Founders should be able to sell secondary whenever they’d like to do so. If you make something - and that thing is valuable - you should be able to sell it. The easiest time to do this would be when investors are already trying to buy a piece of your company.
Actually selling that secondary can be tricky. Below, I’ll explain the process a founder should use when selling. We’ll deal - in another essay - with the arguments for/against secondaries.
The first challenge with any secondary negotiation is to actually run a successful fundraising process. I’ve written extensively about that in the past. Founders should think of secondary as a key term that they will need to negotiate alongside partner, price, board structure, option pool, re-vesting, pro ratas, veto rights, etc. The tricky bit here is in figuring out the order in which to negotiate for each of these things that you want, and how to approach that negotiation.
Getting secondary is complicated because of the strong reaction that many VCs have when founders ask for it. Because of this dynamic, founders who ask for secondary while still negotiating to get a term sheet usually blow themselves up. Investors bucket these founders into “difficult” and “not in it for the long run” which can kill a deal.
The better path is for founders to first figure out what kind of leverage they have in the negotiation. The main driver of that leverage is the number of quality term sheets which a founder has in hand.
A founder with multiple, high quality term sheets can make the call to put a secondary allocation into the term sheet as a factor in deciding which term sheet to take. Generally, you’ll want to do this with one investor first, see how it goes, and then use that first answer as a jumping off point for everyone else.
If you only have one term sheet, your job is harder. Generally, the order of operations here is a little something like this:
Get the term sheet.
Negotiate “normal” major terms: dollars in, price, board, etc.
Don’t forget about re-vesting. Founders often do.
Sign the term sheet. Go out and start figuring out allocations for the remaining dollars.
If you’re lucky enough to have more demand than you do space, you have the opportunity to sell some secondary. Figure out how much excess demand you have.
Talk to your lawyer and your accountant about what you want to do. Ask them to explain the pros and cons of selling secondary as common shares vs. preferred shares (which is a bit out of scope for this essay).
Decide how much secondary you want - ideally this is “reasonable,” which is a moving target. One good way to frame “reasonable” is to give a clear reason as to why you want to sell. This is particularly important in early rounds. Good reasons include: “Need to pay off student debt” and “Just had our first kid after years at below market salary.” Less good reasons include “Need a new Porsche” and “LinkedIn ghostwriter prices went up.”
Go to your new lead investor and say “Hey! Great news! We have 2x demand for available shares. It would mean quite a lot to me and my cofounder if we could take (insert reasonable amount here) off the table because (insert reasonable reason) here. Obviously as our lead, you get first access. Sound good?”
Work with the buyer to figure out if you are selling common shares or preferred shares.
If you are selling common shares, and the buyer is willing to buy these at the same price as preferred, great! Just make sure that you aren’t creating any challenges around voting by giving those shares to an outside party. Also, talk to your lawyer and accountant.
If you are selling preferred shares, go back to your lawyer and accountant to make sure you’re not creating any issues for yourself. You’ll also need to confirm with your existing investors that they are ok with you doing this because it will change the preference stack - which impacts them.
Triple check your numbers.
Complete your transaction and close the round.
Most of the time - if you do this in the interest of long term alignment where taking some risk off the table allows you to focus on the company more intensely - your investors will be happy with it. Interestingly, more senior/experienced investors seem to be quicker to agree to these deals than more junior investors. They know that the “NO SECONDARIES” rule is less of a rule than a thing people say on podcasts.
And it’s generally that simple. Not scary at all.
___
Disclosures
This material is intended for information purposes only and does not constitute investment advice, a recommendation or an offer or solicitation to purchase or sell any securities to any person in any jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. Unless otherwise stated, all views or opinions herein are solely those of the author(s), and thus any view, comments, or outlook expressed in this communication may differ substantially from any similar material issued by other persons or entities. The information contained in this communication is based on generally available information and although obtained from sources believed to be reliable, its accuracy and completeness cannot be assured and such information may be incomplete or condensed. The information in this communication does not constitute tax, financial, or legal advice.