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What to expect in a secondary market transaction
You’ve created and funded an emerging growth company or a startup, you own unregistered shares of a private company not listed on a national stock exchange, but you need cash now.
You run a company or sit on the board of directors of a private company where a stakeholder has informed you of their intention to obtain liquidity for an equity stake.
What are your choices?
If you are still in the business, what signal is sent by your desire to sell? If you are the business, what signal is being sent by your facilitation of a secondary transaction? Are you promoting or hurting retention? Are you helping or hindering your company’s ability to raise capital in the future? What do you need to know to navigate the murky waters of secondary markets as a buyer or seller?
Historically, a shareholder in a private company had to wait until the company went public or acquired to get a return on their equity or initial capital investment. But as the path from ideation to public listing has lengthened over the course of this century, so too has the pressure to secure or enable a liquidity transaction.
Shareholders of many private companies are increasingly participating in “liquidity rounds”, also known as side sales, where they sell shares for money before the company goes public. There are many factors that a holder or a private company must take into account in deciding whether and how to structure this type of transaction. Will a liquidity transaction help a company retain key talent, or does it allow its own demise by helping its key talent to retire quickly? Is it fair for those who participate and those who do not have access? A company can also take specific steps to control secondary transactions in its stocks in the future.
The following is a brief legal guide to the main considerations in buying and selling shares of private companies under liquidity cycles.
Liquidity transactions can be structured in the form of a buyback of shares by the company, financed by cash on the balance sheet or cash from equity financing. Alternatively, the transaction can be structured as a direct purchase of shares by a third party, pairing the purchase with the primary equity financing of a company or even as a stand-alone transaction. In a company-sponsored transaction, the company must decide the limits and the shareholders who can sell shares.
As with any securities transaction, it is wise to consult with the company’s legal and tax advisors to ensure that all required approvals are received, determine the appropriate tax, reporting and withholding requirements, and prepare the right documentation. Other important legal considerations must be taken into account, including disclosures made by the seller to the buyer and who knows what at that time. Will transmitter information be disclosed to competitors or will it cause damage if learned by customers? These concerns may be accentuated during a takeover bid by a company or a third party to unitholders. What will be said in a future S-1 file about the transaction? What will be the impact of the transaction on a company’s prior or subsequent determination of the fair market value of its common stock for the purpose of providing future capital grants (eg, “409A value”)? What capital gains will be declared? How will such a transaction affect the federal share tax-exempt status under Section 1202 of the Internal Revenue Code, commonly referred to as “QSBS Rules”?
As with any transaction involving actions, the parties can be held responsible for disclosing relevant material and non-public information to other parties (or for not disclosing this information!). This is extremely important when salespeople do not have board level details about the business. Whether the business is exposed to liability will depend on its involvement and the relevance of any undisclosed information. Making disclosures to potential buyers can trigger leaks from competitors, customers, suppliers, or other ecosystem players that could be dangerous to the issuer of the stock.
When secondary purchases are made through a “takeover bid,” depending on the number of sellers, the transaction may need to be structured to comply with certain elements of SEC Regulation 14E.
In addition, transactions between the company, its officers and other persons in the three years preceding the IPO must be reported as related party transactions in the IPO filing of the company on Form S-1. A third party purchase not involving the company may need to be disclosed depending on its importance. Some states, including Delaware and California, have statutory balance sheet tests limiting the amount of capital a company can use to buy its shares.
The degree of impact of a transaction on the company’s 409A valuation depends on the terms of the transaction, the identity of the parties, the size of the transaction and the valuation firm’s methods.
A purchase of shares that are priced higher than what the board of directors of the company otherwise considers to be the “fair market value” of the common shares creates the risk that current or former employees or service providers selling shares. shares cannot claim capital gains treatment on 100% of the sale price. Thus, the difference may have to be taxed as regular income, and the business may then have a withholding obligation.
The repurchase of shares by a company can affect whether or not shares held by other shareholders qualify under QSBS for federal income tax. A purchase by a third party will not have this impact, but the purchased shares will not be eligible as QSBS. Therefore, it must be determined whether or not the transaction requires a “Hart-Scott-Rodino” antitrust filing, which involves a lot of effort and high costs.
How do you ensure that your company controls secondary equity trades in the future? It would help if you consider implementing a “right of first refusal” on transfers of shares in your company. Ordinary shares may be subject to a right of first refusal, which offers the possibility of purchasing shares that a shareholder intends to sell to a third party. The right of pre-emption is generally contained in the articles of association of the company, so it automatically applies to all shares issued after the adoption of the articles. This is a useful way to control shareholding as the company or its transferee can spend the necessary funds to buy the shares. Otherwise, the shares can be sold to the proposed buyer.
A private company tends to feel pressure to provide liquidity to its shareholders as its value increases. So whether you decide to engage in a liquidity transaction or allow your shareholders to sell while the company is private, setting your expectations as shareholders both early and clearly can go a long way. Getting the right details will save you legal, accounting, HR, and tax headaches that are immediately preventable.
Originally posted Mar 29, 2021
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.