What is a secondary stock purchase transaction?

A secondary stock purchase transaction (often casually referred to as a “secondary”) is a transaction where existing shareholders of a company, such as founders, early employees, or other investors, sell their shares of stock to new or existing investors. This transaction typically occurs alongside a financing round where the company issues preferred stock to raise new capital. As many start-ups wait longer and longer to go public, secondaries can play an important role in providing liquidity for founders and early employees.

Key Considerations in a Secondary Stock Purchase Transaction:

1. Deal Structures: The way a secondary stock purchase is structured can significantly impact the stakeholders involved. Below are examples of three financing structures involving secondaries. In each case, an investor spends $40 million to acquire stock in AcmeCo, a fictional technology start-up.
   1. Structure A: AcmeCo raises $40 million by selling new preferred stock to an investor and then uses $15 million of the proceeds to repurchase common stock from existing shareholders. This approach is often favored by investors as it allows the investor to secure a $40 million preferred position. However, founders and other common shareholders should be cautious, as this structure can lead to a situation where they receive less in a liquidation scenario.
   2. Structure B: The investor purchases $15 million of AcmeCo common stock directly from selling stockholders while also purchasing $25 million in primary preferred stock. This structure is generally more favorable for the company and existing common shareholders because it minimizes the creation of new liquidation preferences. This allows the company to attract investment without overly burdening existing shareholders with potential payout disparities in the event of a liquidation.
   3. Structure C: In this scenario, the investor buys $15 million in common stock from selling stockholders and $25 million in primary preferred stock directly from AcmeCo, with an option for the investor to exchange the common stock for preferred stock later. This structure can help mitigate tax implications for selling shareholders, as it may allow long-term capital gains treatment. However, it may introduce complexities regarding the timing of the exchange and the valuation of shares at the time of conversion. Like Structure A, this structure ultimately results in $40 million of new liquidation preference after the $15 million of purchased common stock converts.
2. Liquidation Preference: Liquidation preferences are critical considerations in any preferred stock financing. When preferred stock is issued, it often includes terms that dictate how proceeds from a liquidation event are distributed. If a secondary transaction creates a significant liquidation preference (as seen in Structures A and C above), it can adversely affect common shareholders. For example, if a company sells for $50 million, preferred shareholders with a $40 million liquidation preference will receive their payout before common shareholders see any returns, leaving $10 million or less to be split among founders and other common shareholders. Understanding these dynamics is crucial for entrepreneurs, as they can influence future fundraising and exit strategies.
3. Compensation Tax Implications for Employee Shareholders: The tax treatment of sales in secondary transactions can vary widely based on their structure:
   1. Structure A may create a situation where founders sell their common stock above the 409A valuation (e.g., $15 per share sold with a 409A valuation of $7). The difference ($8) could be taxed as ordinary income, leading to a significant tax burden, including potential W-2 withholdings. This can be a deterrent for founders contemplating a sale, as it diminishes the net proceeds from the transaction.
   2. In Structure B, the entire transaction could potentially be treated as long-term capital gains if structured appropriately, providing a more favorable tax outcome. The key factor is whether the purchaser is considered a “new” investor or an existing one, as this can affect the capital gains treatment.
4. Qualified Small Business Stock (QSBS): QSBS provides significant tax benefits to founders and investors if certain conditions are met, including holding the stock for at least five years and meeting specific gross asset tests. However, secondary transactions can jeopardize QSBS eligibility. For instance, if the company redeems more than 5 percent of its stock during a two-year period (as happens in Structure A above), it may taint the QSBS status for future investors. Entrepreneurs must be mindful of these thresholds to ensure they do not inadvertently sacrifice valuable tax benefits for themselves and their investors.
   
   Delayed Sale Options: Delaying the sale of shares can be a strategic move for founders wishing to take advantage of QSBS tax benefits. By holding shares for three to five years (depending on the date the stock was initially issued), founders could qualify for the 0 percent capital gains tax rate on up to the first $15 million of gain (subject to certain limitations). This strategy requires careful planning and negotiation, often involving terms that allow for the secondary sale to occur after the QSBS holding period. Such terms should be clearly defined in the transaction documents to avoid complications later.
   
   An example of a delayed sale structure might involve a loan from an investor to the founders, secured by the shares based on their 409A valuation. This loan could be structured to convert into a sale option after the five-year period, allowing founders to benefit from favorable tax treatment while providing the investor with a potential upside.
5. Professional Guidance: Given the complexities and potential implications of secondary stock purchase transactions, it is essential for entrepreneurs to seek counsel from legal and tax professionals before engaging in a secondary stock sale. These specialists can provide insights into the nuances of different deal structures, tax implications, and compliance issues. Additionally, consulting with auditors is crucial to understand any withholding tax obligations that may arise, especially in transactions where the sale is treated as compensation.

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