Getting rich from secondary sales

Over the years, I’ve wired hundreds of millions of dollars to founders and early employees in secondary transactions.

(Author’s note: I also once accidently wired 8 figures to the wrong person, but we won’t talk about that today because it triggers my PTSD (Post Treasurer Stress Disorder) and I’m writing this from the fifth floor)

Releasing those wires is a surreal feeling. You try to remain all professional and “business as usual”, but you know you’re changing that person’s life (and maybe their descendants’ lives) forever.

Today we’ll discuss what secondary transactions (more formerly called “tender offers”) are so you’re prepared to take advantage of one when the time is right.

More specifically we’ll cover:

Privately held venture-backed companies often grant their employees stock options as a form of compensation. This incentivizes employees to work hard and contribute to the company's growth, as they have a vested interest in its success. It also helps attract talent at a lower salary - the company gives you less cash today in exchange for unlimited upside tomorrow.

However, these stock options are typically not liquid until the company goes public, which can take several years. As a result, many pre-IPO companies allow their employees to participate in tender offers, commonly called secondary transactions, which allow them to sell a portion of their vested shares to outside investors.

A tender offer is a liquidity event in which a company, investor, or group of investors propose to buy a fixed number of shares from existing shareholders at a set price. Tender offers can be made for both private companies and public companies, with recent examples Stripe and Twitter.

It’s important to note that the company does not get any money from a secondary transaction. The balance sheet does not change. While primary dollars are used to fund future operations, M&A, and to hire more talent, there are no new shares created in a secondary transaction, as they merely change hands.

From the company’s perspective, there’s no operational or financial benefit to doing one. And if I’m being really honest, it’s a total pain in the ass to administer. The company merely acts as an approver, book maker, and conduit by which employees and early shareholders match up with new or existing institutional shareholders. I’ve wasted dedicated hundreds of hours of my career coordinating between employees, early angels, future shareholders and the army of lawyers on both sides of the transaction.

Tender offers typically occur in conjunction with a later stage fundraise (Series C and beyond). This is the sweet spot where founders have been at it for long enough to take a little off the table.

Anytime before then is usually a pretty big red flag to investors - it would be suspect if a Series A founder wanted to line their pockets before the company has achieved product market fit.

That’s why all tender offers require board approval.

Tender offers may also occur outside of a primary fundraise if the company is dragging it’s feet on going public, either by choice or due to macro economic conditions. Stripe recently made headlines recently with an employee tender offer, as did OpenAI.

You have to approach this from three strategic angles:

Founders and long time employees can only sleep on air mattresses and eat ramen noodles for so long before they get antsy for a sale. Tender offers allow them to de-risk their ongoing commitment to a single startup. In other words, they’ll have something to show for [x] years of work, even if this whole thing does blow up.

You see, tech employees are smart people. They can get jobs at well paying salaried jobs if they so choose (McKinsey is always hiring), so allowing them to re-coup some of the sweat-equity they’ve put into the business is a nice nod to their efforts and a way to keep them in the game.

It’s disingenuous for investors to tell founders to get back to work and make them more money if founders are worried about buying their first house or affording to send their kids to college. Secondaries solve for that.

Therefore, investors hope that by allowing early employees to take some money off the table, they’ll strap back in for another tour of duty. With some money in their pockets, ideally they feel more empowered to swing for the fences, and get that homerun outcome the portfolio calls for.

One more key reason - secondary transactions help employees get the cash needed to cover exercising options and paying said AMT taxes on those options. Don’t underestimate how expensive exercising and covering can be. We wrote about it here.

And from the investor’s perspective, this can be a good thing too. It allows them to increase their stake in the company by buying up more shares than they initially received allocation for in a primary transaction.

Founders are wary of dilution, so there are only so many dollars to go around in a primary fundraise. So if a round is “oversubscribed”, then the next best option is to shake some secondary dollars from the tree.

CFOs will often reserve secondary allocation for their favorite investors, allowing them to creep up their fully diluted ownership via common shares.

Secondaries can serve as a polite way to do some cap table cleanup. Lot’s of startups have early angel investors and advisors who become increasingly less helpful as the years wear on. If the price is right, this is a great juncture to ctrl alt delete them off the cap table and send them on their way, fat and happy.

Secondary transactions are also great from an employee morale perspective, and a way to cushion the blow of any hierarchical changes that need to occur. With a fundraise often comes urging by investors to uplevel the talent at key positions (e.g., hire a real CMO, hire an experienced sales leader, etc). This can be a huge ego blow for employees who have helped get the company to this point.

But what got the company here isn’t going to get it to the next level. So allowing early employees now moving into less prominent roles to take a few million off the table can really help quell the pain. Getting leveled is never fun. But it’s slightly less painful when you have a new set of jet skis.

It’s important to note that secondary transactions often consist of buying up common shares, while the primary fundraise is characterized by the creation of new preferred shares. Preferred shares have a liquidation preference (they get paid out first) and have more voting rights (more control over the company), among other benefits.

As a result, common shares in a secondary transaction will often trade at a ~20% discount to the primary shares.

But this discount is always a function of supply and demand. If it’s a hot pre IPO company, investors may not care if they’re getting primary or secondary shares. They just want to gobble up as much equity on the cap table as possible. This was a common theme in 2021 and 2022, when investors often paid employees the same exact price for their common shares as the company’s newly minted Series [x] preferred shares.

If all goes well and the company IPOs, the preferred shares (usually) convert with all other shares into the same publicly traded share class. So, in other words, all’s well that ends well in an IPO.

But if the company’s valuation falls, the common shares are at a disadvantage, as they’re seated behind the preferred shares in the liquidation pecking order. It’s a calculated risk for investors who want to increase their fully diluted ownership.

While the criteria for participation can vary from company to company, here are some common guidelines I’ve seen for employees choosing to participate:

Some inside baseball - often the lawyers work with the company’s management to “mold” the criteria to fit their general needs. In other words, the seller guidelines often “conveniently” fit the goals the founders want to accomplish.

And here’s a zinger - sometimes a company requires you to sell a minimum amount to even participate. In other words, if you hold under [x shares], it’s all or nothing. This is purposeful to force smaller former employees or angel investors off the cap table.

While secondary transactions can provide liquidity for employees, they can also have downsides for the company. One major concern is that these transactions can lead to a decrease in employee motivation. If employees are able to sell their shares before the company goes public, they may not be as invested in the company's long-term success, since they’ve made a buck.

In fact, some may even decide to leave the company, and go vest elsewhere. You always have to think “which sellers are now flight risks?”

Additionally, secondary transactions can attract outside investors who may not have the same long-term goals as the company. These investors may be more interested in a quick return on their investment rather than the company's overall success.

Finally, secondary transactions can be complex and time-consuming, requiring significant resources from the company's management team. I’ve had to administer a few secondary transactions in my day. It requires a shit ton of coordination between you and the employees doing the selling, and the company obviously makes no money as a result of the administrative burden.

The whole point of giving employees equity is to keep them motivated, help them de-risk, and show them appreciation.

If you don’t allow them to sell anything for a long period of time, they don’t feel like there’s any value in this component of their compensation, and it’s all for naught. On the other hand, if you allow them to sell a whole whack at once and stuff their pockets, they may a.) get complacent in their current role or, even worse, b.) pick up and hit the road for the next job where they can start to vest.

Similarly, equity is a tool to get the most out of your investors. Some investors won’t get out of bed in the morning to help a portfolio company if they don’t have at least a $50M stake. If you can’t get them $50M in allocation in the primary fundraise, then topping them up with secondary dollars is an excellent tool to get them to their target fully diluted ownership, and ensure they stay on the ball.

I guess you could say there’s an art in making people rich… just not too rich.

Part I: What's a 409A Valuation?

Part II: Maximize Your Returns: A Tech Worker's Guide to Exercising Equity & Optimizing Taxes