Startups are taking longer and longer to go public. That leaves early employees and investors in a difficult situation. How do you get cash? What are the key considerations when selling?
Hey friends -
We're tackling a recurring topic this week - startup equity.
An earlier letter covered how startup employees should evaluate the shares they receive when they join a startup. This letter looks into what you can do once you own equity. Specifically, we're exploring the world of secondary markets and how to sell your startup equity.
In this week's letter:
Total read time: 10 minutes, 22 seconds.
Before exploring how to sell startup equity, the first question is - can you?
Yes... probably. But there's nuance to that answer.
Startups raise money in the primary market. That leads to headlines like "Fireblocks raises $550 mln, company valued at $8 bln".
In the primary market, the startup sells shares of the company to investors in return for cash. In return, the investors become part-owners in the hope that the value of the startup will grow over time and they can sell their part-ownership for more than they paid.
Startup employees typically receive part of their compensation in the form of shares in the startup. While different than the "get cash from investors" primary market, it's also a primary market. The startup is "selling" shares to employees in lieu of cash compensation and in exchange for labor. In return, the employees deliver labor and become part-owners in the company. This equity compensation model helps align incentives - the startup employees get richer as they make the company more valuable.
Secondary markets are different. A secondary market is one where the seller is a shareholder, not the startup. That means the shareholder receives cash rather than the startup.
A lot can go wrong with secondary market sales. Most startups damage control by restricting sales.
Equity helps keep everyone "along for the ride." As Investors, founders, and employees do work on behalf of the company, they increase the value of their own equity. Selling equity reduces or eliminates that incentive alignment.
Startups, especially when they're young, typically prohibit secondary sales and pledging of any kind. It's only as companies get older and bigger that they permit secondary sales.
Pledging results in the same incentive misalignment as an outright sale without the sale taking place. It's a critical hole for startups to plug. Examples of pledging include:
In all cases, the current equity owner gives up the economic rights of the shares no differently than if they had sold. That undoes the original purpose of the equity - aligning incentives.
Prohibition is one tool. Restrictions are another. The most common restriction is a right of first refusal - the startup has the right to buy back your equity at the same price a buyer is willing to pay. That dissuades buyers from even attempting to purchase the equity. It's common for startups to also maintain a "do not cooperate" policy - refuse to provide any information to the potential buyer. Without data about the company, the buyer will struggle to determine an appropriate price.
Right of co-sale is a third tool that ensures any secondary sale will be a tremendous pain for the seller. A right of co-sale requires that when one owner attempts to sell, they must first notify all other owners who then have a right to also participate in the sale. Not only will that materially delay any sale, but it can also result in many owners competing for a limited number of buyers. The result will either drive down the price per share for all sellers or the quantity sold by each seller at the previously agreed-upon price.
All these restrictions aren't just to keep incentives aligned. Startups also have to stay on the right side of regulations.
Startups generally sell equity under three different regulations: Reg CF, Reg A+, and Reg D. Each one imposes different restrictions.
A minimum holding period and a shareholder count limit are two key restrictions. The table below highlights the differences between each regulation. Please note that there are additional - but less common - restrictions that can also matter.
The minimum holding period is the amount of time an individual or entity must own the equity before they can sell it in the secondary market. The shareholder count limit is the maximum number of shareholders a startup can have before they're required to become a fully reporting company with the SEC. "Fully reporting" is what public companies do. It's expensive and a huge burden. Startups avoid it by capping the number of shareholders. Thankfully, anyone receiving equity through an employee compensation program is excluded from the shareholder count.
A common way to solve the shareholder count limit is through Special Purpose Vehicles (SPVs). Investors can own equity in an SPV whose sole purpose is to own equity in the startup. SPVs themselves can have up to 2000 shareholders, but the startup only treats it as one investor. That allows the startup to work around the 2000 investor limit. The structures can get as complex as the investors would like to make it - startups can have multiple SPVs as investors and SPVs can be investors in other SPVs.
Probably, even if the startup tries to restrict it. But you're almost always better off waiting.
Pledging rather than selling outright avoids tripping the regulatory restrictions. Many of the company-enforced provisions, while legally binding, are difficult to enforce in practice. As a result, even if you legally are bound not to sell or pledge, you can in practice although I wouldn't recommend it.
Larger and older startups typically set up programs to allow investors, investors, and early employees to sell or pledge some of their equity. Part-owners who have most of their net worth tied up in company stock are often equity-rich and cash-poor. Cash allows you to buy a house, pay down student loans, and take vacations. You can't do that with equity, no matter how valuable it may be.
This problem has gotten bigger and affects many more employees today than did just a few years ago. From 1995 through 2005, the average age of a technology startup when it went public was 7.3 years old. For the past five years, the average age has been 12 years old and it never dipped below 11.
Startups get it. They're starting to facilitate secondary sales. A whole industry has sprung up to help.
Turn the clock back just a few years and you would struggle to find companies facilitating robust secondary markets. SecondMarket, later acquired and rebranded as NASDAQ Private Market, was among the biggest early players. Just a decade ago in 2010, they only facilitated $400 million in trades. Fast forward to today. CartaX, a secondary market launched just three years ago, facilitated $7.4 billion.
There are many companies to choose from if you want to pursue secondary sales. CartaX, EquityZen, Forge, and NASDAQ Private Market are the most prominent. Together they facilitated over $20 billion in secondary trades in 2021.
Sellers want to optimize for the best deal - the shortest transaction time, at the best price, with the least risk.
EquityZen and Forge are the two main options. They are similar in their essentials and have only a handful of differentiators.
Both charge sellers a 5% fee. That may seem like a lot - and it is - but it's driven by the nature of the underlying business. From the outside, Forge and EquityZen appear to be software companies, but a lot of the business is in fact a people-based matching service.
The problem is a lack of liquidity. At any given point in time, there's a limited number of shares that might be up for sale in a given startup. Traditional market-making methods don't work in such illiquid markets, a problem we dove into in a previous letter. What does work is people - someone sitting in between buyer and seller to help them meet on a price.
That process is generally slow, cumbersome, and suffers from the risk that either the buyer or seller will walk away from the deal. Forge and EquityZen both have methods to help mitigate such challenges - like putting forward an indication of interest before actually posting a price - but the challenges remain nonetheless.
The high cost, high friction nature of the transaction also underpins the transaction size minimums. On Forge, sellers must sell at least $100,000 of shares. On EquityZen, the minimum is $175,000, but small sellers can pool together to create a single large transaction. As a general rule of thumb, it's just as difficult to close a small deal as a big one. Large minimums ensure that the matchmakers only work on deals that generate enough revenue to make it worth the while.
A sale results in a single lump-sum payment. That means there's one more key consideration - taxes. If you're selling options or equity that you've owned for less than a year, you will pay regular income taxes on the gains from the sale. If you're selling equity that you've owned for over a year, then you will pay the long-term capital gains tax (0%, 15%, or 20% depending on your income). If the gain is large enough relative to your income, you may have to pay the tax in the same quarter the deal closes.
In short - you better really want that cash if you're going to sell. Even transactions at the best-of-breed secondary markets are high friction, expensive, and lengthy. If you do successfully sell, you'll find a sizable tax bill waiting for you. This isn't a knock against the secondary market companies. They've made life much easier for buyers and sellers than it used to be and they're continuing to improve the quality of the market. It's simply the state of the world today. The market for startup equity is illiquid and secondary markets are relatively new.
Nonetheless, getting access to cash is important. A broader universe of secondary markets - including Forge and EquityZen - work directly with startups to arrange regularly scheduled sales.
CartaX and NASDAQ Private Market each facilitate more transactions annually than EquityZen or Forge, in part because they focus on setting up liquidity programs directly with the startups.
Startups that want to allow their founders, investors, and/or employees to sell can do so at their leisure. The simplest is for the startup to arrange for a one-off secondary opportunity alongside a primary raise. That ensures that there's a readily available price for the stock as determined in the raise, there's a compelling event to force transactions to close in a reasonable time, and the startup can bring in more new investors without needing to dilute existing owners.
Startups can also use the secondary market as an opportunity to buy back shares. Airbnb was famous for this in the years leading up to its IPO - it allowed employees to sell shares, but only back to Airbnb.
Rather than just conducting a one-off secondary sale, startups can facilitate regular sales. Palantir took 17 years to become a public company. Not only is that a painfully long time to wait for access to cash as an employee, but employee stock options also have a 10-year expiration limit. That means that many employees could have been stuck without the cash to exercise options. To help its employees, Palantir facilitated a regular, standing secondary market event a few times a year. Employees who wanted to sell some of their equity could do so. This concentration of sellers helps solve many of the illiquidity challenges with predictable dates when both buyers and sellers can expect reasonable liquidity.
CartaX has an advantage when it comes to these types of programs - the technology is integrated into Carta, a capital table management solution. Capital table management is how startups manage their list of investors, how much each investor owns, and any communications. Carta also functions as the transfer agent, meaning that they're authorized to update the capital table. By combining CartaX and Carta, the company offers a one-stop shop to both facilitate the secondary sale and manage all of the paperwork. That's a big leg up. Carta can also effectively compete on price by using one service to subsidize another as needed.
NASDAQ Private Market has an advantage when it comes to companies that intend to IPO soon. Most startups will list on the NASDAQ and the Private Markets can serve as an onramp. NASDAQ even offers a "continuous auction" for almost-public startups, almost like a mini version of what they'll experience once they IPO.
Both companies, as well as competing offerings from Forge and EquityZen, can create a better experience for all parties involved - the startup, investors, founders, and employees. A formal program gives owners access to much-needed cash while reducing risk for the startup. Executed successfully, prices will also more accurately reflect the value of the company.
Even the best secondary markets can't solve that problem. But there are companies that can. It's the topic of next week's letter.
I was in a weird place and found exactly what I was looking for.
2.0oz Bully Boy Boston Rum
1.0oz Drambuie
0.25oz Laphroaig 10 Year Single Malt Whisky
Pour all of the ingredients into a mixing glass. Add ice until it comes up over the liquid. Stir for ~20 seconds until the glass is frosted, ~50 times. Add ice to a cocktail glass and strain the drink in.
I couldn’t make up my mind. I wanted an all-spirit cocktail focused around an aged, molasses rum. I also wanted something warm and wintery. There’s not a lot that straddles those. Apparently, Simon Difford had the same want on what I can only assume was a wet, dreary London day over a decade ago because he created a wonderful mashup of two very different worlds. A Nail is any drink with scotch and Drambuie. Using an aged rum as the base and a smokey Islay single malt as the accent was a stroke of genius. As much as I’m enjoying this now, I’m perhaps even more excited to enjoy this in front of a fire late in the winter season when it’s probably well past the temperature where it’s appropriate, but I’m going to want one anyway.
Cheers,
Jared
