Understanding Secondary Market Transactions with Becki DeGraw | Wilson Sonsini Startup Legal Basics

0:00All right, everybody. Welcome back to Startup Legal Basics with my attorney Becky DeGraw from Wilson Sonsini. Welcome back to the program Becky. Hi, how are you? Good to be here. I am great. It's great to have you back. You and I do this every year or two. We look at all the topics that founders face, capital allocators face, and we just try to have a really thoughtful discussion about them. All of these live at thisweekinstartups.com slash basics, thisweekinstartups.com slash basics, or you can just search startup legal basics playlist on YouTube. You'll find it immediately. Over the past few weeks, you've heard us cover a lot of topics that are important right now in the year 2023 going into 2024.

0:42down rounds repricing options um and just generally the the trends of 2023 one thing that's new in our industry becky is the concept of founders being able to sell in secondary let's dive into this because when i started in the industry vcs had the position 20 years ago that secondaries were evil and that you wanted a hungry founder you wanted like a really hungry wolf pack that was going for the ipo and they had nothing but suffering and pain until that point in time but something changed along the way so maybe you can give us an overview of what changed and you know how often these are occurring and some of the best practices yeah absolutely happy to so i think you're absolutely right you know you go back 20 years and these were rare rare rare you know if we go back five years um maybe i'll call you know that period kind of the the new normal and you know And during that time, secondaries were largely reserved for later stage companies and were usually done at a discount, anywhere from maybe 10 % to 25 % of whatever the last preferred stock round was.

1:51But beginning in the second half of 2020, there was, as we all experienced, this bit of a funding frenzy that really kicked off and gained momentum through early 2022. And during that time, valuation soared, amounts raised soared. firms became more and more company and founder friendly, including on secondaries. We started seeing secondaries as early as series A and 50 to 75 % of deals. I mean, it just really became almost the norm to have a secondary included. And when they were included, it was almost always at the same price as the preferred stock round. Maybe you get a little of a discount um and then you know when last year when things started cooling down the secondary market did start to you know get back to normal you know where secondaries certainly aren't happening at the series a stage right now and they they really are you know reserved for the later stage and part of the reason we're not seeing so many is because the later stage financing market has slowed down um but i think on a percentage basis it's still probably back to that normal time period of you know when we are seeing in an up round not not in connection with a down round at a later stage but if we are seeing an up round at a later stage probably about half of them are still have secondaries associated with it yeah and these are done because companies were staying private longer so to stay private longer in uber airbnb uh and facebook most famously i think uh back in the day i mean facebook kind of got forced to go public at a certain point they just had so many investors it was causing some uh agita with the sec i believe where there's a certain number of people you can have in a private company um but yuri milner very famously did a blended deal uh in facebook i believe where he bought some secondary at a bit of a discount and then he paid a very high price for the uh primary shares the preferred shares in facebook and this gave him an ability to outbid other people so on the buy side you can and this i think masayoshi san did the same thing he paid a certain amount for preferred shares in uber and then he paid some of us with uh existing shares and some common shares a slightly different price and then i guess he netted out hey when this thing goes public it all becomes one class of share anyway so i'll just blend the price that lets the startup have a higher valuation in the press um and it lets me buy some at a discount that don't have the same rights so what's the tension between founders and how much they sell and how much they're allowed to sell typically let's take out the crazy highs and the crazy lows we've been through recently and just talk about sort of maybe the steady stay going forward how much should a founder in the eyes of most investors and boards be allowed to sell percentage wise number wise and what's the the best and the the gold standard now yeah i would say usually five percent or less of their total holdings is where we normally look now as as we start looking at later stage companies and the value gets higher and higher that number the percent the total percentage that we want a founder to sell gets lower because some part of it too right is about the motivation the compensation you don't necessarily want them to sell 20 million dollars worth of stock and are they really going to be motivated to stay with the company and make the company grow to the next biggest thing um so sometimes it is founder specific in that regards um you know you've got a founder who is always going to you know have you know uh work 110 so maybe you know a bigger secondary would be okay but i would say a good rule of thumb five percent or less that decreases as the company gets more mature and is there a dollar amount you see most frequently and does it relate to you know any sort of benchmarks in the real world?

5:48Not really. I think it varies a lot. A lot of times you'll see a million dollars as kind of the minimum, particularly if you're dealing with founders. Yeah. So there's kind of two different categories. There's founder liquidity and then employee liquidity for really late stage companies. And if you're doing like an employee liquidity where you're going to offer it to all of your employees that meet certain eligibility requirements on a per person basis, it's probably going to be a whole lot less than that. But if looking at founder liquidity wouldn't be surprised to see it around a million or higher yeah and the upper bound for me tends to be you know three four or five million you're starting to get to the point of well is this going to be a distraction and i think you know the conversations i hear on the back channel is hey enough to buy a house but maybe not two enough to maybe uh if you're getting a little frisky you know buy a jet suite card buy yourself 25 hours of private jet service on a tiny jet if you're into such things but maybe not enough to buy the entire 30 million dollar jet and when we do see i don't point out any specific companies but there was a transaction that occurred where somebody sold 200 million for a company that is now worth less than 200 million is my understanding and i know some friends who were invested in that and they just said are bad we just got so high on this company we were so high on this opportunity that people came in and just bought literally 200 million from the founder uh which is the equivalent of what would have been raised in you know an ipo in the past right like your ipo and you raise 200 million the ipo here that money's not going into the company it's not going to make the enterprise stronger and that's really what you have to look at i think is how much money is available for the company itself to go in their coffers to be deployed to increase the value of the company that 200 million man And that just went right to a personal bank account.

7:40And that's where you have to get concerned as an employee, as a board is, you know, do we, should we have this inside the company? And wouldn't that be a better use for these proceeds? Yeah, absolutely. You know, I'm like. That's a big consideration, you know, when we're looking at these and anytime we're looking at liquidity transactions, and there's a few different ways that we can structure those. But there's a number of different considerations that come into play. you're looking at it from the buyer's perspective, you're looking at it from the seller's perspective, and you're looking at it from the company perspective.

8:13And layered on top of that is tax considerations, impact on the company's 409A valuation, whether that transaction could jeopardize QSBS, qualified small business stock status for either stock that's been issued in the last 12 months or stock that will be issued in the 12 months going forward. you know whether there's tender offer rules you have to think about there's there's a number of considerations and they all have pros and cons to different players so trying to find the right fit that is magic for all three players and doesn't cause you know adverse tax consequences is always the goal but they're not always necessarily able to achieve it perfectly for all three parties so if the company's raising 100 million it's at a billion dollar valuation I'm just picking even numbers here and 20 million of that is going to go towards secondary 80 million is going to be primary goes into the company.

9:10So 20 % of the round goes to secondary or 2 % of the total value of the company 80 % of the round or, you know, 8 % of the total companies shares get issued new shares get issued and a purchase with that 80 million. There's a concept that comes up. Pari passu. maybe we could explain this and how it relates to early investors and early employees and the founders yeah absolutely so if we if the buyer or investor in that situation buys directly from the employees they're going to buy common stock and common stock doesn't have all the bells and whistles that the preferred stock does it doesn't have a liquidation preference so sometimes investors will say, I don't want to hold common stock because I want the downside protection that goes along with that liquidation preference.

10:04And I want the other bells and whistles that go along with holding a preferred stock. We will see that sentiment disappear the closer the company is to an exit transaction. Because the closer that they feel assurance that, okay, the company is going to exit, all of my preferred stock is going to convert to common anyway, and we're all going to get paid out the same thing no big deal for me to hold that common stock yeah but the earlier it is the farther away from that point investors are more hesitant to yeah to hold the common stock and sometimes people will want to have fairness that we all share on equal footing so i am the found the two founders get to sell five percent of their holdings shouldn't the angels be able to sell five percent shouldn't the early investors so how does that occur there have been some bad feelings where um the founders got to sell i won't mention any specific companies but very famous companies founders get to sell ipo happens ipo tanks uh the employees are holding their shares let's just say it was a ten dollar ipo founder sold at you know before the ipo at nine dollars a share or ten dollars a share because somebody just saw that as a way of getting you know pre-ipo or you know the the friends and family around so they sell at 10.

11:25Stock goes down to five six months later and the employees didn't get to participate in that so you know talk about those dynamics and how those are avoided or is that just part of the game here in Silicon Valley? I think I think it's part of the game is Silicon Valley. But the board of the company does have to make the decision as to who's allowed to participate, how much are they going to participate, even if the company's not involved. And almost always the company is involved in some regard. But even if the company's not involved in the actual purchase itself, and there's a true third party purchase going on, the company probably still has to waive its right of first refusal.

12:05So, there are components where the company can weigh in. And usually, in the bigger purchases, the investor is going to go through the company anyways, to kind of help structure the transaction. And in that case, right, the company's board is now have to exercise their fiduciary duties in determining what is in the best interest of the company and the stockholders. And that's where the heart of the discussion is going to go. And depending on who's participating, if it's directors or officers or insiders you may you may decide to go out and get a majority of disinterested stockholder vote to kind of help approve the transaction if there are interested parties involved and we've talked about this on previous issues episodes this concept of interested parties like everybody's interested we're all showing up every day for work we're all on the board we all have bought shares so it's it's really like how interested are we and and how thoughtful of a process did we do how many people signed off on this transaction and the best practice seems to be just being honest with everybody about what's going on and everybody getting a chance to participate that's what i always tell founders is hey you know instead of going off on your own and trying to do a tender offer you met somebody when you were on some trip around the world who wants to buy your shares some russian oligarch or somebody you met in singapore wants to buy your shares and you create an llc and you start doing off the cap table transactions this kind of stuff does occur and it can get people in downstream trouble yeah it does i i think it doesn't happen as often as you know like you only need one of them to happen and then it hits the news and everybody's like oh my gosh this crazy stuff is happening but they are i think those types of transactions are more rare i think that boards generally are at least having the discussions and they you know not everybody may agree with where they come out as to what the right group of people are but um i think more often than not discussions are happening uh let's say you were a shareholder in a very promising unicorn company that you were an angel investor in making up a complete hypothetical here and you created an llc for yourself because the founders of the company said we're not allowing secondary transactions you create an llc you say i'm going to pledge my shares in this company here and then somebody else says you know what i'd like to buy 50 of that llc uh from you is there anything the company can do to stop this kind of stuff when it occurs or is it a fair thing to occur in the world or is it a gray area it all depends on the document So some transfer restrictions are broad enough to where it picks up pledges as well.

14:47There's all sorts of different types of contracts where you can sell, you know, an interest but not the shares themselves or the future payout but not the shares themselves. So depending on how broad the transfer restrictions are and what type of transfer restrictions there are, usually investor shares have less transfer restrictions than, you know, common stock shares. shares yeah exactly so sometimes there's bylaw there's transfer restrictions in the bylaws which just purely say no transfers of any shares preferred or common without board approval period do those hold up in delaware court or that had those ever been challenged to the best of your knowledge as long as stockholders approve it so right like if if you if you put that type of transfer restriction in place on day one all the stockholders will be bound by it but not a lot of people do that and particularly around preferred stock sometimes you know when as the company started staying private longer and you know the really popular company companies and there was you know the secondary markets that came out and there was a huge distraction of like oh my gosh all these people are selling and yeah this is just a huge distraction for the company we want to put you know restrictions on both the preferred stock and the common stock if you do that people have to sign off on it though exactly and it's not just getting a majority of the stockholders to approve it at that point that does approve the bylaws amendment but it's only going to apply to folks that actually sign the consent so if you put a new type of transfer restriction in place that is hey you can't transfer without board approval in the middle after you already hold your shares, then yes, that would not be applicable.

16:31Or they could just do with new investors going forward. So hey, you want to invest, these are the rules. And I think that's what happened in this hypothetical company was some of us who got in very early had a lot more freedom than people who came in later in a completely hypothetical example. But venture firms have a long history of doing this because I might have an LP interest in a company that invested in Airbnb. b okay airbnb is 99 of their returns in this seed fund let's call it a 20 million dollar fund that you were lucky enough becky to own be a 10 lp so you own two percent of it which means you own two percent of the 99.99 returns that are coming from that and it's uh you know i don't know let's make it a billion dollar return so you've got whatever that is 20 million in carry coming to you uh two percent of it you could sell your interest in that for that venture firm uh at a discount for 18 million or something and just clear your position that way and some known large endowments type entities have done this in the past yep most likely right again always got to check the documents that you signed you know to see what restrictions are on them but that is a very very common fact pattern is early investors get into these companies there weren't all those transfer restrictions in place they didn't sign on later and yeah they have the ability to to do have more freedom to sell and transfer shares or interest in them or interest in spvs or funds that they they're hold the shares there might have even been banks that were in this hypothetical example banks that would go to these endowments and say hey you're a giant endowment you have x number of shares in this beautiful uh you know promising unicorn that's going to change the world we'd like to uh give you liquidity for that now for your endowment and you know we'll we'll have the shares as collateral and get some amount of the gain tender offers have started i remember getting this when masa did his uber um tender offer and i can speak to this one because it was very public you get like a little link uh from um second market nasdaq private market yeah that's one private market and then it just says hey what percentage you want to sell you put in a request and then it tells you how much you were able to clear maybe talk a little bit about how often do those happen through like the nasdaq secondary product or are they typically just done with you know uh a lawyer emailing people it depends on how many folks are involved if you have two or three founders the company's just going to handle it you're not going to go through you know the secondary platform but if you're going to go out and offer it to 100 employees you're going to want to go through that secondary platform because the administration of it you're you're going to pay way too much to have somebody manage all of those elections.

19:28And with the tender offer, there's just additional disclosure that has to happen. So, when you log onto that platform, you probably click through it pretty quick, but there's all sorts of disclosure around what the offering is, and it has to stay open for at least 20 business days. So, when you go through that, there is a much more formality disclosure process around it. so they are more costly to to execute and more timely to execute than a smaller transaction involving three or four people and tighter and less uh errors hopefully or any cantankerousness that can occur qsbs qualified small business um yeah it becomes an issue right you have to hold these shares from five years from the pricing of the share is that am i generally when you acquire the shares yeah so it's a convertible note until it converts you actually don't have the shares or you do or debatable from a from a qsbs standpoint i believe that it starts when the shares are actually issued but there may be some tacking available um so definitely check with tax folks on that but um there are a few pieces of qsbs that's really critical like one you have it has to be the stock has to be acquired from the company directly so if i'm an investor and i buy from an employee that doesn't count like that those shares are just never going to be qsbs eligible i have to buy from the company so sometimes that's one of the factors that influences how an investor will say nope i don't want to do the secondary but i'll put more money into the primary and then company you can go and repurchase the shares ah although a caveat there like if there are significant repurchases and there's a few different tax tests so you know definitely call up call the tax folks and have them do the math on it but if there is a significant repurchase then that could cause the shares that were issued in the last 12 months and also the next 12 months to be ineligible to receive qsbs treatment so on one hand the investor who is buying primary says oh wait i got to get the stock from the company in order for it to be qsbs but i'm okay go ahead and do a repurchase if the company does that repurchase it could make all the stock that that investor just received to be qsbs ineligible so lots of balancing factors as you're looking at this now if you're looking at a company with more than 50 million in assets qsbs doesn't apply so in those really big examples that we were talking about qsbs too late the stock isn't eligible for it anyway so yeah you tend to see more company repurchases then yeah just because that piece is uh for the land of uh series a and below seed investors angel investors mainly get to benefit from this yeah yeah and you know i mean it's a really big benefit if you if you buy the stock and you hold it for more than five years, which also relates to you generally are acquiring it in those really early days because you got to hold it for five years before you sell it.

22:40But you can be eligible for a percentage-based exclusion from your federal income taxes. And there's a number of nuances around it, but definitely talk to your tax advisors, but the exclusion could be up to$10 million. So it's very significant. again yeah you got to want to really make sure your attorneys and your tax folks are being thoughtful about this and you're getting statements from your companies and their cfos that this is qsbs stock all right listen great job um if you uh need an attorney becky's amazing probably doesn't have many slots but you take on a couple of new startups every year yeah always always looking for for new companies so feel free to reach out what's the ideal is there like a zone because i mean listen you've been at this for a while um and you get to pick your customers i think to a certain extent so is there a zone that's like best for you to work with like right after they raise a series a or a seed or do you like when it's they're graduating from yc or you're just open-minded generally speaking curious open-minded you know we we really do just like our companies we concentrate on the funnel and you need more at the top and you know as the there's not going to be as many series vcd companies um so we love to work with them as early as as we can um sometimes you know an idea may be too early um and that hey like they can't afford our fees and we don't really see a path to funding for them um but generally outside of that if there's if there's like wow this is a really cool idea let's talk because we have all sorts of deferral programs and ways that we work with startups.

24:21We have a lot of automation that we're doing to make it cheaper, faster for us to be able to work with those early stage startups. Deferral programs are great. If you raise funding, you get the bill. If you don't, we can work on it. Love it. All right. Great job, Becky. And we'll see you all next time on This Week in Startups. Bye-bye.