Five years ago, finding buyers for the shares of a private startup was basically impossible. Now electronic platforms and an entire cottage industry of buyers have emerged, but what are the risks and benefits of founder liquidity? In this article, we tackle some of the thorny issues you should consider before selling pre-IPO shares.
My experience concerning this matter comes from working in VC as well as personally advising countless entrepreneurs about liquidity options, strategies and risks. I also started a fund called Stockbridge Equity Partners that bought common shares from founders. The fund returned capital 1 year after we started it and has been very successful. Capshare is in the business of managing private stock, so it seems like we talk to a client every week about questions and issues related to early liquidity.
Why Sell in the First Place?
This first question may seem obvious, but why should you consider selling shares in the first place? After all, you are in the game for equity, right? It seems strange to sell what is perhaps your most important asset before it has fully matured.
First, you should realize that you have the option to sell only a portion of your stock. You could sell 5% now and retain 95% of your upside. By selling a portion of your equity early, you are reducing your risk profile. You are converting an asset of uncertain and unusable value (your private shares) into something of clear and fungible value (cash).
Many entrepreneurs prematurely dismiss the idea of selling early. They (often) rightly feel that they are in the game for the long haul and dismiss those who seek to sell-out early. Although this position makes sense, it misses several key points:
- A seller may have an urgent liquidity need
- A huge portion of a seller’s net worth may be concentrated in one basket
- A seller may no longer believe strongly in the upside of the company
- A seller may believe in the upside but want to protect against downside
- A seller may be a better entrepreneur (more focused, less stressed) with a little more cash in the bank
- Without early liquidity, a seller could easily hold illiquid paper value for 6-10 years (the current average period from start to exit for successful startups)
Most entrepreneurs that want to sell have some kind of an immediate liquidity need, but in many ways, that is the worst time to sell–i.e., when you are most desperate.
Also, until recently, founder liquidity was almost impossible because investors and board members would block it.
Let’s review the history of founder liquidity before we dive into suggestions for making the process work better at your company.
A Brief History of Early Liquidity
Until the early 2000s, most VCs adamantly opposed entrepreneurs taking early liquidity. Some VCs even took offense at the request. They felt that “selling out early” sent a number of negative signals from founders: 1) they didn’t really believe in their company; 2) they wanted “better” liquidity options than their investors; and 3) they didn’t want to put “skin in the game.”
In recent years, however, the prospects for early liquidity have dramatically changed. This shift has been driven by a number of factors:
- Favorable market dynamics
- Increasing entrepreneurial awareness and negotiating leverage
- The emergence of more efficient secondary markets
- Changes in investor attitudes
Recent examples of high-profile founder liquidity deals include the following:
- Robinhood’s two co-founders took money off the table in September of 2014 as part of their $17M first major financing round, before the company had released its product.
- The two co-founders of Snapchat took $10M of founder liquidity as part of their $80M Series B round.
- The CEO of Buffer sold $2.5M worth of his shares in his Series A round of $3.5M.
- The co-founders of Secret sold $6M worth of shares in an early round (though the company subsequently folded).
After the Secret deal blew-up, Bill Maris, the well-known Google Ventures investor in the company, compared the secondary deal to a bank heist. He even requested that the founders return the buy-out money. Later, he said that his views had evolved and that he didn’t think the founders acted unethically. However, Maris did state that his firm is “not excited” about founders that sell in the early days of their company’s existence.
While attitudes will likely shift with the tides of entrepreneurial market conditions, most industry commentators believe that the long-term trend is moving towards increased founder liquidity.
Based on our experience at Capshare, we have seen the most significant changes in the three areas described below.
Signaling Lack of Confidence
In the past investors believed that early stock sales from founders signaled a lack of internal confidence in the company. Now founder selling can be a non-controversial part of a successful startup experience for all involved. However, it does require careful advance planning and discussions with key stakeholders (like other founders and investors).
As evidence of this shift, just read some of the recent commentary from investors and other influential figures in the startup world, including Founders’ Fund, Fred Wilson at Union Square Ventures, Hunter Walk at Homebrew, Andre Gharakanian at Silicon Legal and Jeremy Liew at Lightspeed Ventures.
Founders Shouldn’t Have Better Liquidity Options Than Investors
Investors used to insist that founders could not have better liquidity options than they did. In reality, it has become clear that investors always have had better liquidity options than founders. The preferred stock that most investors purchase has many more features that make the stock vastly more sellable than most founder (or common) stock. With perks like information rights, liquidation preferences, rights of co-sales and so forth, preferred stockholders definitely have a more marketable security.
Investors may rightly feel that they should get liquidity when the founder does, but because most term sheets include a Right of Co-Sale clause, many if not most investors actually can sell right along with the founder.
But the truth is that most investors don’t want to sell. For a number of reasons, they would prefer to see their investments through to an exit.
Founders Will Work Harder If They Don’t Have Liquidity
For many years, investors have believed that founders will work much harder if they stay hungry. But recent studies seem to disprove this belief.
Research involving Norwegian entrepreneurs shows that the relationship between entrepreneurial success and the starting wealth of the entrepreneur follows a curve. The graph below suggests that as an entrepreneur becomes more wealthy, the likelihood of success increases.
Image credit: voxeu.org
This graph compares wealth percentiles of Norwegian entrepreneurs to the ultimate profitability of the startups they create. Ignoring the bottom 2%, it shows that there is a positive relationship between profitability (the metric used for startup success) and the entrepreneur’s wealth until you reach the wealthiest 25%. At that point, the wealthier the entrepreneurs get, their likelihood of success decreases.
So according to the graph, your best bet is an entrepreneur in the 75th percentile. Richer and poorer entrepreneurs fare worse. But remember, even entrepreneurs ranging from the 10th to the 95th percentile still fare quite well in terms of probability of success. It is really just the extreme top and bottom ends that seem to perform poorly.
So a lot has changed in our understanding of the good and bad of early liquidity. With that history as a backdrop, here are our biggest suggestions for making founder liquidity work within your company.
Tip #1: Only Sell When Your Company Has Achieved a Significant Level of Success
As discussed in the Secret deal above, the most important tip we can give you if you value your relationships with your co-founders, employees, and investors is to limit your selling activity until the company has already achieved significant success.
Defining “significant success” is probably beyond the scope of this post because it can be somewhat subjective. However, here are a few ideas:
- Your company has achieved a large amount of revenues and is still growing rapidly ($5M+ in annual sales)
- Your company has achieved profitability on a reasonably large amount of revenues ($2-5M annually)
- Your fundraising process is fast and easy with a high valuation (relative to the market and to your last round), and you could easily oversubscribe the round
Tip #2: Talk to Key Stakeholders in Advance (Especially Investors!)
Your co-founders and investors might resent you for asking for liquidity if they are not given the same opportunity. Further, they might think that you no longer believe in the company.
It is easier to avoid these concerns if you bring up your desires for liquidity well in advance. Few entrepreneurs have perfect foresight, but you should give as much notice as possible.
Most companies and their investors have a Right of First Refusal, which means that you will likely have to give your company and its investors the right to buy your shares before you can sell them to somebody else.
Sometimes investors will also have a Right of Co-Sale. This means that if a buyer wants to buy $250,000 worth of your shares, the investors in the company can force you to swap some of your shares for theirs as part of the $250,000 deal.
Again, communication with the company, other founders, board members, and investors is crucial.
You may also want to consider issuing liquidity-friendly stock to your founders from the get go. Liquidity-friendly stock (like the Founders’ Fund Series FF) is a type of founder-friendly stock that is designed to make liquidity easy without harming the company’s other shareholders (selling your Series FF stock will NOT increase the strike price for all the options issued to employees going forward).
Tip #3: Carefully Consider the Percentage You Want to Sell
You should carefully consider the percentage you wish to sell. After all, you could be selling the most valuable asset you own. Here are few additional factors to consider.
If you are leaving the company, the company stakeholders generally won’t mind you selling all or most of your holdings. However, they will want to get to know the buyer(s) and make sure that they approve of the incoming shareholder(s) (see Tip #6 below).
If you are staying at the company, selling too much of your stock could be a bad signal to current and prospective investors, your co-founders, and your employees. You should balance the benefit of liquidity against the risk of signalling a lack of belief in the upside of the company.
Beyond that, you should model out the likely value of your stock in the future and the value you can sell it for now. You want to make sure that you are comfortable giving up any future returns.
Tip #4: Consider Tax Implications
Taxation of stock is complicated. If you sell stock or options too early, you may get hit with a big tax bill. Be careful that your tax obligations don’t offset most of your gains, and make sure the timing and structure of the sale are optimized for the most favorable tax treatment.
We have seen entrepreneurs get excited about finding liquidity only to realize that their after-tax return is very small compared to the upside they just lost. The mechanics of tax treatment are well beyond the scope of this article, but you can learn more by reading up on various tax strategies and consequences.
Tip #5: Learn from Investment Bankers–Run a Process
Your equity is the key to getting significant monetary upside from your startup. You wouldn’t sell your your house without advertising it to multiple buyers, but you would be surprised how few entrepreneurs try to create competition for their shares.
Most entrepreneurs do not want to rock the boat or burn any bridges, so they often sell their shares back to the company or its investors. Company insiders often discourage founders from reaching out to any other potential buyers in these situations for several reasons:
- Often they have a Right of First Refusal (as discussed above) making it likely that you will ultimately sell to them even if you do get other bidders on your shares
- They may want to get a bargain on your shares, so they don’t actively encourage you to shop them around
- Marketing your shares to other potential buyers often requires sharing private information about your company to third parties
So should you just sell your shares back to the company or investors? Ultimately, this decision is up to you, but you are unlikely to maximize the value you receive for your shares without soliciting some competitive bids.
Given the expanded market for private shares, there’s probably few reasons not to get competitive bids. There are a number of options to consider. Knowing how to evaluate these options would require a much longer discussion, but here is a list of potential buyers:
- The company itself
- Board members
- All investors including angel investors
- Private share market makers including SharesPost, SecondMarket, EquityZen, or Equidate
- Secondary direct funds (you can also contact us here at Capshare to discuss working with partners in our network)
- Outside venture funds or venture fund partners interested in your company
- Other accredited investors that you know personally
This should help you build out a pretty robust set of potential buyers. Arming yourself with multiple bids can help you maximize the value of your shares.
Tip #6: Help the Company Select and Manage Its New Shareholder(s) Carefully
Finally, selling some of your shares will bring new shareholders onto the cap table. If you aren’t selling all of your shares, you are financially motivated to make sure the company operates smoothly moving forward. However, if you do sell your entire stake, the remaining shareholders will likely have opinions about who you decide to sell to.
You also need to consider the overall cap table. In the run-up to Facebook’s IPO, secondary share selling raised concern from the SEC that the company had exceeded the number of shareholders allowed for a private company. This nearly forced Facebook to prematurely go public. The SEC was also concerned about the potential for fraud.
If you want your company to support liquidity programs, and if you want your company to remain in good standing with the SEC, you should consider using a cap table management software solution like Capshare. This can help your company keep track of all of its shareholders no matter how many times shares change hands.
Obtaining early liquidity for entrepreneurs and founders has become much more feasible and acceptable over the last 5-10 years. However, plenty of risks persist. If you address these risks carefully and early in the process, you may be able to decrease your personal stress and risk profile. This can reduce the financial pressure that many founders face and provide a little breathing room as you help your company progress toward an exit.
At Capshare, we’re anxious to help fellow entrepreneurs as they make their journey. Feel free to reach out any time, and hit up @capshare on Twitter if you ever have questions.