What exactly do we mean by Secondary

15.07.2018
Nimrod Vromen
We all know (or at least we will allow ourselves to act as if we know) what an "Exit" is. We understand that by Exit we mean a transaction, in which the entrepreneurs and the investors of the company sell it (this has many different forms, the topic of which will be discussed in a different article) and carry on with their lives, leave the company, and in general are freed from the day to day duties of the average Joe. On the basis of the above understanding, we could have concluded that the answer to the question "what is Secondary" is – "Secondary is the new Exit".

To the point, one can purchase shares in a company in two acceptable ways: an investment transaction, in which shares are purchased from the company, i.e. walking in through the front door. In such a transaction, the company will actually issue additional shares, so that if the number of issued shares in the company was one million, for example, and an investor purchased 20% of the company, the company issued said investor 250,000 shares, thus making the company's total number of issued shares 1,250,000. A Secondary Sale is a transaction, in which a person purchases shares of the company in a manner which is "secondary to the company", meaning – from an existing shareholder. The money is transferred to the existing shareholders in consideration of their shares, and the total of issued shares does not increase. Utilizing the previous numerical example, the secondary investor could have settled for purchasing 200,000 from an existing shareholder in order to reach 20% holdings.

Secondary sales are commonly seen in two acceptable methods: first, there are funds whose purpose it is to approach existing shareholders in successful companies (entrepreneurs, investors or even employees who have exercised options) and offer them a personal Exit in the form of a secondary sale. In light of these shareholders' occasional need for liquidity, a secondary purchaser might succeed in receiving a good price for the shares, better than the company's "market value". Second, occasionally an investor looking to invest in companies executes – alongside an investment in the company – a "secondary" transaction to the investment transaction, in which said investor also purchases shares from existing shareholders of the company.

In this type of transaction, we will often see the entrepreneurs selling shares.

On the surface, this is a simple transaction – a price is set and the shares exchange hands through s simple agreement and a share transfer deed. Nevertheless, secondary sales have a few nuances:

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  • Required approvals: In private companies, we need to understand what are the required approvals for such a transaction. The classic situation requires a simple share transfer deed, although in most startup companies a specific board of directors approval is required. There are companies in which shareholders of a certain percentage of holdings and lower may not transfer their shares at all until an Exit.
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  • Derivative rights: The sale of shares often triggers certain rights to which other shareholders are entitled.  First, there must often be an offer made complying with a Right of First Refusal, which allows the other shareholders to purchase the shares instead of the external purchaser. In addition, the existing shareholders can sometimes join the seller and sell a significant amount of shares instead of the seller (Right of Co-Sale).
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  • Share upgrade: Often the purchaser will not settle for the class of shares being sold. Often times the seller is a founder (holding ordinary shares) or a previous investor (holding inferior shares compared to newly issued preferred shares of the company). The purchaser would like to upgrade the shares to the most senior class of preferred shares issued and outstanding at a certain point in time, in order to hedge the purchaser's risk. This usually creates various challenges. In the first place, why would the existing shareholders agree to protect money, not entering the company, with rights attached to preferred shares (read more about preferred shares here)?

    Second, there is a question of who executes the upgrade – obviously the seller cannot do so, and in essence it requires obtaining the support of the company's shareholders, which does not always go over smoothly.
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  • Tax: Notwithstanding everything noted above, these types of transactions, which usually turn a profit for the seller, have tax implications, both procedural (occasionally the seller has duties of deducting tax at source) and material (tax authorities will examine whether the shares were sold at a fair market value).
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