As startup ecosystems create a larger number of valuable companies, the likelihood of secondary sale transactions increases. In this guide we cover the legal issues that you should think about if there are proposed secondary share sales in your company.
what is a secondary sale?
A secondary sale is where private company shareholders sell a portion or all their shares before the company exits, i.e. completes an IPO, or is acquired by a third party in its entirely. This can be contrasted with a primary issuance, which is where money comes into the company as consideration for the issue of new shares.
Founders typically consider secondary sales after a few years because they want some cash out after having bootstrapped the company. Alternatively, early stage investors may seek to sell down because they need to return funds to their limited partners. A secondary sale could be a standalone transaction or part of a larger financing event for the company.
the transaction is between buying investor and selling investor
The company itself would not be party to any one-off transaction between a buyer and seller of its shares. However, if founders are selling shares, they would clearly need to be careful as to what warranties they are giving and their total exposure to the buyer (see below – the liability gap).
secondary sales as part of a financing round
It is more common to see secondary sales as part of a financing round for the company. This enables incoming investors in later stage companies to acquire shares where the funding round is oversubscribed and there is a reluctance amongst existing shareholders to be diluted further.
Whilst the sale of shares in this scenario is again really just a transaction between the selling shareholders and the incoming investor, the company could be more impacted, because it may then have to address the liability gap.
the liability gap
Imagine a scenario where an incoming VC and PE fund is investing a total of $30 million but only $10 million is new money into the company (i.e. the primary issuance). Had the investment been made with all new money into the company, then in all likelihood the company’s exposure for claims for breach of warranties or indemnities would be up to the full $30 million.
In our scenario $20 million worth of shares are being acquired from existing shareholders. And that’s an issue, as those selling shareholders may be founders or early stage investors – so they are unlikely to stand behind the warranties of the company for up to the $20 million (if at all).
Selling VCs and similar investors are unlikely to give warranties other than title and capacity, and will certainly not take on substantial liability for breaches of business warranties given by the company under the equity financing. Investors, after all, have not been running the company so cannot take responsibility for the accuracy of disclosures made against the warranties.
Generally this gap is closed by negotiation, with the incoming investor accepting lower warranty coverage than it usually would, and the company stepping up to cover some of the exposure. There is also the commercial reality that it is rare for claims for breaches of warranties to be so large that maximum caps ever come into play.
restrictions under governance documents
Like any transfer of shares, sellers will need to check the governance documents to see what restrictions there are on the secondary sales occurring. For example, founders may be subject to share lock-ins. There may also be rights-of-first-refusal (ROFR) on share transfers and tag-along/co-sale rights to manoeuvre through. In short, you will likely require a series of waivers to enable the sales of shares to proceed.
If an early stage investor is selling down, the company may also need to consider the existing governance documents more generally. For example board seats, veto rights for investors, and other rights that you might typically see in a shareholders’ agreement or constitution may no longer be appropriate for early stage investors holding smaller shareholdings following their sell down.
different classes of shares
An added complication is that an incoming investor acquiring shares via a primary issuance and secondary sale could end up with shares of different classes – usually a new highest class of shares for the money in, and whatever shares they buy from selling shareholders.
This is more of an issue for the investor to consider than the company. However, if the investor wants to have the same liquidation preference across all of its shares (irrespective of whether they were issued by the company or acquired from existing holders), things can get tricky. In those circumstances, the company may need to reclassify existing shares held or consider other mechanism to give the same effect. For example the company could buy-back a selling shareholder’s shares, and reissue the new class of shares to the incoming investor at the same price.
In short, combining a secondary sale with a new equity financing is not a straightforward transaction. Just wrangling the cap table is no easy task with a lot of moving parts. Then there is the issue of liability on the deal, and ongoing shareholders rights to be agreed. If you’re considering a financing transaction that incorporates some secondary sales, talk to us.