A secondary transaction is the sale of existing equity interests in a private company by current shareholders — founders, employees, or early investors — to new investors, rather than the issuance of new equity by the company. Secondary sales allow individuals to achieve partial liquidity before a company goes public or is acquired, converting some of their paper wealth into cash without requiring a full exit. As private companies have stayed private longer and employees at successful startups have accumulated large equity values that may take years to convert to cash, secondary transactions have become an important part of the private capital markets ecosystem. Understanding how they work and the legal and tax implications they carry is essential for any founder or employee considering a secondary sale.
Tender Offers vs. Direct Secondary Sales
Secondary transactions are structured in one of two primary ways: as direct sales from an individual seller to a buyer (a bilateral transaction), or as a formal tender offer in which the buyer makes an offer to purchase shares from all eligible shareholders at a specified price. Direct secondary sales involve negotiated transactions between the selling shareholder, the buyer (often a secondary fund, a private equity firm, or a strategic investor), and sometimes the company (which may have consent rights or right of first refusal). Tender offers are typically used when the company or a sponsor wants to enable broader employee liquidity at once, providing a structured mechanism for multiple employees to sell simultaneously.
SEC Rule 14e-1 and the other tender offer regulations apply to tender offers by or for the equity of public companies. Whether these rules apply to tender offers for private company shares is a more complex question that depends on the size of the offering, the number of shareholders, and whether the offer is made on the internet or through other means that could constitute a “general solicitation.” In general, properly structured private company tender offers are not subject to the full public company tender offer rules, but legal counsel should be consulted to ensure compliance with applicable securities laws.
Right of First Refusal and Transfer Restrictions
Most private company shareholder agreements and equity plan documents include transfer restrictions and rights of first refusal (ROFRs) that must be complied with before any secondary sale can occur. A right of first refusal gives the company (and sometimes the existing investors) the right to purchase any shares that a shareholder proposes to sell before those shares can be sold to a third party. The ROFR process typically works as follows: the selling shareholder notifies the company of the proposed sale, including the price and terms offered by the prospective buyer; the company (and any other ROFR holders) have a specified period to exercise the ROFR and purchase the shares on the same terms; if the ROFR is waived or not exercised, the shareholder can complete the sale to the third party.
Transfer restriction provisions often go beyond ROFRs to impose additional conditions on secondary sales: board approval may be required, co-sale rights may allow existing preferred investors to participate in the sale alongside the selling shareholder, and there may be requirements that the buyer be an accredited investor and a “permitted transferee” within the definition in the shareholder agreement. Some shareholder agreements include a right of first offer (ROFO) that requires the selling shareholder to offer the shares to the company or preferred investors before seeking a buyer in the market. Sellers must carefully follow these procedures to avoid a void or voidable transfer.
Securities Law Considerations: Section 12(g) and Rule 701
Secondary transactions can trigger federal securities law issues that companies and selling shareholders must be aware of. Section 12(g) of the Securities Exchange Act of 1934 requires a company to register a class of equity securities if, as of the last day of its fiscal year, the company has more than a threshold number of record holders of that class (generally 2,000 holders, or 500 holders who are not accredited investors) and assets exceeding $10 million. A secondary transaction that results in a company exceeding the Section 12(g) threshold for record holders can trigger an obligation to become a reporting company, with all of the associated costs and disclosure obligations of a public company. Companies that are approaching the Section 12(g) threshold should monitor their shareholder records carefully and may need to impose transfer restrictions or redeem shares to avoid crossing the threshold.
Rule 701 under the Securities Act provides an exemption from securities registration for compensatory equity awards made to employees, directors, and consultants under written compensatory plans. Secondary sales of Rule 701 shares are not themselves Rule 701 transactions (Rule 701 covers only issuances, not resales), and the resale of Rule 701 shares by employees must comply with a separate exemption from the Securities Act’s registration requirements. Employees who want to sell shares in a secondary transaction must ensure that either an exemption from registration is available (most commonly Section 4(a)(7) for sales to institutional investors, or Rule 144A for sales to qualified institutional buyers) or the shares have been registered.
409A Valuation Implications
Section 409A of the Internal Revenue Code governs the tax treatment of nonqualified deferred compensation, and in the private company context its most significant application is to the requirement that stock options granted to employees must have an exercise price equal to or greater than the fair market value of the underlying stock on the grant date. Fair market value for private companies is typically established through an independent 409A valuation performed by a qualified third-party appraiser.
Secondary transactions can affect 409A valuations in important ways. When a secondary sale of common stock occurs at a price higher than the most recent 409A valuation, the secondary transaction price is evidence that the fair market value of the common stock is at least as high as the secondary price. This can force a new 409A valuation at a higher level, which means that any stock options granted after the secondary transaction must have a higher exercise price to comply with Section 409A. Companies that want to continue granting employee options at lower exercise prices should be cautious about secondary transactions that establish a higher price floor for common stock.
Interaction with Primary Financings and Exit Processes
Secondary transactions can interact with planned primary financing rounds and exit processes in important ways. A secondary sale that establishes a high price for the company’s shares can complicate a subsequent primary financing if new investors are unwilling to invest at a valuation consistent with the secondary price. A secondary that reduces the founder’s economic stake below a threshold that investors or strategic partners view as essential for alignment can affect the company’s negotiating position with those partners.
In the context of a planned exit, secondary transactions that occur close in time to an M&A sale or IPO may be scrutinized to determine whether the secondary price reflects market value and whether the transaction was arms-length. If the secondary price is significantly below the eventual exit price, it may raise questions about whether the selling shareholder received fair value and whether appropriate disclosures were made. If the secondary price is significantly above the eventual exit price, it may suggest that the buyer in the secondary transaction was misled about the company’s value. Founders and employees considering secondary sales should be mindful of these timing and valuation considerations and should consult with legal and tax counsel before proceeding.