By Jared Sorin
Building a startup is exciting but can also be a long, uncertain and often exhausting ride. It is certainly not for the faint of heart. Founders put years of their lives into these companies — usually at great personal, financial and professional risk, with little financial reward until a big exit happens or, in much more rare cases, on the creation of liquidity following an IPO.
And, those exits are taking longer than ever. IPOs are rare, acquisitions can take 10-plus years, and, in the meantime, the expenses of everyday life do not hit pause — mortgages, families and other responsibilities keep rolling in, with compensation often below market and benefits delayed until sale or post-IPO, if at all.
Given their risk profile, many, if not most, startups do not succeed at the levels that founders and their investors seek.
With this backdrop, more founders are now looking to “secondary transactions” as a way to get some liquidity during the building phase, before a sale or IPO. A secondary deal typically involves a founder selling some of their personal shares, often timed around a new fundraising round.
It doesn’t — and shouldn’t — mean that they are checking out. Instead, the deal provides founders with an opportunity to unlock a portion of the value they’ve created without having to wait for a public offering or full-blown acquisition, mitigating risk while remaining highly motivated to pursue continued success.
From where I sit as legal counsel to startups, early-stage and emerging growth companies, as well as the investors who support them, I strongly believe that secondaries, when done right, can be a smart and strategic move.
Considering the risks
But founders need to consider the risks of secondary financings as well: There are complicated legal, tax and governance questions that need to be carefully considered.
To start, most founders typically can’t sell their shares whenever they want. The company’s governing documents, stock agreements and/or investor documents often place restrictions on transferring shares, including company and investor rights of first refusal and co-sale rights. Board approval is almost always required, and investor sign-off is usually required as well. These restrictions on selling shares aren’t just red tape — they protect the company’s structure and make sure that everyone’s interests remain aligned.
Then there’s the question of who’s buying the founder shares. Whether it’s a new investor or someone already on the cap table, buyers will usually want to do their due diligence.
Founders need to be careful about the information they share about the company to potential investors: A founder sharing material nonpublic information might create regulatory issues or enhanced competitive and market risk — especially if the company is relying on exemptions under securities laws.
Don’t forget tax considerations
Taxes are another important question. If a founder is selling qualified small business stock or exercising options before a sale, there can be serious tax implications for the seller, buyer and company. Limits under Rule 701 of the Securities Act of 1933, investor thresholds and valuation concerns under IRS Rule 409A can also come into play.
Founders should always, in advance of contemplating a secondary sale, seek advice from both legal and tax advisers. What seems like a straightforward transaction can get complicated quickly.
Beyond the technical requirements/considerations of a secondary sale, it’s critical that entrepreneurs and the company think about how the sale might affect team dynamics, future fundraising and the cap table. If the reasons for the sale are not communicated clearly, it might spook employees or send unintended or improper signals to investors, both current and future. And investors will generally expect to see founders maintaining sufficient holdings to motivate their continued best efforts.
We generally advise founders to time secondary sales around meaningful milestones, such as a major product launch, a successful funding round, or strong business traction. A founder selling 5%-10% of their holdings is usually seen as reasonable, particularly when in connection with other strong business milestones. Anything much higher can start raising eyebrows.
Investors are increasingly receptive to founder secondary sales so long as they trust that the founder still has enough “skin in the game” to remain fully committed for the long haul.
A tool, not a shortcut
In my experience, when structured thoughtfully, secondary sales can strengthen alignment. Founders who can relieve a bit of financial pressure are often in a better place to focus, make smart decisions, and keep building their company. The messaging is that the secondary sale is not about cashing out, but creating some financial breathing room and mitigating risk.
At the end of the day, a secondary sale isn’t a shortcut. It’s a tool. Used the right way, it can help founders manage risk without losing sight of the larger goals. As legal advisers, our role is to help navigate the transactional complexity while ensuring that secondary sales comply with applicable law and the company’s long-term vision stays intact.
Done well, these transactions aren’t just about taking money off the table — they’re about sustainability, a focus on the future. Building something great takes time, sometimes a lot of time, and founders can gain the financial breathing room to stay in the game for the long run.
Jared Sorin is co-practice group leader of Brown Rudnick’s Transactions Practice Group and a co-practice group leader of the firm’s Emerging Growth Companies & Venture Capital group. He advises founders and investors in early-stage tech and life sciences companies on corporate and transactional matters, from formation to exit.
Illustration: Dom Guzman
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