this is where those nice VCs can get a little grumpy, especially where a syndicate reflects an asymmetrical contribution of “primary” and “secondary” investment. Many VCs (other than Founders Circle, we should point out) will contribute to the secondary, but those VCs want the same, exact class of shares as the investors are getting in connection with the “new” money.
Optimizing the Canadian tax consequences for the sellers, while at the same time providing that “pull up”, is a little tricky, and that’s where LaBarge’s tax team (including Paul LaBarge, Estelle Duez, Dineen Beath, and Suzanne Pellerin) really shines, and where we’re here to help.
If you’re staring down the unfortunate luxury of an early payday for you and your team, most definitely reach out. We’d be happy to assist in defining your secondary offering “values”, and more importantly getting that value into your bank account in as tax-, time- and fee-efficient a manner as possible.
If you have questions related to a secondary offering, please contact James Smith and he will be more than happy to assist you.