Process alternatives for a secondary transaction
There are several processes alternatives a company or investor might consider in connection with the sale secondary interests. Each of those processes has pros and cons and some are better suited to certain types of companies. In addition, the pricing dynamics are different in each scenario.
Sell shares on a secondary exchange like Sharespost, Second Markets or NYPPE
Selling shares on a secondary exchange can result in a high price if the shares are from a large, well known company like Facebook, Twitter, Zynga, LinkedIn, etc. Secondary transactions of these companies represent a huge majority of all trades on these exchanges. These types of transactions are great for employees who own a very small numbers of shares and prices tend to be high. However, outside of those types of transactions, very few other companies’ shares trade on the secondary exchanges, and when they do, it is typically not at attractive valuations. In addition, these sales are often not controlled by the company
which existing investors and boards tend to dislike since they are unable to have any discretion over the choice of the new investor.
Complete a primary round of financing through a preferred stock issuance and use some or all of the proceeds to purchase common shares
This form of secondary transaction can also provide a very high price to a seller because the buyer can provide better pricing as they are purchasing a preferred security. Since the new securities have liquidation preferences and often come with a variety of rights and privileges superior to those of a common stock holder, the valuation can be maximized. However, these types of transactions also have negative ramifications for existing investors and the common shareholders as additional liquidation preference is added to the capital structure, thereby reducing the value of the existing preferred securities and common shares. In addition, company stock repurchases may raise additional issues in relation to corporate and contract laws.
Have the existing investors make an offer
There are many benefits to having an existing investor provide liquidity. They know the company so there is often no required diligence and issues regarding rights of first refusal are frequently less relevant. However, existing investors can be quite conservative in their valuation particularly if they perceive little or no outside competition. Existing investors also think that their ROFR rights provide a significant deterrent to outside investors, so they often have little incentive to pay a full price. Lastly, many of them may need to hold their capital for reserves against future financing rounds, limiting their willingness to invest
meaningful amounts of money.
Sell to a primary investor who missed out or was the “cover bidder” on the last round of financing
Clearly an investor who provided a term sheet but was not selected or who got a smaller allocation than it wanted in the last round often can be quite aggressive in valuing securities being sold on a secondary basis. While many venture firms may not be interested in common shares, some will consider it and if they have already done a great deal of diligence they can be a good choice for a purchaser of securities.
Hire a banker or broker to run a “mini-auction” for the secondary shares
While this approach to a secondary sale can result in attractive valuations in certain circumstances, it can also result in a significant burden being placed on company. In most cases the company will need to cooperate to maximize value as the buyers will want to review financials, projections and spend time with management. Since there is often little benefit for the company, the willingness of management to spend time with multiple buyers is limited and, in our experience, these efforts frequently fail. Many secondary firms refuse
to participate in these processes unless they are limited, thereby reducing the benefits of a broad auction. In addition, engaging a broker, even if they are acting on behalf of the seller, can result in unexpected legal issues for the company (see Important Legal Considerations section). Further, a broker will often include unfunded sponsors in the auction process who
will eventually have to convince a funding sponsor to provide the capital. Because fund-less sponsors have to raise capital after agreeing on the terms of the deal, the close rate of deals with these types of investors is often low. Lastly, since fund-less sponsors need to share information with potential funding sources to complete these deals, there is a significant potential to jeopardize the confidential information of the company.
Approach a couple of the established secondary firms and determine their interest level Secondary firms tend to be conservative by nature so valuations tend to be lower than that offered by “retail” investors, but they have some advantages as well. They provide a high degree of confidence of closing, they have extensive experience in doing these types of transactions, they are likely to be flexible on structure and economic sharing arrangements, and they are often well-known and accepted by the existing investors.