A Founder's Guide to Secondaries

In our recent post, The State of VC, we deemed secondaries an “ecosystem savior.” We discussed the broader liquidity challenges in VC and the drop in M&A/IPO activity as well as the dynamic of startups staying private longer (catalysts for secondaries).

Sharing an excerpt here (be sure to review the full post if you have time) :

“With the target ARR required to achieve an IPO growing from $80m in 2008 to ~$250m today, secondaries will become a permanent fixture in venture capital markets. It’s not just a temporary anomaly, but a structural evolution in how venture capital will function and ultimately evolve to look a bit more like private equity.” - Thomas Tunguz

For the record, VC-specific secondary dry powder has more than doubled since 2022! Founders should view secondaries amicably (it does not mean an investor wants out of the cap table due to a lack of belief in the future of the business). It’s a GP’s fiduciary duty to their LPs. It’s also a great opportunity for founders if they sell responsibly (more below).

In the context of CPG companies specifically, pressure to ‘get profitable earlier’ (unlike AI companies) has enhanced the average capital efficiency quality of Series A+ businesses. They need less primary capital to get to the finish line because they are more focused on margin fundamentals up front (at least they should be unless they are amazing at raising capital). As a result, I am already seeing mid stage/growth equity funds making secondaries an even bigger part of their deployment strategies - it will be the only way the best growth-stage founders accept capital (and the only way for big consumer growth funds to deploy enough capital).”

Secondaries: A Founder-Friendly Guide

Today, we’ll take a step back and return to the topic of secondaries and explain the basics. “Secondary” has become a buzzword among founders and investors — especially around the holidays when “going back for seconds” means something very different. But in the venture world, what is a secondary, how does it work, and why does it show up in term sheets?

This overview breaks down the most common types of secondary transactions, how they create liquidity, how they reshape the cap table, and how they affect deal terms.

Topics in today’s post:

1. What is a Secondary?

2. Flavors of Secondaries

3. Tender Offers

4. Secondary Pricing

5. Exchanging Common for Preferred

6. Tax Considerations

7. The Psychology of Secondaries

If you enjoyed this article, feel free to view recent prior articles:

• Standing Out Pre-Traction

• The State of VC

• Corporate Governance 101: Part 2

• Corporate Governance 101: Part 1

• Anti-Dilution Provisions

Ongoing Term Glossary

Anti-Dilution Rights: offer investors protection against dilution in unfavorable financing rounds. This term is usually not contentious from a negotiation perspective between founder and investor - in fact, studies have founds that 92-95% of preferred stock financings include some form of anti-dilution protection.

Authorized shares: the MAX number of shares of each class a company can issue without further shareholder approval.

Automatic Conversion: in the context of convertible notes (or SAFEs), a clause that triggers a convertible note to automatically convert into equity at maturity.

Board of directors: a group of individuals that represent sharesholders in major corporate decisions. A critical responsibility is the oversight of management - simply, the ability to fire of hire the CEO. Other board activities include assesing company performance, providing strategic guidance, developing corporate policy, approving budgets, options plans, mergers/IPOs, and fundraising.

Bridge Financing: when investors agree to provide temporary financing to secure a company’s cash balance before the company raises their next priced round - aka the bridge that gets you to your next priced round.

Capped Price: conversion price per share awarded to noteholder (or SAFE holder) if investor exercises valuation cap

Change in control: a significant shift in the ownership or control of a company, often triggering specific rights or obligations for investors (M&A most commonly)

Clawback provisions: provisions that give the company the right to buy back vested shares at the original issue price or at fair market value after dismissing an employee under defined circumstances (leaving for a competitor, severe misconduct, etc)

Co-Invest: triggered when a fund raises “one-off” new capital from LPs/investors (as opposed to pulling from existing permanent fund) to unlock ability to execute an investment; associated management fees and carry (if any) typically flow back to the fund or individual who raised the co-invest capital. Funds often give major LPs prioritized “co-invest“ rights, which gives such LPs the first rights to participate in the co-invest opportunity before others.

Comparable Company Analysis: a valuation methodology that entails identifying comparable companies and transactions to the company being valued as a means of deriving multiples that can be used to generate a landed valuation

Confidentiality: prevents the startup from disclosing the terms of a term sheet to outside parties (i.e., other investors, startups). This enables both parties to negotiate in good faith.

Convertible Note: a debt instrument that can be converted to equity based on the occurrence of certain events (most commonly during a priced equity financing round).

Conversion: convertible notes (and SAFEs) automatically convert into equity if certain triggers occur. The most common trigger that leads to the conversion of a convertible note (or SAFE) into equity is a priced equity financing round

Corporate governance: a set of principles and mechanisms that balances the interests of company stakeholders (not only shareholders but also employees, customers, suppliers, etc) and affects control over company decision-making

Co-Sale: the inverse of ROFR by nature; if a founder sells shares, the investors will have the opportunity to sell a proportional amount of their stock as well.

Debt repayment terms: in the context of convertible notes, defines specifics associated with principal, interest rate, maturity date, and default provisions.

Definitive documents:  the legal contracts between the investors and the company that detail the terms of the transaction and are drafted by a lawyer

Dilution (D): losing a portion of your ownership as the company sells equity to investors

Discounted Cash Flow Analysis (DCF): a valuation methodology that entails forecasting the future cash flows of a business and discounting the cash flows by a determined cost of capital to derive an enterprise value

Discount: a discount is a term awarded to the convertible noteholder (or SAFE holder) that drives a reduction in the conversion price per share that they are awarded during a qualified financing. Discounts typically range from 10-30% with 20% being the most common.

Down Round: when the pre-money valuation of a future financing is lower than the post-money valuation of the prior financing; often seen as a negative sign for the company

Double-trigger: requires two events to occur to accelerate the completion of your vesting. The first trigger is the acquisition, and the second trigger is the founder or employee getting terminated by the acquirer without cause or good reason in a specified period (typically one year)

Drag-Along Rights: in short, drag along rights enable majority shareholders often including VCs to force minority shareholders to participate in the sale of a company on the same terms. Minority shareholders are “dragged along” disabling them from holding out on a deal to try to get something better for themselves.

Employee Option Pool (EOP): stock that is reserved for existing and future employees to compensate, retain, and motivate workforce

Equity conversion terms: in the context of convertible notes, defines the specific event(s) that triggers conversion of debt to equity, the formula used during conversion (considering the impact of the valuation cap and/or discount – to be discussed), the type of equity received upon conversion by the note holder (common vs. preferred equity), and any associated rights the new equity holders will get after their convertible note is converted to equity (voting, dividends, etc).

Exclusivity: often referred to as a “no shop,” this provision locks parties into negotiating only with each other for a defined period (i.e., 30-60 days)

Exercise (options): buy options at the strike price

Full Ratchet Anti-Dilution Protection: adjusts the conversion price of the protected securities downward all the way the price of the shares issued in the new round. Full-Ratchet is the most investor friendly.

Fund Model: a forecasting exercise that a VC conducts to project what a successful fund will look like in terms of returns from each investment. VCs typically build a pathway to 3.0x net DPI

Indifference point: the price per share at which the noteholder or SAFE holder is indifferent between exercising the discount or valuation cap

Interest Rate & Payments: convertible notes often feature interest rates. Unlike a traditional loan, startups rarely pay the interest in cash to the convertible noteholder periodically. Instead, convertible notes accrue interest until the time of conversion.

Issued Shares: those that the company has issues to shareholders; can’t be greater than the number of shares authorized to be issued for that class

Lead Investor: primary investor(s) (co-leads can exist) in a funding round that set terms and typically are writing the largest check(s); often take a board seat

Legally nonbinding: refers to the nature of term sheets. A signed term sheet does not legally mandate a deal be completed

Liquidation Preference: is one of the rights that makes preferred stock more valuable than common stock and a large part of why investors agree to purchase the right to preferred stock (i.e., SAFEs or convertible notes) or purchase preferred stock directly during financings. Liquidation preference is the legal entitlement to receive a pre-determined portion of a company’s value in the event of a sale or liquidity event before the holders of common stock (i.e. the right to get paid first in an exit).

Major Investor: refers to a participating investor in a financing that surpasses a certain check size threshold, unlocking certain rights. I.e., “all those who invest over $500k will be deemed major investors and shall receive information and pro rata rights”

Maturity: the date at which the debt (plus any accrued interest) is due for repayment. This is typically 12, 18, or 24 months from the issuance of the convertible note. We will talk about conversion momentarily but the norm for a convertible note is that it has converted into equity prior to the maturity date

Maturity Extension: in the context of convertible notes, this entails moving the maturity date back. A common alternative to repayment is for the company and noteholders to agree to an extension on the maturity date of the note

Multiple: a ratio that is calculated by dividing the valuation of an asset by a specific item on the financial statements

Multiplier (Liquidation Preferences): Multiplier refers to the multiple on the original price per share of a class or series of preferred stock an investor is entitled to receive before others get paid. A 1x preference means getting paid one times the original investment, a 3x preference would mean getting paid three times the original investment back before the next most senior preference is paid.

Multiple on Invested Capital (MOIC): compares the value of an investment on the exit date to the initial equity contribution

Non-priced financing: financing round in which founder and VC do not explicitly set a share price and thus do not set an associated pre-money valuation (i.e., convertible notes, SAFEs)

Option pool: an amount of common stock primarily reserved in the cap table for future employees (in certain cases, options can be pulled out of the option pool for existing employees/founders as well)

Optional conversion: in the context of convertible notes, entitles the noteholder to convert their note into equity if desired if the note is still outstanding on the maturity date.

Oustanding Shares: shares owned by shareholders such as investors or employees (could be in process of vesting).

Ownership (O): the % of a company a shareholder possesses prior to or post-closing of a financing.

Participation (Liquidation Preferences): is the right of a preferred stock to participate in remaining acquisition proceeds (on an as-converted to common stock basis, along with common stock) after the initial multiplier liquidation preference is satisfied. When preferred stockholders have a participation preference it’s called “double dipping” as preferred stockholder enjoys preferential return of capital in liquidation preference and then enjoys pro rata share of remaining proceeds. Participation can be capped (limited to a certain multiple) or uncapped.

Prepayment: in the context of convertible notes, payment of the principal and accrued interest by the startup before the note matures. This is generally only allowed if there is a majority of supermajority vote in favor of prepayment by the noteholders.

Post-Money Valuation (P_O): the valuation of the company after the round size is invested by the VC(s)

Pre-Money Valuation (P_M): what the investor is valuing the company at TODAY, prior to the investment

Priced round/financing: a round of financing in which the valuation and price per share of a unit of stock being sold is officially determined (as opposed to a SAFE or convertible note in which case the valuation is left officially undetermined)

Price Per Share (PPS): the cost of acquiring a share of company x, typically determined by pre-money valuation and fully diluted shares outstanding prior to close of financing

Primary transaction: is when the company (the “issuer”) sells shares for the first time to investors. Primary issuances must comply with U.S. securities laws — meaning they must either be registered or qualify for an exemption.

Principal: in the context of convertible notes, the amount of investment provided by the noteholder (investor) to the company through the convertible note. In an unfortunate scenario where the note never converts to equity (we will discuss this), the principal (plus any accrued interest) is what the company owes the noteholder (unless nuanced legal terms dictate otherwise). Assuming the note does convert to equity (the norm), the principal (plus any accrued interest) is the quantity used to calculate how many shares the note holder will receive upon conversion into equity.

Pro rata rights: give investors the right (but not obligation) to participate in future rounds of financing to maintain their initial level of percentage ownership in the company.

Pro rata on a dollar-for-dollar basis: gives the investor the right to invest an amount equal to or less than the amount invested in their first round à VC Z invested 200K in the seed round and has the right to invest 200k in the Series A

Pro rata on a fixed sum basis: least common, investors get the right to continue investing an amount as agreed upon that is decoupled from the investment amount. VC Z, who invested $1M in a seed, negotiates pro rata rights up to $700K - they will be able to invest up to $700K in each subsequent round of financing.

Pro Rata ROFR: gives particular investor(s) the right to another investors voluntarily waived pro rata in a future financing  

Protective provisions (negative controls) are contractual clauses that have the goal of preventing the company and its shareholders from taking actions without getting explicit consent of the investors protected by the provisions. They effectively are veto rights that investors (preferred shareholders) have on actions so that they are protected against expropriation.

Qualified financing: in the context of convertible notes/SAFEs, the round size of an equity financing typically must meet a certain dollar threshold to trigger conversion into equity.

QSBS: a tax benefit under Section 1202 that incentivizes investment into small businesses (often startups) with less than $50 million in aggregate gross asset value. Investors who purchase stock (common or preferred) directly (as opposed to via secondaries) from a c-corp business with less than $50 million in aggregate gross asset value and hold that investment for > 5 years, followed by a sale of the held stock, can avoid paying capital gains tax. The tax exclusion can be up to 100% of the gain, subject to limits: the greater of $10 million or 10x the original investment. Recently big beautiful bill updates: 1/ asset value threshold up to $75 million, 2/ cap limit extended to higher of $15 million or 10x investment, and 3/ exclusion starts to come into play after just three years (at 50% exclusion potential).

QSBS Gain Deferral: if you have to liquidate a position before the QSBS holding period requirement ends, you can defer the tax on capital gains, by reinvesting the gains into another QSBS qualified business within 60 days of liquidation. You also get to roll over the holding period of the original investment, continuing the clock (as opposed to starting over).

Redemption rights: allow the investor to sell their shares back to the company for a guaranteed return (often at the original puchase price), granting them a guaranteed exit/liquidity path no matter what.

Registration Rights: defines the circumstances in which investors can require the company to register its shares or piggyback on a registration of other classes of stock.

Repayment: in the context of convertible notes, the process of paying back the debt (plus any accrued interest) due to noteholders

Restricted Stock: company stock given to employees, usually as a bonus or additional compensation; does not have a strike price unlike options; usually awarded to company directors and executives and is subject to vesting

ROFR: gives existing shareholders the first chance to buy shares from an existing shareholder who is attempting to sell them to an outside third party. In simple terms, if I want to sell my shares in a startup as a founder or investor, I need to give existing company shareholders the right to purchase my stock at the agreed upon price with the third party first

Round Size or Investment Amount (R): how much capital the founder is raising for the financing or VC round

RSUs: refers to an agreement by a company to issue employees shares on a future date. One RSU is the right to get one common share. RSUs, like options, are also subject to a time-based vesting schedule and can be trigger based; however, RSUs don’t have a strike price and are instead released directly to the recipient after vesting without any need to “exercise” or buy them; typically awarded to lower level employees than restricted stock

SAFE: an agreement between an investor and a company that converts into equity in the next financing round if certain conditions are met

Secondary Transaction: the resale of existing shares by a current stockholder. A secondary occurs either: when the company buys back the shares (a redemption), or when a stockholder sells their shares to a third party (a transfer). Secondaries are also subject to securities rules, but the requirements are generally lighter for non-affiliated stockholders — especially in true peer-to-peer sales.

Seniority (Liquidation Preferences): refers to whether preference is senior, junior or even (pari passu) with other preferred stock. Senior preference means having a first-tier liquidation right, junior preference means having a liquidation right that is paid after the senior preferred and pari passu means preference amongst different preferred stock is the same time.

Single-trigger: states that only one event must occur to accelerate the vesting of your equity. If the company is acquired, you gain complete ownership over all your options

Stock options: incentive mechanisms granted to employees, advisors, and consultants. Employees joining a VC-backed startup typically receive an option grant, which allows them to acquire company common shares in the future at a certain price by “exercising vested options”

Strike Price: the predetermined price an employee pays to exercise (aka purchase) their stock options and turn their stock options into actual shares of the company owned outright. Tax regulations (IRS Section 409a) require options grants to have a strike price equal to or above the fair market value of the underlying company stock on the date that the option is granted

‘Success disaster’: employees run the risk of being harmed financially for building a succeeding business that has grown in value significantly

Supermajority: require votes in excess of the majority; frequenty established in the charter and typically only apply to certain scenarios / investor classes. Supermajority thresholds are often set to give a minority investor veto power.

Supervoting: Supervoting shares entails one class of shares having more votes than another voting class of shares. It distances cash flow and voting rights from each other. In the VC industry supervoting has been heavily debated as companies with supervoting like Theranos, Uber, and WeWork have encountered governance controversies. Founders are typically the beneficiaries (for better or worse) as their voting power becomes a multiple (like 10x) of their share count.

Tag-Along Rights: tag-along rights are triggered when the majority shareholders decide to sell the company. In a similar but opposite nature to Drag-Along, Tag-Along protects minority shareholder’s right to exit alongside the majority. While drag-along “forces” the minority to sell, tag-along allows the minority to sell on the same terms as the majority so they are not left behind

Tender Offer: is a proposal by a buyer (often an investor or the company itself) to purchase shares from multiple stockholders during a set time window and at a set price.

Uncapped Note/SAFE: a convertible note (or SAFE) that lacks a valuation cap

Up Round: when the pre-money valuation of a future financing is higher than the post-money valuation of the prior financing; often seen as a positive sign for the company

Valuation: the process of deriving an enterprise value for a company

Valuation Cap: a valuation cap is an investor favorable terms that puts a ceiling on the conversion price at which a convertible note or SAFE would convert into the equity security sold at the qualified financing.

VC Valuation Method: a valuation methodology that entails projecting a company’s exit value in the future and a VC’s required MOIC in order to back into an implied valuation and ownership level at time of investment (starting with the future and backing into the present)

Vesting: the process of gaining ownership over granted stock options

Voluntary conversion: in the context of convertible notes, gives the investor (noteholder) the power to convert into equity whenever desired (even before maturity) under specified details, negating any prepayment potential

Warrants: when issued/contracted, give the warrant holder the right to buy a certain number of shares of the company’s common or preferred stock at a predefined price over a specified period

Weighted Average Anti-Dilution Protection: adjusts the conversion price of the protected securities downward to a value between the price originally paid by the protected investor and the price paid by the investors in the current (down) round.

P_M + R = P_O ➡️ the pre-money valuation plus the round size = the post-money valuation

P_O – R = P_M ➡️ the post-money valuation minus the round size = the pre-money valuation

P_M / FDSO = PPS ➡️ the pre-money valuation divided by shares outstanding = price per share

R / P_O = O ➡️ round size divided by the post-money valuation is the amount of ownership acquired in a financing by participating investors

D / P_O = Daniel’s O ➡️ Daniel’s investment divided by the post-money valuation is the amount of ownership Daniel is acquiring in a financing

Fundraising

Rule #1: Communicate early and consistently. Goal: build long term relationships with a roster of investors before you kick off a process.

Rule #2: Ask for help. The only way to get maximal value out of your cap table is by asking for help. Especially when times are tough, great investors can potentially be the difference between make or break.

Rule #3: Keep knocking. As hard as it is, keep communicating with rejectors and make them aware of your progress.

Dont #1: OVER-FOMOing

Don’t #2: Focusing on who instead of what

Don’t #3: Exaggerating objectively “auditable” traction

Don’t #4: Asking for follow up intros from rejectors

Is there a topic you’d like us to cover? Don’t be a stranger! Ever want to dive deeper on a topic in VC Investing or Law?

We can be reached here:

Daniel Faierman ➡️ [email protected] 

Chuck Cotter ➡️ [email protected]

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✍️ Written by Daniel Faierman and Chuck Cotter 

Disclaimer: The information provided in this entry does not, and is not intended to, constitute legal or investment advice; instead, all information, content, and materials available in this entry are for general informational purposes only.