Understanding Secondary Market Transactions with Becki DeGraw | Wilson Sonsini Startup Legal Basics

Episode Summary

Executive Summary: This episode explains how startup secondaries evolved from rare, frowned-upon transactions into a common late-stage liquidity tool, then partially normalized as markets cooled. Becky DeGras outlines typical founder-sale limits, governance and fiduciary concerns, transfer restrictions, tender-offer mechanics, and tax issues like QSBS and 409A. The core theme: secondary transactions must balance founder liquidity, investor preferences, company optics, and legal/tax risk.

Main Topics: Evolution of startup secondaries (Priority: 5/5): The discussion traces secondaries from being rare and discouraged by VCs to becoming common during the 2020-2022 funding boom, then retreating to later-stage use as markets normalized. Founder liquidity norms and limits (Priority: 5/5): Becky recommends founders generally sell no more than 5% of holdings, with smaller percentages at later stages; liquidity size is often driven by motivation and distraction concerns. Governance, fairness, and board duties (Priority: 5/5): Boards must decide who can participate in secondary sales and how much, often considering fiduciary duty, disinterested approvals, and whether all stockholders or only founders should benefit. Transaction structures and pari passu considerations (Priority: 4/5): The episode explains blended primary/secondary deals, common-vs-preferred distinctions, and why investors may accept common stock closer to exit even though earlier they prefer preferred downside protection. Transfer restrictions and workaround risks (Priority: 4/5): The conversation covers bylaws, stockholder-approved transfer restrictions, pledge/LLC structures, and how some documents can restrict indirect transfers, not just direct share sales. Tender offers and platform execution (Priority: 3/5): Larger liquidity events are often run through secondary platforms like NASDAQ Private Market, with formal disclosures and minimum open periods, while small deals may be handled directly by lawyers. Tax impacts, especially QSBS (Priority: 5/5): QSBS eligibility can strongly influence whether a buyer prefers primary over secondary, and company repurchases can accidentally impair QSBS for stock issued around the repurchase window.

Key Arguments: Secondaries were once rare and viewed negatively because VCs wanted founders fully locked in, but private-company growth and later-stage capital markets made liquidity more acceptable. The ideal founder secondary is usually 5% or less of holdings, and that percentage should shrink as the company matures to avoid distraction and misaligned incentives. A secondary sale must be evaluated from the buyer, seller, and company perspectives, with taxes and securities rules layered on top. Boards need a thoughtful process because secondary transactions can raise fairness concerns if founders or insiders sell while employees do not. Investors often prefer buying primary shares when QSBS benefits matter, because buying from employees does not qualify for QSBS treatment. Large repurchases can create unintended QSBS disqualification for shares issued in the prior 12 months and the following 12 months, so company buybacks must be timed carefully. Transfer restrictions vary widely; some govern only direct share transfers while others can reach pledges, LLC interests, or similar indirect structures. Tender offers are more formal, slower, and more expensive than small private transfers, but they are necessary when many holders are involved. Secondary transactions can improve founder liquidity and help deals close, but they can also look bad if too much value goes to individuals instead of the company. The best practice is transparency and process: involve the board, consider stockholder approvals when needed, and avoid off-cap-table side deals that create downstream trouble.

Data Points: Founder secondary guideline: 5% or less of total holdings - Becky’s rule of thumb for founder liquidity, with smaller percentages at later stages Typical founder liquidity dollars: Around $1 million or higher - Common minimum seen for founder secondary transactions Upper bound for founder liquidity: $3 million to $5 million - Beyond this range, distraction concerns increase Late-stage secondary prevalence during boom: 50% to 75% of deals - During the 2020-early 2022 funding frenzy, secondaries became common in growth rounds Late-stage secondary trend after cooling: About half of up rounds - Current later-stage up rounds still often include secondaries, though less than during the boom Secondary price discount in older market: 10% to 25% discount - Earlier “normal” period for later-stage secondary sales relative to last preferred round Example round size: $100 million - Used to illustrate a blended primary/secondary financing Example primary capital: $80 million - In the example, this portion goes into the company Example secondary capital: $20 million - In the example, this portion goes to selling holders Secondary share of round: 20% of round - Illustrative split between secondary and primary in the example Tender offer duration: At least 20 business days - Minimum open period referenced for formal tender offers QSBS ownership threshold: More than $50 million in assets disqualifies QSBS - For large companies, QSBS generally does not apply QSBS holding period: 5 years - Stock generally must be held long enough to qualify for QSBS benefits QSBS exclusion: Up to 10% of gain excluded from federal income taxes - Speaker described the potential tax benefit as highly significant

Pivotal Quotes: "I would say usually 5% or less of their total holdings is where we normally look." — Becky DeGras: On the typical amount founders should be allowed to sell in a secondary "The board of the company does have to make the decision as to who's allowed to participate, how much are they going to participate." — Becky DeGras: On governance and board responsibility in liquidity transactions "It all depends on the document." — Becky DeGras: On whether transfer restrictions can block pledges, LLC structures, or indirect transfer attempts

Implications: Founders, boards, and investors should treat secondary sales as a governance-and-tax exercise, not just a liquidity event. The right structure can reduce founder pressure and facilitate deals; the wrong one can create fairness, tax, and securities problems.