This Week in Startups - Understanding Secondary Market Transactions with Becki DeGraw | Wilson Sonsini Startup Legal Basics

Episode Date: July 13, 2023

Today’s show: Wilson Sonsini Partner Becki DeGraw joins Jason to kick off another series of Startup Legal Basics! In this episode, they break down secondary market transactions, including the evolution of secondaries (00:50), trends in the industry (3:16), critical aspects of Qualified Small Business (QSBS) stock(20:06), and much more! * Time stamps: (00:00) Wilson Sonsini Partner Becki DeGraw joins Jason (00:50) The increased use of secondary markets (3:16) How companies staying private longer influenced the rise in secondaries (4:25) Determining how much founders should be allowed to sell (6:21) Spending more than a company is worth (9:26) The Pari-Passu concept explained and how it applies to early investors, founders, and employees (10:38) Who gets to sell pre-IPO (12:44) Off the cap table transactions and hypothetical scenarios (18:26) Tender offers and the NASDAQ secondary market (20:06) The critical aspects of qualified small business (QSBS) stock * Check Out Wilson Sonsini: https://www.wsgr.com/en/ * Read LAUNCH Fund 4 Deal Memo: https://www.launch.co/four Apply for Funding: https://www.launch.co/apply Buy ANGEL: https://www.angelthebook.com Great recent interviews: Steve Huffman, Brian Chesky, Aaron Levie, Sophia Amoruso, Reid Hoffman, Frank Slootman, Billy McFarland, PrayingForExits, Jenny Lefcourt Check out Jason’s suite of newsletters: https://substack.com/@calacanis * Follow Jason: Twitter: https://twitter.com/jason Instagram: https://www.instagram.com/jason LinkedIn: https://www.linkedin.com/in/jasoncalacanis * Follow TWiST: Substack: https://twistartups.substack.com Twitter: https://twitter.com/TWiStartups YouTube: https://www.youtube.com/thisweekin * Subscribe to the Founder University Podcast: https://www.founder.university/podcast

All right, everybody, welcome back to startup legal basics with my attorney, Becky DeGra, from Wilson Sincini. Welcome back to the program, Becky. Hi, how are you? Good to be here. I am great. It's great to have you back. You and I do this every year or two. We look at all the topics.

That founder's face, capital allocators face, and we just try to have a really thoughtful discussion about them. All of these live at this week in startups.com slash basics, this week in startups.com slash basics. Or you can just search startup legal basics playlist on YouTube. You'll find it immediately. Over the past few weeks, you've heard us cover a lot of topics that are important right now in the year 20203, going into 2024, down rounds, repricing options, and just generally the trends of 2023. One thing that's new in our industry, Becky, is the concept of founders being able to sell in secondary. Let's dive into this because when I started in the industry, VCs had the position 20 years ago that secondaries were evil and that you wanted a hungry founder. You wanted like a really hungry wolf pack that was going for the IPO and they had nothing but suffering and pain until that point in time.

But something changed along the way. So maybe you can give us an overview of what changed and, you know, how often these are occurring and some of the best practices. Yeah, absolutely happy to. So I think you're absolutely right. You know, you go back 20 years and these were rare, rare, rare. You know, if we go back five years, maybe I'll call, you know, that period kind of the new normal. And, you know, during that time, secondaries were largely reserved for later stage companies and were usually done at a discount. You know, anywhere from maybe 10 to 25 percent of whatever the last preferred stock round was.

But beginning in the second half of 2020, there was, as we all, experienced, this bit of a funding frenzy that really kicked off and gained momentum through early 2022. And during that time, valuation soared, amounts raised sword. Firms became more and more company and founder friendly, including on secondaries. We started seeing secondaries as early as series A. And, you know, 50 to 75 percent of deals. I mean, it just really became almost the norm to have a secondary included. And when they were included, it was almost always at the same price as the preferred stock round.

Maybe you get a little bit of a discount. And then, you know, when last year when things started cooling down, the secondary market did start to, you know, get back to normal, you know, where secondaries certainly aren't happening at the Series A stage right now. And they really are, you know, reserved for the later stage. and part of the reason we're not seeing so many is because the later stage financing market has slowed down. But I think on a percentage basis,

it's still probably back to that normal time period of when we are seeing an up-round, not in connection with a down-round at a later stage. But if we are seen an up-round at a later stage, probably about half of them still have secondaries associated with it. Yeah, and these are done because companies were staying private longer. So the stay private longer in Uber, Airbnb,

and Facebook most famously, I think, back in the day, I mean, Facebook kind of got forced to go public at a certain point. They just had so many investors. It was causing some agita with the SEC, I believe, where there's a certain number of people you can have in a private company. But Yuri Milner, very famously,

did a blended deal in Facebook, I believe, where he bought some secondary at a bit of a discount, and then he paid a very high price for the primary shares, the preferred shares in Facebook. And this gave him an ability to outbid other people.

So on the buy side, you can, and this, I think Masayoshi-San did the same thing. He paid a certain amount for preferred shares in Uber, and then he paid some of us with existing shares

and some common shares a slightly different price. And then I guess he netted out, hey, when this thing goes public, it all becomes one class of share anyway. So I'll just blend the price it lets the startup have a higher valuation in the press, and it lets me buy some at a discount that don't have the same rights. So what's the tension between founders and how much

they sell and how much they're allowed to sell typically? Let's take out the crazy highs and the crazy lows we've been through recently and just talk about sort of maybe the steady stay going forward. How much should a founder in the eyes of most investors and boards be allowed to sell percentage-wise, number-wise, and what's the best end, the gold state? end or now. Yeah, I'd say usually 5% or less of their total holdings is where we normally look. Now, as we start looking at later stage companies and the value gets higher and higher, that number, the total percentage that we want a founder to sell gets lower.

Because some part of it, too, right, is about the motivation, the compensation. You don't necessarily want them to sell $20 million worth of stock and are they really going to be motivated to stay with the company and make the company grow to the next biggest thing. So sometimes it is founder specific in that regards. You know, you've got a founder who is always going to, you know, have, you know, work 110%. So maybe, you know, a bigger secondary would be okay. But I would say a good rule of thumb, 5% or less, that decreases as the company gets more mature. And is there a dollar amount you see most frequently?

And does it relate to, you know, any sort of benchwork? marks in the real world? Not really. I think it varies a lot. A lot of times you'll see a million dollars as kind of the minimum, you know, particularly if you're dealing with founders. Yeah. So, you know, there's kind of two different categories.

There's founder liquidity and then employee liquidity for really late stage companies. And, you know, if you're doing like an employee liquidity where you're going to offer it to all of your employees that meet certain eligibility requirements on a per person basis, it's probably going to be a whole lot less than that. But if you're looking at founder liquidity, wouldn't be surprised to see it around a million or higher. Yeah. And the upper bound for me tends to be, you know, three, four, five million. You're starting to get to the point of, well, is this going to be a distraction? And I think, you know, the conversations I hear on the back channel is, hey, enough to buy a house. But maybe not to. Enough to maybe if you're getting a little frisky, you know, buy a Jet Suite card. buy yourself 25 hours of private jet service on a tiny jet if you're into such things,

but maybe not enough to buy the entire $30 million jet. And when we do see, I don't point out any specific companies, but there was a transaction that occurred where somebody sold $200 million for a company that is now worth less than $200 million, is my understanding. And I know some friends who were invested in that, and they just said, are bad. We just got so high on this company. We were so high on this opportunity that people came in. and just bought literally 200 million

from the founder, which is the equivalent of what would have been raised in an IPO in the past, right? Like your IPO and you raised 200 million in the IPO. Here, that money's not going into the company. It's not going to make the enterprise stronger.

And that's really what you have to look at, I think, is how much money is available for the company itself to go in their coffers to be deployed to increase the value of the company? That 200 million, man, that just went right to

a personal bank account. And that's where you have to get concerned as an employee as a board is, you know, should we have this inside the company? Wouldn't that be a better use for these proceeds? Yeah, absolutely. You know, like...

That's a big consideration, you know, when we're looking at these. And anytime we're looking at liquidity transactions, and there's a few different ways that we can structure those, but there's a number of different considerations that come into playing. You're looking at it from the buyer's perspective,

you're looking at it from the seller's perspective, and you're looking at it from the company perspective, and layered on top of that is tax considerations, impact on the company's 490A evaluation, whether that transaction could jeopardize, you know, QSBS, qualified small business stock status for either stock that's been issued in the last 12 months or stock that will be issued in the 12 months going forward. You know, whether there's tender offer rules you have to think about. There's a number of considerations and they all have pros and cons to different players. So trying to find the right fit that is magic for all three players and doesn't cause, you know, adverse tax consequences is always the goal, but they're not always necessarily able to achieve it perfectly for all three parties.

So if the company's raising $100 million, it's at a billion dollar valuation. I'm just picking even numbers here. And $20 million of that is going to go towards secondary. $80 million is going to be primary. It goes into the company. So 20% of the round goes to second. or 2% of the total value of the company, 80% of the round,

or 8% of the total of companies' shares get issued, new shares get issued, and a purchase with that 80 million. There's a concept that comes up, pari passu. Maybe we could explain this and how it relates to early investors

and early employees and the founders. Yeah, absolutely. So if we, if the buyer or investor in that situation buys directly from the employees, they're going to buy common stock. And common stock doesn't have all the bells and whistles that the preferred stock does. It doesn't have a liquidation preference. So sometimes investors will say, I don't want to hold common stock because I want the downside protection that goes along with that liquidation preference. And I want the other bells and whistles that go along with holding a preferred stock.

we will see that sentiment disappear, the closer the company is to an exit transaction. Because the closer that they feel assurance that, okay, the company is going to exit, all of my preferred stock is going to convert to common anyway, and we're all going to get paid out the same thing, no big deal for me to hold that common stock. Yeah. But the earlier it is, the farther away from that point, investors are more hesitant to hold the come and style. And sometimes people will want to have fairness that we all share on equal footing.

So I am the found, the two founders get to sell 5% of their holdings. Shouldn't the angels be able to sell 5%? Shouldn't the early investors? So how does that occur? There have been some bad feelings where, um, the founders got to sell. I won't mention any specific companies, but very famous companies. Founders get to sell IPO happens. IPO tanks.

The employees are holding their shares. Let's just say it was a $10 IPO. Founder sold at, you know, before the IPO at $9 a share or $10 a share because somebody just saw that as way of getting, you know, pre-IPO or, you know, the friends and family round. So they sell at 10. Stock goes down to five, six months later, and the employees didn't get to participate in that. So, you know, talk about those dynamics and how those are avoided or is that just

part of the game here in Silicon Valley? I think it's part of the game in Silicon Valley, but the board of the company does have to make the decision as to who's allowed to participate, how much are they going to participate, even if the company's not involved. And almost always the company is involved in some regard. But even if the company is not involved in the actual purchase itself and there's a true third party purchase going on, the company probably still has to waive its right of first refusal. So there are components where the company can weigh in. And usually in the bigger purchases, the investor is going to go through the company anyways to kind of help structure the transaction. And in that case, right, the company's board has now have to exercise their fiduciary duties

in determining what is in the best interest of the company and the stockholders. And that's where the heart of the discussion is going to go. And depending on who's participating, if it's directors or officers or insiders, you may decide to go out and get a majority of disinterested stockholder vote to kind of help approve the transaction if there are interested parties involved. And we've talked about this on previous issues episodes. This concept of interested parties, like everybody's interested. We're all showing up every day for work.

We're all on the board. We all have white shares. So it's really like, how interested are we and how thoughtful of a process did we do? how many people signed off on this transaction. And the best practice seems to be just being honest with everybody about what's going on and everybody getting a chance to participate. That's what I always tell founders is, hey,

you know, instead of going off on your own and trying to do a tender offer, you met somebody when you were on some trip around the world who wants to buy your shares, some Russian oligarch, or somebody you met in Singapore wants to buy your shares and you create an LLC and you start doing off the cap table transactions. This kind of stuff does occur and it can get people in downstream trouble, yeah? It does.

I think it doesn't happen as often as, you know, like, you only need one of them to happen and then it hits the news and everybody's like, oh, my gosh, this crazy stuff is happening. But they are, I think those types of transactions are more rare. I think that boards generally are at least having the discussions and they, you know, not everybody may agree with where they come out as to what the right group of people are. but I think more often than the discussions are happening. Let's say you were a shareholder in a very promising unicorn company that you were an angel investor in, making up a complete hypothetical here, and you created an LLC for yourself

because the founders of the company said, we're not allowing secondary transactions. You create an LLC, you say, I'm going to pledge my shares in this company here, and then somebody else says, you know what, I'd like to buy 50% of that LLC from you. Is there anything the company can do to stop this kind of stuff when it occurs? Or is it a fairer thing to occur in the world or is it a gray area?

It all depends on the document. So some transfer restrictions are broad enough to where it picks up pledges as well. There's all sorts of different types of contracts where you can sell, you know, an interest but not the shares themselves or the future payout but not the shares themselves. So depending on how broad the transplants. restrictions are and what type of transfer restrictions there are. Usually investor shares have less transfer restrictions than, you know, common stock shares. Exactly. So sometimes there's bylaw, there's transfer restrictions in the bylaws, which just purely say no transfers of any shares preferred or common without board approval period. Do those hold up in Delaware court or

had those ever been challenged to the best of your knowledge? As long as stockholders approve it. So, right? Like if you if you put that type of transfer restriction in place on day one, all the stockholders will be bound by it. Got it. But not a lot of people do that and particularly around preferred stock. Sometimes, you know, as the company started

staying private longer and, you know, the really popular companies and there was, you know, the secondary markets that came out and there was a huge distraction of like, oh my gosh, all these people are selling. And this is just a huge distraction for the company. We want to put restrictions on both the preferred stock and the common stock.

And then you have to sign off on it, though. Exactly. And it's not just getting a majority of the stockholders to approve it at that point. That does approve the bylaws amendment, but it's only going to apply to folks that actually sign the consent. So if you put a new type of transfer restriction in place that is, hey, you can't transfer without board approval in the middle after you are written whole. your shares, then yes, that would not be applicable. Or they could just do with new investors going forward. So, hey, you want to invest. These are the rules.

And I think that's what happened in this hypothetical company was some of us who got in very early had a lot more freedom than people who came in later in a completely hypothetical example. But venture firms have a long history of doing this because I might be an LP interest in a company that invested in Airbnb. Okay, Airbnb is 99% of their returns in this. seed fund, let's call it a $20 million fund that you were lucky enough Becky to own be a 10% LP so you own 2% of it, which means you own 2% of the 99.99% returns that are coming from

that and it's, you know, I don't know, let's make it a billion dollar return. So you've got whatever that is, 20 million and carry coming to you, 2% of it. You could sell your interest in that for that venture firm at a discount for 18 million or something and just clear your position that way. And some known large endowments type entities have done this in the past. Yeah, most likely, right? Again, always got to check the documents that you signed. You know, to see what restrictions are on them.

But that is a very, very common fact pattern is early investors get into these companies. There weren't all those transfer restrictions in place. They didn't sign on later. And yeah, they have the ability to have more freedom to sell and transfer shares or interest in them or interest in. SPVs or funds that they hold the shares.

There might have even been banks that were, in this hypothetical example, banks that would go to these endowments and say, hey, you're a giant endowment. You have X number of shares in this beautiful, you know, promising unicorn that's going to change the world. We'd like to give you liquidity for that now for your endowment. And, you know, we'll have the shares as collateral

and get some amount of the gain. tender offers have started. I remember getting this when Masa did his Uber tender offer. And I can speak to this one because it was very public. You get like a little link from second market. NASDAQ. Private market.

Yeah, that's one. NASDAQ private market. And then it just says, hey, what percentage you want to sell? You put it in a request and then it tells you how much you were able to clear. Maybe you talk a little. bit about how often do those happen through like the NASDAQ secondary product or are they typically just done with, you know, a lawyer emailing people? It depends on how many folks are involved. If you have two or three founders, the company is just going to handle it. You're not

going to go through, you know, the secondary platform. But if you're going to go out and offer it to 100 employees, you're going to want to go through that secondary platform because the administration of it, you're going to pay way too much to have somebody manage. all of those elections. And with the tender offer, there's just additional disclosure that has to happen. So when you log onto that platform, you probably click through it pretty quick. But there's all sorts of disclosure around what the offering is. And it has to stay open for at least 20 business days.

So when you go through that, there is a much more formality disclosure process around it. So they are more costly to execute and more timely to execute than a small, transaction involving three or five people. But more buttoned up and tighter and less errors, hopefully, or any cantankerousness that can occur. QSBS, qualified small business. It becomes an issue, right? You have to hold these shares from five years from the pricing of the share.

Is that my generally correct? From when you acquire the shares. Yeah. So it's a convertible note. Until it converts, you actually don't have the shares or you do or debatable. From a QSBS standpoint, I believe that it starts when the shares are actually issued, but there may be some tacking available. So definitely check with tax folks on that.

But there are a few pieces of QSBS. That's really critical. Like one, it has to be, the stock has to be acquired from the company directly. So if I'm an investor and I buy from an employee, that doesn't count. Like that, those shares are just never going to be QSBS eligible. I have to buy it from the company. So sometimes that's one of the factors that influences how an investor will say, nope, I don't want to do the secondary. But I'll put more money into the primary and then company, you can go and repurchase the shares.

Although, a caveat there, like, if there are significant repurchases and there's a few different tax tests. So, you know, definitely call up, call up the tax folks to have them do the math on it. But if there is a significant repurchase, then that could cause the shares. that were issued in the last 12 months and also the next 12 months to be ineligible to receive QSBS treatment. So on one hand,

the investor who is buying primary says, oh wait, I got to get the stock from the company in order for it to be QSBS, but I'm okay, go ahead and do a repurchase. If the company does that repurchase, it could make all the stock

that that investor just received to be QSBS ineligible. So lots of balancing factors as you're looking at this. Now, if you're looking at a company with more than 50 million in assets, QSBSBS doesn't apply. So in those really big examples that we were talking about, QSPS, the stock isn't eligible for it anyway. So you tend to see more company repurchases then,

just because that piece of the plan. U.SBS is for the land of series A and below. Seed investors, Angel investors, mainly get to benefit from this, yeah? Yeah, and, you know, I mean, that's a really big benefit. If you buy the stock and you hold it for more than five years, which also relates to you generally are acquiring it in those really early days because you've got to hold it for five years before you sell it.

But you can be eligible for a percentage-based exclusion from your federal income taxes. and there's a number of nuances around it, but it definitely talk to your tax advisors, but the exclusion could be up to $10 million. Yeah. So it's very significant. Yeah, you've got to want to really make sure

your attorneys and your tax folks are being thoughtful about this and you're getting statements from your companies and their CFOs that this is QSBS stock. All right, listen, Becky, great job. If you need an attorney, Becky's amazing. Probably doesn't have many slots. but you take on a couple of new startups every year, yeah.

Always, always looking for new companies, so feel free to reach out. What's the ideal, is there like a zone? Because, I mean, listen, you've been out this for a while, and you get to pick your customers, I think, to a certain extent. So is there a zone that's, like, best for you to work with, like right after they raise a Series A or a Seed? Or do you like when it's, they're graduating from YC, or you're just open-minded, generally speaking?

Curious. Open-minded. You know, we really do, just like our companies, We concentrate on the funnel and you need more at the top. And you know, there's not going to be as many series VCD companies. So we love to work with them as early as we can. Sometimes, you know, an idea may be too early in that, hey, like, they can't afford our fees. And we don't really see a path to funding for them.

But generally outside of that, if there's, if there's like, how, this is a really cool idea. let's talk because we have all sorts of deferral programs and ways that we work with startups. We have a lot of automation that we're doing to make it cheaper, faster for us to be able to work with those early stage startups. Deferral programs are great. If you raise funding, you get the bill. If you don't,

we can work on it. Love it. All right. Great job, Becky. And we'll see you all next time on this week and startups. Bye bye.