Not every liquidity transaction is a “Tender Offer.” Many private company secondary transactions are one-off, individually negotiated sales of shares by a founder, employee, or early investor to a new or existing investor. These transactions avoid much of the regulatory apparatus discussed in our companion article on Tender Offers, but they are far from unregulated and raise their own legal, tax, and practical considerations for the seller, the buyer, and the company.
Secondary Sales vs. Tender Offers
If a secondary transaction does not meet the definition of a “Tender Offer” (a determination made under the Wellman test discussed in another Catalyst article), the Tender Offer rules – including those mandating minimum disclosures, a minimum offering period, withdrawal rights, and others – will not apply. Instead, the terms of each transaction are negotiated between the buyer and the seller, with the company sitting in the middle as the party whose consent is needed and whose stock records must reflect the transfer.
Documentation and Settlement Mechanics
Secondary sales are typically documented in a secondary stock purchase agreement negotiated between the buyer and the seller. Although such agreements typically follow a similar format, they are usually tailored to the transaction at hand, addressing sale mechanics, representations and warranties, waivers and disclaimers, and any additional rights, and they typically feature company consent, the waiver or expiration of rights of first refusal and co-sale rights, and the allocation of transfer costs and taxes.
Settlement mechanics deserve more attention than they often receive. Because private company shares are not held through a clearing system, closing is a coordinated exercise among the buyer, the seller, and the company (or its cap table administrator), and it can get complicated if the seller must first exercise stock options or convert other securities. In that case, the mechanics must often provide an advance of the exercise price to the seller (whether by the buyer or the company), the company’s processing of the exercise, and the calculation and processing of any associated tax withholdings. The agreement should spell out the sequence of events and the responsibilities of each party clearly; note also that option exercises may take several days to process, so the timeline should be clear and precise.
Securities Law Considerations
Exemption from Registration
As these are still transactions in private company stock, they must be conducted in reliance on a valid exemption from the registration requirements of Section 5 of the Securities Act of 1933 (the “Securities Act”). Because the seller is not the issuer, the question is whether the seller can resell its shares without being deemed an “underwriter.” Two approaches have become the most common over the years:
- The “Section 4(a)(1½)” exemption: Historically the most commonly used exemption, especially prior to the introduction of Section 4(a)(7), this is a product of practice and case law rather than statute. The idea is that a resale by a non-issuer should be exempt under Section 4(a)(1) (which exempts transactions by persons other than issuers, underwriters, and dealers) so long as it is conducted in the manner required of an issuer’s private placement under Section 4(a)(2): generally, a sale to a limited number of sophisticated or accredited purchasers with access to information about the issuer, with no general solicitation and with the purchaser taking the shares for investment. The full list of conditions is longer, and although the Section 4(a)(1½) exemption is typically viewed as a well-trodden path, it requires careful analysis and structuring of each transaction. Note also that there is no statutory safe harbor and no preemption of state blue sky requirements when this exemption is invoked.
- Section 4(a)(7): Added to the Securities Act by the FAST Act in 2015, Section 4(a)(7) effectively codified the Section 4(a)(1½) exemption into the Securities Act, although it introduced a number of additional requirements (including that each purchaser be an accredited investor, that no general solicitation be used, and that the securities have been outstanding for at least 90 days). Notably, where the issuer is not a reporting company, the seller must make available to the purchaser prescribed information about the issuer, including a description of its business, the names of its officers and directors, and its most recent balance sheet and two years of income statements. Securities sold under Section 4(a)(7) are “covered securities” exempt from state registration requirements, although they remain restricted securities in the buyer’s hands. Section 4(a)(7) was not intended to invalidate the Section 4(a)(1½) exemption when it was introduced and is typically viewed as a more certain path to an exemption for individual secondary transactions.
There are other exemptions that may be available to sellers, including Rule 144, but these are much less frequently used due to compliance complexity and limited availability in light of the typical structure of such transactions.
Antifraud – Rule 10b-5
Secondary sales are frequently marked by an asymmetry of information between the parties. An employee seller may know the company’s operations but not its financing plans; an investor buyer may sit on the board and know both. Whatever the direction of the asymmetry, Rule 10b-5 still applies to the purchase or sale of any security – public or private – and prohibits material misstatements and omissions in connection with the transaction. Insiders who trade with less-informed counterparties while in possession of material nonpublic information face real exposure, as does a company that facilitates such a trade. Parties commonly manage this risk through “big boy” letters and non-reliance provisions, in which each side acknowledges that the other may possess undisclosed material information. These provisions help but are not a complete defense, as their enforceability often turns on the facts and circumstances and their specific wording. As with Tender Offers, any information material to an investment decision should be disclosed to both parties before they commit to the transaction (including by the company, even though it is not a direct party to the transaction).
Corporate Law Considerations
Transfer Restrictions and Protective Provisions
Many VC-backed companies restrict transfers of their shares to third parties. These restrictions typically include a right of first refusal in favor of the company and major investors, co-sale rights, a board consent requirement, and – especially for preferred stock – protective provisions requiring the approval of a majority of the preferred holders for specified actions. Each must be reviewed, waived, or complied with before closing. Protective provisions are easy to overlook: a transfer of shares, a repurchase, or other distribution by the company on account of its stock, or a sale large enough to change the outcome of a class vote may require consents beyond the board. Larger sales should also be checked against “Deemed Liquidation Event” definitions and interested party transaction rules.
Capital Impairment and Distribution Requirements
Where the company itself is the buyer, the transaction is a repurchase and is subject to statutory limits on distributions. Under Delaware law, for example, a corporation may not repurchase its shares when its capital is impaired or when the repurchase would cause impairment, and directors who approve an unlawful repurchase face personal liability. Debt agreements and preferred stock terms frequently add restrictions on repurchases and restricted payments. A company repurchase should therefore be supported by a board determination of available surplus and reviewed against all contractual covenants and protective provisions.
Using the Company’s Consent as Leverage
Because the company’s consent is almost always required, a secondary sale is an opportunity for the company to tidy up its relationships with both the incoming buyer and the departing seller. Companies regularly condition consent on the following:
- Additional obligations on the buyer, including:
- A joinder to the company’s voting, right of first refusal and co-sale, and drag-along agreements, often without the information or registration rights afforded to lead investors.
- A market standoff or lock-up agreement in anticipation of an IPO.
- Confidentiality obligations and limitations on further transfers of the shares, including to competitors.
- Releases and confirmations from the seller, including:
- A general release of claims against the company.
- Confirmation of the seller’s remaining equity, if any.
- Reaffirmation of confidentiality, invention assignment, and other continuing obligations, particularly for current and former employee sellers.
Tax Considerations
Tax consequences to both the seller and the buyer deserve special attention and are too often addressed only after the price has been agreed. For the seller, the central questions are whether the gain is capital or ordinary, whether the holding period qualifies for long-term treatment, and whether the shares are qualified small business stock eligible for the Section 1202 exclusion (i.e., QSBS). Employee sellers face additional issues: a purchase price above the company’s most recent 409A valuation may be treated in part as compensation; shares acquired on exercise of incentive stock options may suffer a disqualifying disposition; and so on. Both sides should understand these issues before the price is set, and structuring matters. Parties also often negotiate separate tax obligations and indemnities directly into the agreement.
Secondary sales offer flexibility that Tender Offers do not, but that flexibility comes with the burden of getting each transaction right individually. While that burden is real, it also carries a benefit: the parties can be more thoughtful about structuring, and the company can control timing and negotiate for terms that benefit it.
