Secondary Stock Sales: A Guide for Startup Employees Looking to Sell Private Company Stock

Table of Contents:

1. What Is a Secondary Sale?
2. Why Do Employees Consider Secondary Sales?
3. How Does a Secondary Sale Work?
4. What to Consider Before Selling in a Secondary Sale
5. How to Sell Private Company Stock
6. The Pros and Cons of a Secondary Sale

If you work for a private company, especially a startup or tech firm, you may own stock or stock options as part of your compensation. While this equity can be incredibly valuable, it’s often illiquid, meaning you can’t easily sell or trade it like publicly listed stock. However, there is a way to cash out some of this value without waiting for an IPO or acquisition: selling your stock through a secondary sale.

Let’s break down what a secondary sale is, how it works, and what you need to know before considering this option.

What Is a Secondary Sale?

A secondary sale allows private company shareholders, such as employees or early investors, to sell their shares to third-party buyers, like institutional investors or individuals before the company goes public. In essence, it’s a way to convert your private company equity into cash by selling it to someone else without waiting for the company to go through an IPO or be acquired.

Why Do Employees Consider Secondary Sales?

Employees often consider secondary sales for a few key reasons:

• Liquidity needs: Employees may want to convert part of their equity into cash for personal reasons—whether that’s buying a house, paying off debt, or funding a new business venture.
• Uncertainty: In some cases, employees may want to reduce risk by cashing out some of their equity if they are unsure about the company’s future or the timing of an IPO.
• Diversification: If a large portion of your net worth is tied to your company’s stock, a secondary sale can help diversify your financial holdings, reducing risk.

How Does a Secondary Sale Work?

Here’s a simplified step-by-step breakdown of how a secondary sale typically works:

1. Identify a Buyer: Secondary sales usually involve private market investors like institutional investors, venture capital firms, or specialized platforms that focus on private equity transactions. Sometimes, other high-net-worth individuals may be interested in purchasing the stock.
2. Get Company Approval: Many private companies have right of first refusal agreements, which means the company has the first right to purchase the shares you intend to sell before you can sell them to a third party. You’ll need to notify your company of your intention to sell, and they will decide whether to buy the shares themselves or allow the sale to proceed with the outside buyer.
3. Negotiate the Terms: You and the buyer will need to agree on the price and terms of the sale. Keep in mind that the price you get in a secondary sale might be lower than what the shares could be worth in an IPO, as secondary buyers often expect a discount for taking on the risk of holding private stock.
4. Finalize the Transaction: Once you and the buyer agree on terms and the company gives its approval, the transaction will be executed. The buyer will pay for the shares, and you’ll transfer ownership of the stock to them.

What to Consider Before Selling in a Secondary Sale

Before moving forward with a secondary sale, there are a few important factors to consider:

1. Check Your Stock Agreements

Before pursuing a secondary sale, make sure you review your stock option agreement or stock purchase agreement to understand any restrictions. Some companies impose limits on when and how employees can sell their shares. For example, your stock may not be fully vested, or there may be restrictions on selling until certain company milestones are reached. These agreements will also explain if your company has right of first refusal, giving them the first right to purchase the shares before you can sell them to a third party.

2. Understand Tax Implications

Selling private company stock can have significant tax implications. Typically, any gains from the sale are taxed as capital gains. If you’ve held the shares for less than a year, they may be taxed at the short-term capital gains rate, which is the same as your regular income tax rate. If you’ve held the shares for over a year, they will be subject to the long-term capital gains rate, which is generally lower.

In some cases, there is the potential for secondary sale proceeds to be taxed as compensation. This arises when the per-share purchase price in a secondary sale exceeds other measures of the private company stock’s fair market value, such as the company’s option price or a recent 409A valuation. The reasoning behind this is that by allowing an employee or founder to sell common stock at a price above its fair market value, the company is providing a benefit to the founder, which is viewed as a form of compensation.

Additionally, if your company qualifies as a Qualified Small Business (QSBS), you may be eligible for substantial tax breaks under Section 1202 of the IRS code if you meet specific holding requirements.

Consult with a tax advisor to understand the full tax impact of your sale.

3. Consider the Price Discount

In secondary sales, private company stock often sells at a discount to its estimated fair market value during an IPO or acquisition. Buyers are taking on the risk that the company may not go public or might be less successful than expected, so they typically negotiate a discount to the potential future value. Understand the trade-off between getting cash now and potentially selling for a higher price after an IPO.

How to Sell Private Company Stock

If you’re ready to explore selling your private company stock through a secondary sale, here are a few ways to get started:

1. Online Secondary Market for Private Company Shares

Several platforms specialize in connecting private company shareholders with interested buyers. These private secondary market platforms streamline the secondary transaction process by helping with valuation, negotiations, and legal paperwork. Popular marketplaces include:

• Forge
• SharesPost
• EquityZen
• Hiive

2. Institutional Investors

Sometimes, large institutional investors (like venture capital firms or private equity funds) will approach private company employees or shareholders to purchase their shares. These investors often buy significant blocks of shares and may offer a straightforward transaction if you’re looking to sell.

3. Company-Sponsored Liquidity Events

Some private companies organize liquidity events where they allow employees to sell a portion of their shares to pre-approved buyers. These events often happen before an IPO or a large fundraising round.

The Pros and Cons of a Secondary Sale

A secondary stock sale may not always be the right choice. You need to weigh the pros and cons of your personal situation.

Pros of a Secondary Sale

• Liquidity: You get access to cash without waiting for an IPO or acquisition.
• Reduce Risk: Selling part of your stock allows you to reduce exposure to a single company’s success or failure.
• Flexibility: You can sell a portion of your shares to meet financial needs while holding onto others for potential future gains.

Cons of a Secondary Sale

• Discounted Price: The sale price in secondary markets is often lower than what you could potentially earn in an IPO or acquisition.
• Company Restrictions: Some companies may have restrictions on when and how you can sell your shares, or may exercise their right of first refusal.
• Tax Implications: Selling stock can trigger significant taxes, especially if you’ve held the shares for less than a year.

Selling private company stock through a secondary sale can be a great option for employees who want to cash out some of their equity before a liquidity event like an IPO. However, it’s essential to fully understand your stock agreements, the tax implications, and the potential downsides, such as selling at a discount. Consulting with a financial advisor or tax professional is always a smart move before making a decision.

Harness Can Help You Navigate a Secondary Transaction

If you need help navigating tax questions around equity compensation like secondary stock sales, working with a Harness Tax Advisor can help you aim to reduce tax liabilities. From comprehensive planning to tax preparation, our experts are here every step of the way. Get started with Harness today.

Tax related services provided through Harness Tax LLC. Harness Tax LLC is affiliated with Harness Wealth Advisers LLC, collectively referred to as “Harness”. Harness Wealth Advisers LLC is a paid promoter, internet registered investment adviser. Registration does not imply a certain level of skill or training. This article should not be considered financial, tax or legal advice and is provided for informational purposes only. Please consult a financial, tax and/or legal professional for advice specific to your individual circumstances.