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Are you a founder looking to take some risk off the table, without a liquidation event in sight? Have you got ample equity and want to cash in on your hard work? If so, it might be time for a secondary sale. A secondary sale is the sale of shares in a company by a shareholder to an investor that can occur as part of a capital raise. If you are a founder, this article will explore some of the key considerations to think about before you perform a secondary sale.
Striking the Balance
When your startup is doing well but a liquidation event is not yet on the horizon, you may want to sell some of your shares. Selling shares has the effect of reducing some risk and can reap the rewards for the growth of your business.
Your Rights
A secondary sale is a great opportunity to attract new investment whilst also profiting off your initial hard work developing your business. To perform a secondary sale, you will need to assess how many shares you are willing to sell, noting how it will impact:
- your ability to control the company as a shareholder;
- any rights that are given to shareholders owning a certain percentage in the company; and
- any rights this may give you to appoint or remove directors in the company.
Other Shareholders’ Rights
When performing a secondary sale, you may also need to discuss this sale with other shareholders in the company. Ensure that you check your shareholders agreement and are aware of the rights of other shareholders in the company before approaching any new investors. These rights may include pre-emptive rights or a right of first refusal. This will require you to offer your shares to the other shareholders before selling them to third parties.
Typically, if you have VCs as shareholders, they will understand that you have worked hard to build your company. Additionally, they may be looking to make some additional profits from your hard work. It is not uncommon for VCs to have ‘anti-dilution rights’. These rights will stop their shareholding from being diluted by a further raise. Be careful about how selling your shares may impact the cap table and whether this may trigger any rights of other shareholders to top up under anti-dilution provisions.
Keep an eye out for the following provisions in your shareholders agreement concerning other shareholders rights:
- pre-emptive rights;
- anti-dilution rights; and
- drag and tag along provisions.
Timing and Consideration
The timing of a secondary sale is extremely important. It dictates how the business is valued and reallocates risk between the old and new parties.
With a secondary sale, there are some essential considerations before approaching new investors. These are listed below.
| The Class of Shares | Consider the class of shares being sold versus the class of shares being issued. If you are issuing preference shares to investors, but you (as the founder) are selling ordinary shares, you may consider converting the shares into preference shares or adjusting the price. |
| Pre-Emptive Rights | Consider whether your existing shareholders have pre-emptive rights on the sale of shares. If these rights exist, you must comply with them or have your shareholders waive the right. |
| Restrictions in Place | Founders may be subject to restrictions on selling their shares, such as vesting or co-sale rights for the investor. |
| Tag Along Rights | Consider whether the sale will trigger tag along rights. This is the case if you are selling a significant proportion of shares, and other shareholders have a right to tag along with the sale. |
| Tax Consequences | What are the tax consequences of the sale? |
After considering these key points, it is now time to prepare the critical legal documents for approaching investors.
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Key Documents
Term Sheet
When looking for investment in your company, a term sheet is necessary to provide important information to investors about the term of their investment:
| Investment and Valuation | The term sheet will need to set out how much the investor will need to invest. It should also detail whether there is an option to raise more and the pre-money valuation of the business. |
| Liquidation Preferences | Investors may want to have a liquidation preference. Hence, consider whether this is something you are willing to give them and what impact this may have on your business if it experiences difficulties. |
| Anti-Dilution | What anti-dilution rights will you offer to investors (if any)? If possible, you want to avoid offering anti-dilution rights to investors, so all shareholders are diluted (pro rata) when the company issues additional shares. Be aware that early-stage VC investors will generally require broad-based weighted average anti-dilution rights. |
Shareholders Agreement
Ensure you review your shareholders agreement before making a secondary sale. What does the agreement outline regarding the process for issuing new shares and transferring shares? Do any shareholders have additional rights under the shareholders agreement?
Your company might not have a shareholders agreement. In this case, it is best practice to prepare this document before performing a secondary sale. Ultimately, the agreement will govern the relationship between you (as the founder) and the investors. If there are certain protections you want to include in the shareholders agreement, you can include the key terms in the term sheet.
Subscription Agreement
You will need to formalise the terms of investment with specific investors. A subscription agreement will set out the terms of this investment and provide the necessary clarity for you and the investors. A subscription agreement will include:
- how many shares your company is issuing;
- the subscription price for those shares;
- when your company will issue the shares;
- any conditions to completion of the subscription (including entry into the sale agreement concerning the secondary sale); and
- any company and founder warranties.
Share Sale Agreement
When completing the issue of new shares to investors, you will need to sell the shares you hold as part of the secondary sale. This ensures that investors receive all of the shares that they are paying for at the same time. The shares include new shares that the company is issuing or existing shares that shareholders are transferring. A share sale agreement will include:
- how many shares are being sold;
- the price payable for those shares;
- any conditions to completion. For example, you may need to convert the shares into a different class before the sale. This conversion ensures that the investor ends up with the same class as they are receiving under the capital raise;
- when the transfer completes; and
- any warranties given by the selling shareholders. These should align with the warranties provided in the subscription agreement.
Key Takeaways
Before deciding to carry out a secondary sale, you should consider:
- timing: is now the right time to raise capital and sell some of your shares at the same time as part of a secondary sale?
- terms: on what terms are you willing to raise capital and sell existing shares?
- preparation: have I prepared all the necessary legal documents, so when it is time for an investor to invest, it will be a seamless process?
If you need assistance with a secondary sale, contact LegalVision’s sale of business lawyers on 1300 544 755 or fill out the form on this page.
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