In the past few years, there has been an increase in secondary transactions globally and in Israel. Secondary investors purchase existing shares held by existing shareholders in a company, as opposed to a regular investment which constitutes the purchase of new issued shares of a company by issuing new shares in return for cash paid to the company.
A secondary deal holds many benefits for both parties - founders and investors. In terms of the company’s founders - the first benefits are the option of realizing value before reaching the “exit”. A secondary deal can allow the company’s founders and early investors to “meet” with money, at an earlier stage without diluting other investors - that’s because the secondary investors are purchasing their shares from existing shareholders. Since secondary deals can delay the investors' desire for a quick exit, it allows “breathing room” for the company to mature, and as a result, it creates a higher company value for the investors. Another benefit of a secondary deal is that it helps reduce the company’s founders leverage. In most cases, the founders invested from their saving in the startup company, and a secondary deal can allow the founders to buy a home, pay off their mortgage, or anything they have held off on.
In terms of secondary investors, the main benefit of a secondary deal is that it helps reduce investment risk. In recent years, the average time it takes for a startup company to reach an “exit” is 10 years from incorporation. Secondary funds/Investors mostly invest in mature companies, usually between 4-8 years from incorporation - thus reducing the risk and generating a safer return for the investors.
Alongside the many benefits secondary deals hold, they might cause significant tax implications such as capital gain vs. marginal tax rate.
The main aspect of tax implications, to which most entrepreneurs and employees are exposed to, derives from the structure of the deal. One example of a secondary deal is entrepreneurs and employees selling ordinary shares (either existing holdings or by exercising options for this purpose) which are then converted to preferred shares. Even though the sellers sold ordinary shares, due to the conversion - the purchasers hold preferred shares which give them preferred rights (liquidation preference, veto rights, and other benefits). This causes the tax authorities to consider these deals as monetary benefits for their employment and thus should be taxed as income rather than capital gain.
Furthermore, Israeli law has no restrictions regarding the exercise price of options granted to Israeli employees and no obligation to be granted at a fair value based on an independent valuation. Without a professional assessment, tax authorities may disagree with the company's valuation of their share value and estimate that the worth of the benefit granted is higher than the assessment or higher than the assessment that would have been provided by a valuation specialist.
Considering the above, here are the main points to consider before participating in a secondary deal:
- Selling at a fair value - The company's entrepreneurs or employees should sell their shares in secondary deals according to an independent valuation in order to sell at a fair value.
- The identity and number of sellers and buyers - The number of sellers and buyers, as well as their role in the company (employees, existing investors, new investors, former employees or investors), will play an important role in analyzing the deal and its impact on the tax and on 409A (fair value vs. fair market value).
- The scope of the deal - The scope of the secondary deal compared to the main deal (direct investment in new company shares), in the event that they co-exist, will be one of the criteria for the weight that is attributed to the secondary deal and the value of the share derived from it.
In conclusion, although secondary deals are relevant to investors, entrepreneurs and even to company employees, most are unfamiliar with the subject and the possible tax implications, the various economical aspects and other aspects such as 409A. The structure of the agreement plays an important role in the exposure to these risks. Therefore, we would recommend consulting with the company’s professional advisors (especially lawyers and tax experts) beforehand.Prior to founding S-Cube, one of the leading valuation firms in Israel, Gidi founded several startup technology companies, hence his background has positioned him and S-Cube at the unique standpoint of having both the valuation and economic background together with real, hands-on experience in managing companies and raising fund as well as M&A.