Are secondary sales a benefit or burden to startup founders?

Kiwi tech startup Parkable, which helps manage employee and tenant parking, has offered secondary sales of its shares for some years to provide early investors a chance to realise some gains.

Shares in publicly listed companies can be traded on stock exchanges but those in private companies are less accessible without a secondary market where existing shareholders sell a portion or all of their shares. 

Typically, founders consider secondary sales after a few years if they want to get some cash out after having bootstrapped the company.

Parkable, founded in 2016 by Toby Littin and Brody Nelson, has raised just over $20 million in new capital to date. Along with raising new capital, it also started running regular secondary events after a few years to offer liquidity to investors who had been with it from the beginning.

“That is really important to some. Another key reason is the change in the markets and people’s investments drying up and giving those shareholders the ability to cash out when they originally may not have wanted to,” says Parkable chief financial officer Brody Stewart.

Parkable also used secondary sale events to get an indication of how people value the company, as under the process the price is set by what existing shareholders offer their shares for and what new investors are willing to pay.

“It does give you a bit of a litmus test as to what the valuation of your company is, or at least what the shareholders think, so that has been good and bad,” says Stewart.

While Parkable hasn’t done so yet, Stewart says it could also use a secondary event to bring on a new shareholder a bit earlier than expected.

“We would like to bring in quite a large or reasonably large private equity firm but we’ve already exhausted our latest capital raise. If we can find some secondaries to almost get a foot in the door for them, then in the future it gives them a reason to follow on with investment for our next round.”

Parkable has an employee share scheme along with an employee share options scheme, and employees can also trade their shares during a secondary event.

Stewart says so far there has been little appetite from employees to sell as “they can see the expected growth”.  But it has also been a good way for the company to clean up its capitalisation table (a list of those owning the company) from the perspective of employees who have left and are no longer engaged with Parkable being able to realise their money.

In Stewart’s view, offering secondaries is something all startup founders should investigate because it is simply “good governance”.

“Obviously being a privately held company the opportunities to buy and sell are so limited that I think it’s almost a right that we should do this for our shareholders.”

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How to go about it (or not)

Secondary sales hit the media headlines is the US early this year after Carta, which manages the cap tables of around 40,000 privately held startups, was embroiled in a conflict-of-interest scandal.

According to Carta, a sales employee used confidential data from one of its customers to write a sales pitch for a secondary stock sale without that company’s permission or knowledge. It violated Carta’s ethics policies and the customers’ data privacy. 

The issue came to light after Carta customer Karri Saarinen, co-founder and CEO of US startup Linear, complained on LinkedIn that Carta was using his company’s private information for self-dealing in its shares. He shared an email received by one of his family members from a director at Carta Liquidity (a subsidiary that handles secondary market transactions) asking whether they wanted to sell their Linear shares to a client.

Saarinen was upset that the Carta employee know his family member owned Linear shares, as that information had not been made public. He accused the cap table services provider of using confidential data without Linear’s approval to build out its own order book for its secondaries market platform. 

The result was Carta exiting the startup secondary trading business and temporarily pausing all sales outreach.

Luke Smith, CEO of Kiwi share administration platform Orchestra, says Carta was essentially offering a matchmaking secondary marketplace rather than a tool controlled by the company. 

“In that situation there is a need for really clear distinguishment and privacy of information so that you’re not using information on one thing around shareholder agreements, constitutions, who owns what, or pricing,  to be able to go out and then monetise a transaction on another product. These things really need to be done with authorisation from the company and management.”

He says it’s unfortunate Carta has now shut down its secondary trading platform, which feels like “one step forward, and two steps back”.

“The more liquidity we can provide in the private asset space the better that market becomes or appeal it has.”

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The providers

Regulations allow companies to offer or facilitate trading of their own shares and traditionally that has been handled through irregular trading events involving emails and spreadsheets without much price transparency for traders. 

There are a number of providers offering their platforms to make doing so easier.

Orchestra, in partnership with equity crowdfunding platform Snowball Effect, has for some years offered a white-labelled platform that allows startups to run their own secondary trading events in exchange for a fee to license the technology. Companies retain control over their data privacy and who they provide access to participate in the process. 

Catalist, the licensed and regulated stock exchange for growth companies, has a wholesale side providing either a secondary market for business’ shares or capital raising and facilitates private trading where only invited people can participate. The purpose of Catalist was to make it as easy to trade shares through periodic auctions in smaller businesses as it would be to trade in a listed business. 

Syndex is another platform offering share registry management and capital raising, including selling secondary shares to wholesale investors through a continuous or periodic market.  

The Unlisted Securities Exchange  (USX) also offers trading in securities and debt of unlisted companies, but that has to be done through brokers.

Snowball Effect CEO Simeon Burnett says providing liquidity is always a balancing act for founders, boards and investors. From a board’s perspective, they want people to participate in raising new capital for growth versus providing investors an opportunity to put some money into their back pockets rather than the company’s bank account. 

But founders have typically put their hearts and souls into their startups, often earning less salary and remuneration than they could elsewhere as they try to build equity value. 

Secondaries can be an elegant way for them to start taking a little bit of money out when things are going well, says Burnett.

“Maybe just to reduce the mortgage or make day-to-day life a little bit easier rather than running off and buying Lamborghinis and all that sort of thing. It’s a chance for founders to take a little bit out, de-risk and still have plenty of skin in the game so they are incentivised like investors would want them to be to get a result in the business.”

Catalist founder Colin Magee says giving investors a reasonably regular opportunity for liquidity makes that investment more valuable to people than if they are locked in. That will make it easier to raise money next time and replace early investors with ones who are more likely to be actively engaged. 

A vast majority of companies can take quite a few years to hit the Series A stage where they might attract venture capital backing and Magee says that’s why providing liquidity before then is a big benefit to all stakeholders.

Burnett says offering secondaries is still not common among Kiwi startups; Snowball Effect has raised capital for around 160 companies and he could list on his hands the number of those that have gone through a proper process of how they could create liquidity.

“There may not be someone yelling at them saying they want liquidity. It’s always sitting as the tenth thing they have to do each day and obviously never gets done or gets to a point where they think hard about it.”

Magee says founders have often been deterred by the administrative burden when handling a secondary sale on their own. 

“Investors don’t want the founder to be spending huge amounts of time running that process because they want the founder focused on getting the business successful at what it’s supposed to be doing so that’s why there has always been not a huge amount of these go through.”

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The buy and sell 

The main question is where the buy side comes from. Typically, startups will hold a secondary event every one to two years in order to build up sufficient demand.

Some of the companies using Catalist’s platform start with private trading among existing investors and then progress to opening auctions of secondaries up to other wholesales investors. That’s still in a private setting rather than on the platform’s retail market where there is an obligation to disclose all material information.  

“The advantage of opening up to additional investors is that the more investors available to buy the shares, the better the pricing you’re going to get. Obviously smaller companies aren’t going to have thousands of people buying and selling every day like you would have on the NZX, therefore, you want to maximise the opportunity to buy and sell,” says Magee.

On Syndex, one company has combined a primary and secondary offer. Tectonus, which has developed technology that minimises structural and other damage in the aftermath of an earthquake, has a primary $3 million offer at $1.23 per share underway, led by deeptech investor Pacific Channel. It also has a secondary offer from an existing shareholder wanting to sell shares at $1.16, a six percent discount to the primary offer.

Depending on sector and how well the company is going, a startup may have people approaching them wanting to buy secondaries if they become available. Sometimes venture capitalists may want to pick up more shares in a company that doesn’t have an immediate need for new capital, says Burnett. 

“Sometimes there is a pricing arbitrage for them there where they can get in a bit cheaper buying an employee’s secondaries, for example, versus a new capital raise.”

While that can happen informally, Burnett says going through a more formal process allows companies to offer price transparency for those participating, and everyone – whether existing or new investors, employees, founders or directors – is provided with the same information at the same time.

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Price setting

Founders and boards need to check their governance documents to see if there are any restrictions on secondary sales. These could include founders being subject to share lock-ins for a period of time or rights-of-first-refusal on share transfers that will require waivers. 

And if early-stage investors are selling down, the governance documents will need to considered – for example, whether an investor with only a small shareholding after a secondary event has the right to hold a seat on the board. 

Magee says one of founders’ main concerns is whether the shares will sell too cheaply, reducing the company’s valuation.

“If you open it up to a wider group of investors, if you provide good information, then you’re going to get a fair price for the shares. Sometimes that does have a bit of a discount to capital raising but that is the same as in the public markets.”

Parkable’s Stewart says the company has a quarterly cadence of investor newsletters and updates and a real-time update is also provided when doing a secondary sale, which they run every couple of years or so.

It can be a time-consuming process, rather than a ‘set and forget', involving a lot of stakeholder and shareholder management, particularly if major shareholders don’t want to see shares sold at a cheap price, he says.

Companies can mitigate that risk of a down round by having an engaged group of shareholders who have been provided good information so they can see the present and future value.

Parkable avoids setting a floor price for the shares, which can lead to less trading, instead allowing buyers and sellers to trade openly at the price they’re willing to offer and accept. Not all have to sell at the same price. 

“It can look bad if an early shareholder who bought in at five cents [per share] is willing to take 20 cents when the company valuation is a dollar so you do run that risk,” says Stewart. “Then in a future capital raise they look at what secondaries were traded at in the last round, so that is a risk but luckily it hasn’t been a problem for us.”