General Questions & Considerations of a Secondary Market Transaction

Guest Post by Mitchell C. Littman, Esq.



So, what is a Secondary Market Transaction?

A Secondary Market Transaction is a negotiated private sale of restricted securities of an Issuer whose securities are not publicly traded. Some transactions are effected directly from Seller to Buyer and in some instances one or both parties may be represented by a broker-dealer who may earn a commission on the transaction.

Who are the Issuers?

The Issuers that have attracted the most market attention have been social networking and technology firms that have chosen to remain private but that have (i) used equity and equity-linked reward systems in attracting and incentivizing employees and (ii) received private equity or venture capital investments from some combination of angels and institutional investors.

Who are the Sellers?

The overwhelming majority of Sellers have been founders or early-stage employees that have left the employ of the Issuer, though there has been some selling by early stage investors (primarily angels, rather than VCs who have tended to participate in follow-on rounds). Ex-employees have typically obtained their Shares through the exercise of stock options or by receipt of restricted stock grants.

What securities are they selling?

Most sales are of Common Stock, though there have been some sales of Preferred Stock. Some Issuers have two classes of Common Stock – a class with super-voting rights and a plain vanilla class of Common Stock. In such cases, the vanilla class is invariably the security being sold. All such shares are typically deemed to be ‘restricted securities’ under applicable Federal and state securities laws.

Additional Hurdles to Effecting a Purchase and Sale: ROFR’s and Co-Sale Rights

In addition to the outright prohibition on Transfers, most Restricted Stock Purchase Agreements or Option Exercise Agreements include provisions granting a “Right of First Refusal” (a “ROFR”) under which the Issuer (or its designee), within a prescribed period of time after receipt of a Transfer Notice, may elect to purchase the Shares on substantially the same terms as those proposed in the Transfer Notice.

In some instances, particularly where the Shares to be transferred consist of Preferred Stock, other early stage investors in the Issuer may also have ROFR’s and/or Co-Sale rights entitling them to also sell Shares along with the Seller.

The exercise of any of these rights by the Issuer or another stockholder effectively derails the purchase by the Buyer.

Virtually all ROFR and Co-Sale provisions provide that, in the event the rights are NOT exercised, the Seller has a fixed number of days in which to complete the Transfer to the Buyer. In the event the transaction is not completed within the allotted time, any subsequent attempt at Transfer must once again pass through the ROFR and/or Co-Sale process.

Effecting the Purchase and Sale: The Stock Transfer Agreement

The core document for effecting the purchase and sale of the Shares is the “Stock Transfer Agreement” (also sometimes called a “Stock Purchase Agreement”) (the “STA”).

The typical STA contains:
• The principal terms of the sale, i.e., number of Shares to be sold, price and the like
• Representations and warranties of the Seller include Title to Shares; Absence of any lien or encumbrance; Power and authority to sell.
• Representations, warranties and covenants of Buyer include Power and authority; Sale was not effected through any public advertising or general solicitation; Buyer is taking for investment intent; Buyer is sophisticated and has sufficient access to information
• Buyer absolves Seller for any liability due to the fact that Seller may have superior information regarding the Issuer Buyer agrees to be bound by same restrictions as were applicable to the Shares in the hands of the Seller

Closing Mechanics

Assuming the ROFR is not exercised, the parties may proceed to a closing. Generally speaking, the Seller and Buyer execute and deliver the STA to the Issuer for its approval.

Seller delivers Stock Certificates to the Issuer or its Transfer Agent.
(Some Issuers actually require that all Stock Certificates be held in escrow by Issuer’s counsel to facilitate transfer in the event of a ROFR exercise. In that case, the other parties will only receive photocopies of the certificates.)

Once approved, a virtual closing is conducted, with the Purchase Price being wired by the Buyer to the Seller and the STA signatures and the opinion of Seller’s counsel being released to the parties. Subsequently, the Issuer issues a new Stock Certificate in the name of the Buyer.

About Mitchell C. Littman, Esq.

Mitchell Littman is a founding partner of Littman Krooks LLP and heads the firm’s corporate and securities department. His practice includes public and private offerings, broker-dealer and investment banking matters, secondary market transactions, venture and private equity capital investments and mergers and acquisitions

About Wedbush Securities Private Shares Group
The Private Shares Group of Wedbush Securities covers the growing base of privately traded securities, with an emphasis on those in the social media space. The mandate of the group is to build our trading network in all private shares, source deal flow in the space (including “initial private offerings”), and to build funds and create other alternative investment opportunities across private shares for our institutional and accredited retail clients.

How The Dodd Bill May Impact The Secondary Market

There has been a lot of debate over a section of the financial reform bill proposed by Senator Chris Dodd, (aka the Dodd Bill), which has a few provisions that could significantly impact angel investing, and ultimately the secondary markets in a very negative way.  Although this has been widely covered, and while it appears as though most of the worst parts will be eliminated, we felt we should discuss how it may ultimately affect the secondary markets.

Currently, most technology startups raise their initial funding from angel investors, which by law must be accredited investors.  An “accredited investor” is currently defined as anyone with a net worth of over $1MM or net income of over $200,000 a year.  The “Dodd Bill” proposes to increase these to $2.3MM net worth and $450,000 annual income, and then index those numbers to inflation.

The second thing the Dodd Bill proposes is to eliminate the existing federal pre-emption over state regulation of “accredited offerings.”  This means that venture and angel financings would be regulated state by state, creating a ton of rules and regulations that each financing would need to be subject to.  Each financing would require startups to register with the SEC, which could take up to 120 days to review the filing.  This may in itself kill most angel investments, since angels like to react quickly to the market, and most technology investments are clearly time sensitive.

Last year, 259,480 angel investors invested $17.6 billion in 57,225 entrepreneurial ventures.   There are over 240 million Americans that reported earnings in 2009, with 2.5 million earning over $200,000.  That means only 1% of the U.S. population currently qualifies as an eligible “accredited investor”.  The problem with the Dodd Bill is that it could dramatically reduce the total number of eligible angel investors, which is what has everyone in an uproar.

The negative impact will be severe.  First, fewer angels will make capital more expensive, fewer startups will be funded, and innovation will be stunted.  However, in the short term, this may actually create an even higher demand for shares on the late stage growth startups like Zynga, Facebook, Twitter and more within the secondary markets among the remaining eligible angel investors.

The secondary market will also suffer as there will be fewer “winners” to invest in.

Government is never in equilibrium, and tends to extremes.  We were basically on a 30 year de-regulation binge, that with 20/20 hindsight, went to far, and destroyed a lot of wealth.  It appears we may now experience the blowback, the new extreme will be too much regulation that will likely destroy even more wealth than the de-regulation binge.