Unlocking opportunities - secondary transactions in the venture market

In the ever-evolving landscape of venture capital, secondary transactions have become a vital component for liquidity and portfolio management. As early-stage companies stay private longer and the time to exit extends, secondary transactions offer a pathway for early investors, founders, and employees to realise partial liquidity without waiting for an initial public offering (IPO) or acquisition. 

This article delves into the mechanics, benefits, and considerations of secondary transactions in the venture market.

The rise of secondary transactions

Secondary transactions refer to the sale of existing shares by current shareholders to new or existing investors without the issuance of new stock. This contrasts with primary transactions, where companies issue new shares to raise capital. 

The growing trend toward secondary transactions is driven by the need for liquidity in a market where the average time from initial funding to exit has increased significantly.

The mechanics of secondary transactions

Secondary sales can occur independently or as part of a broader financing round. They often involve the transfer of shares at a discount, providing an attractive entry point for new investors while offering liquidity to existing shareholders.

Key considerations for secondary transactions

Transfer documentation

Proper legal documentation is crucial for secondary transactions. Stock transfer forms (STFs) are commonly used to transfer legal title and are often accompanied by a sale and purchase agreement (SPA) that outlines additional terms of the sale, such as warranties and provisions relating to stamp duty.

Constitutional documents

The company's articles of association and any pre-emption rights must be reviewed to ensure compliance with share transfer restrictions. Shareholders' agreements may also contain consent regimes that impact the transaction.

Warranties

In secondary transactions, the warranty suite is typically limited to title and capacity warranties, especially if the buyer is an existing investor with extensive information rights or a board seat.

Co-sale provisions

Co-sale rights allow investors to participate in liquidity events alongside founders and other shareholders, potentially affecting the number of shares a founder or ordinary shareholder can sell.

Lock-up arrangements

Founders and employees may be subject to lock-up arrangements that restrict their ability to transfer shares within a certain period. Reviewing any carve-outs or required consents is essential before proceeding with a secondary transaction.

Re-designation of shares

If there is a mismatch between the class of shares being sold and the class desired by the investor, a re-designation or conversion of shares may be necessary, subject to board and shareholder approval.

The benefits of secondary transactions

Secondary transactions offer several benefits to the venture ecosystem:

• Liquidity for shareholders: they provide an exit opportunity for early investors, founders, and employees looking to diversify their assets or access cash.
• Portfolio management: investors can rebalance their portfolios by selling shares in mature companies to invest in new opportunities.
• Price discovery: secondary sales help establish a market price for a company's shares, which can be informative for future financing rounds.

The challenges of secondary transactions

Despite their benefits, secondary transactions come with challenges:

• Valuation discrepancies: determining the fair market value of shares can be complex, especially in the absence of recent financing rounds.
• Shareholder alignment: ensuring that all shareholders are aligned on the terms and conditions of the sale is critical to avoid conflicts.
• Regulatory compliance: adhering to securities laws and tax regulations is essential to avoid legal repercussions.

Best practices for managing secondary transactions

To navigate secondary transactions successfully, startups should:

• Engage experienced advisors: work with legal and financial advisors who specialize in secondary transactions to ensure compliance and optimal structuring.
• Maintain transparent communication: keep all stakeholders informed about the transaction process, terms, and potential impacts.
• Prepare thorough documentation: ensure all transfer documents, consents, and agreements are in order to facilitate a smooth transaction.

In summary

Secondary transactions have become an integral part of the venture capital market, offering liquidity and flexibility to shareholders while allowing early-stage companies to remain private longer. 

Understanding the intricacies of these transactions is crucial for founders and investors alike. By carefully considering the legal, financial, and strategic aspects, early-stage companies can leverage secondary transactions to support their growth and provide value to their shareholders.

As the venture market continues to evolve, secondary transactions will likely play an increasingly prominent role in shaping the trajectory of growing businesses and the realisation of returns for investors. Navigating this landscape with diligence and foresight can lead to successful outcomes for all parties involved.