Alternative Paths to Liquidity in Private Companies

The sale of private company shares on the secondary market is becoming increasingly prevalent as the timeline to reach a liquidity event has lengthened over the last decade.

In order to proactively manage secondary transactions, the boards, management teams, and investors of these companies need to be aware of the relevant issues, challenges and considerations.

Unlike public markets, where information disclosure rules are well established, rights and privileges of existing investors are limited and securities laws are well defined, the world of secondary share sales in private companies is much less understood. While companies and investors are familiar with security transactions involving a primary issuance of shares and are experienced with those dynamics, secondary sales frequently involve a host of different issues.

Secondary transactions are often complex in structure, can have securities law implications for companies and participants in the transaction, and regularly involve specific arrangements between buyer and seller.

For secondary transaction participants, relevant considerations include:
• a transaction’s implications on the motivations of employees and investors
• enforcement or waiver of the rights and privileges of the company and shareholders (particularly Rights of First Refusal, also referred to as a ROFR)
• implications of the transaction on a company’s 409A valuation
• selection of the appropriate buyer and potential new shareholder of the company

• processes allowed by the seller and the company
• legal issues for all parties involved
• information disclosure to a potential secondary buyer.

What is a secondary sale of shares?
A secondary sale (also referred to as a direct secondary sale) refers to the buying and selling of an investor’s ownership in a privately held, frequently venture-backed or private equity-backed, company. The direct secondary market creates an option for management and investors, especially minority investors, to sell their stock when the entire company is not being sold.

Investment stakes can be sold in a single company or across an entire portfolio of companies. While a robust secondary market for private equity-backed companies has existed for decades, historically, venture capital was too small a segment within the alternative assets class to support a vibrant secondary market. However, over the past decade, there has been significant growth in
the amount of money allocated to venture capital investments (from $7.4B in 1995 to $28B in 2008; source: NVCA). This growth in the venture industry has resulted in a striking disparity between venture capital investments and venture-backed company exits: venture capitalists invested in 31,676 deals between 2001 and 2009, but only 3,164, or 10%, of venture backed
companies have had exits in that time period (source: NVCA).

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