Liquidity for Start Up Employees – Secondary Market Sales
In Part I if this discussion we looked at liquidity options that a company may provide for employees with illiquid stock. Namely, tender offers and stock buybacks. In Part II we’ll discuss one option that the employee can take to gain liquidity – selling on the secondary market. In Part III we’ll look at the other way an employee can get liquidity – loans against the stock. Loans and sales are often used in a hybrid approach, which we will also discuss in Part III.
Because a private company’s stock, by definition, does not sell on a public exchange, employees cannot simply sell shares through their ETrade account when they want liquidity. Employees may, however, still have an opportunity to sell their stock on what is commonly referred to as the secondary market. Technically a “secondary market” is a market one in which the original owners of a security can sell to others. This does not differentiate between private or public markets. The New York Stock Exchange, for example, is a secondary market. However, for start-up investors it has a different meaning. In more common parlance, when we refer to the secondary market we refer to those markets for illiquid assets whereby an original owner of a security can sell to a third party.
In order to sell an illiquid stock to a third party several things must happen. First, you must own the stock. Second, you must find someone willing to buy the stock. Third you must be able to transfer these shares of stock to the buyer. Let’s look at each of these in turn.
You must own the shares
An employee cannot sell or transfer an option to buy shares to another party. Nor can they sell or transfer shares that are not yet vested. Therefore, if the value you hold is all in stock options or unvested restricted stock, you cannot sell these rights. For unvested stock, you simply must wait for them to vest. With stock options, you have the ability to exercise options (buy shares at the price that was stated at grant) and then sell the shares. In other words, if the fair market value of a stock is $20, and I have the option to buy 1,000 shares at $1, I cannot sell that option to another party and receive $19 per share. I must buy the shares myself for $1, then sell the stock I now own to the other party for $20. This is an important nuance because essentially it means that you will not get long term capital gains treatment on this sale, even if you’ve owned the option for more than 1 year, because you cannot sell the option. For more information check out our blog for discussions on taxes and options.
You must find someone willing to buy the stock
Since shares cannot be easily sold on an exchange, a seller must somehow find a buyer. This is a very inefficient process because, while there may be a market for the stock (i.e. people willing to buy) each buyer will have their own price they are willing to pay. A seller would be wise to shop the stock to several buyers to obtain the highest price. Sometimes a company will recommend a buyer they’ve worked with, especially to executives, but often it’s completely up the employee to find a buyer. Companies such as Forge, SharesPost, EquityZen, and MicroVentures allow people to put up large blocks of stock for sale and gives buyers an opportunity to purchase smaller amounts. These sites are curated and use analysts to help set a sales price.
Large shareholders may prefer to sell to a third party directly (such as a private equity fund) or through a specialized broker who works with large private buyers (such as sovereign funds, family offices, etc.). For large sales the company will want to control who is purchasing the stock, because the buyer could become a major stakeholder, so working with the company is important.
You must be able to transfer these shares to the buyer
To sell a security the seller must have a mechanism for transferring ownership after payment is received. The first major hurdle, and one that must be investigated before even contemplating a transaction, is the employee agreement. Most employee agreements explicitly state that an employee cannot sell shares in a secondary market transaction. When that is the case, you must get approval from the company first in order to sell shares. You may want an attorney to review your employment agreement to determine if you are able to sell without company approval. If you do need company approval, you may want an attorney who can negotiate on your behalf. There are few firms that specialize in employee stock agreements where they are representing the employee instead of the employer. One of our favorites is Mary Russell: http://stockoptioncounsel.com/blog
The next major hurdle is the process of working with the company to transfer the shares. This is not a do-it-yourself type of transaction. Attorneys and finance professionals must be involved to manage the contracts and transfer the shares. It is a big project for the employer and one major reason they’ve written clauses into employment agreements prohibiting transactions. It’s valuable to use a professional that can make the process as smooth as possible for the employer and an employee would be wise to choose a broker with a reputation as being easy to work with.
WRP can help clients by analyzing and planning for a sale, determining the tax implications of a sale, and providing access to resources such as specialized attorneys and secondary market brokers.
In Part III of this series, we’ll look at another opportunity for gaining liquidity, non-recourse loans.