I have been through three secondary purchases this year, and I wanted to share my experience with the entrepreneurs who read my blog.  Secondary purchases are a major lifecycle event for companies with plenty of complexity.

For those who don’t know what a secondary purchase is:  there are two types of investments, primary and secondary.  Primary investments go directly to the company, and the company issues stock to the new investor.  Secondary investments are paid out to selling shareholders.  Secondaries are very common, particularly in late stage companies, and the selling shareholders are most often senior management and early investors.

The major issue in every secondary transaction is that someone has to determine the purchase price.  You would think this would be easy, but it is the first time an entrepreneur learns what his or her common stock is really worth.  It is a tough conversation because investors want the liquidation preferences, anti-dilution protection, and control that you get from preferred shares.  This means that common stock trades at a discount to the preferred, and sometimes there is no appetite to purchase common stock at all.

Because of this, investors have come up with a creative way to do stock buybacks.  Instead of buying common stock directly from founders, investors often try to make an investment into the company and then have the company repurchase the common stock.  This means that the new investors get all the rights and preferences directly from the company, and they leave the difficult conversation of negotiating the common stock valuation to other people.

As an early stage investor I really dislike this approach; it has a lot of risks for management that I will explain below.

The new investors use two arguments for this approach.  First, they say that liquidation preferences are not that meaningful.  The rationale is that company will eventually go public and then all the shares are converted to common stock, so it doesn’t matter if the company issues a few more preferences.  Second, they will say that the secondary will close faster if the company acts as a middle man.  This is actually not true, but it is a common misconception.

One of the issues that is coming up more frequently, particularly in competitive investments, is that the new investors will try to sweeten the deal for management.  It goes something like this, “If you let us invest in preferred stock we will make sure that the company repurchases common shares at the same price”.  This is a big selling point for management because they get paid more.  The issue is that it creates a lot of risk, including a potential tax liability.

From a sellers perspective, the most important thing is to ensure that the stock purchase gets taxed at capital gains rates and not ordinary income rates.  This is the difference between paying 15% in taxes and 50%.

Unbeknownst to many CEOs, if the transaction is run through the company it often gets flagged as compensation and not capital gains.  If your transaction was run through the company and has the characteristics below, you are at risk of getting an unexpected tax bill:

1.) The secondary wasn’t offered to every shareholder.  If the company is making the repurchase it must make a tender offer to every shareholder, offering them a pro-rata participation in the secondary.  Most of the time management doesn’t want to do this because it takes a lot of time and it encourages employees to sell.  This also reduces the amount of secondary available for management.  If you skipped this process that is strike one.

2.) There is a discrepancy between the secondary purchase price and the 409A.  For those who don’t know, 409A is an audit guideline for pricing common options.  As an example, if you issued common stock to employees with a strike price of $1 right before the secondary, and then sold your stock at $3, that raises a red flag.  If the next 409A after the transaction closes is only $2 then you are in real trouble.

Ultimately these two missteps are common and they can create serious issues for management.  I have even heard of CEOs pushed to bankruptcy by major tax bills that popped up out of the blue years later.  My recommendation for teams that are going through this process is to insist on stock purchases directly from management.  It is sometimes hard to get new investors to agree on price, but in the long run it is better for the company and most likely better for you.