The startup secondary market is something that was considered a grey market, but in recent years has gotten more acceptance from the industry as this is a great way to offer founders, key employees, and early-stage investors a shortcut to liquidity. In the secondary market, private startup equity owners can sell their shares to third parties without waiting for a final exit. Even though it’s less transparent and open than the public market, its flexibility attracts more and more investors.
Startup founders can greatly benefit from the secondary market – from minimizing equity dilution to employer branding. Here is the key reasons startup founders should consider facilitating secondary transactions.
1. Cleaning the cap table
When the startup’s capitalization table is too long, managing a large number of minority shareholders can take up too much time and effort. It can leave the company open to risk, not to mention make different legal proceedings a logistical nightmare (e.g. try to get 50 signatures in a few days). In the fast growth phase, it’s a good time to refocus. Secondary transactions give small investors an opportunity to cash in their shares and help clean the cap table.
2. Ensuring equity for the new lead investors
Cleaning the cap table is also essential in terms of future investments. Many VC firms have set rules about how much equity they expect from the startup. Often, the founders can’t spare this much equity without risking high dilution. In that case, it would be reasonable to persuade earlier investors to sell their shares. Even if they’re not eager to sell at first, the founder can motivate them by stressing the overall strategic long term goals.
3. Raising employee motivation
Many startups offer equity options to their employees to keep them loyal and motivated. To cash in that equity, employees need an opportunity to sell – which raises the anticipation for an exit. A secondary transaction, when done right, can actually further motivate the employees, as well as enhance employer branding.
When a startup has already operated for more than 5 years, it might be reasonable to offer employees a balanced opportunity to cash out some of their equity. Offering too much liquidity can backfire and sway people to leave. Offering too little liquidity can deter the talent and undermine the company brand when having equity doesn’t provide tangible value to the employees.
4. Mitigating the founder’s personal risks
We all love invested and passionate founders, but that’s surely one good thing you can have too much of. When a founder has too much riding on their company, for example, their entire family’s financial future, they start operating from a place of fear. A secondary transaction can help alleviate that pressure and help them focus on growing the company. Eventually, it benefits everyone involved.
Whatever the reason is for a need for a secondary transaction, there are different ways to execute it. Probably the easiest is to have a secondary element built into the primary round as a cherry on top of the cake, but as this is not always possible, it is also feasible to consider dedicated secondary funds. Either way, secondary transactions should not take too much time and effort (compared to a typical 6 month primary round fundraising process).