Secondary Markets: A Guide for Employees with Equity

Congratulations! You've received equity compensation, which often comes in the form of stock options, restricted stock units (RSUs), or other similar instruments. This means you have a stake in the company's success and potentially significant wealth down the line. However, what happens if you need or want access to some of that value before the company goes public (IPO) or gets acquired? That's where secondary markets come in.

What are Secondary Markets?

In simple terms, a secondary market is a place where existing shareholders (like employees with equity) can sell their shares to other investors (typically individuals, venture capital firms, or other funds). This contrasts with the primary market, where a company first issues shares to the public during an IPO.

Why are Secondary Markets Important for Employees?

• Liquidity: Perhaps the most significant benefit. Employee equity is often illiquid. You can't simply sell your stock on a public exchange. Secondary markets provide a way to convert some of your equity into cash before a liquidity event (IPO or acquisition).

• Diversification: Having a large portion of your net worth tied up in a single company's stock is risky. Selling some equity on the secondary market allows you to diversify your investments.

• Funding Life Goals: Maybe you need a down payment for a house, want to pay off debt, or have other pressing financial needs. Secondary markets can provide the funds to meet these goals.

• Flexibility: You have more control over when and how much of your equity you access, instead of waiting for the unpredictable timing of an IPO or acquisition.

• Understanding the Value of Your Shares: Participating in the secondary market can offer valuable insight into what investors actually think your equity is worth, which is often different from what your company values it at internally.

Types of Equity That May be Traded on Secondary Markets

• Stock Options: The right to purchase shares at a predetermined price (the strike price) for a set period. Secondary markets typically deal with exercised options (where you own the underlying shares).

• Restricted Stock Units (RSUs): Shares that vest over time. Once vested, RSUs become actual shares of the company that can be sold. Secondary markets handle the sale of vested shares.

• Common Stock: Once options are exercised or RSUs vest, the shares become common stock, which is what you'll actually sell in the secondary market.

• Other Equity Instruments: Some other equity types, such as phantom stock or profit-sharing units, might be traded, but are less common.

How Secondary Market Transactions Work

1. Finding a Buyer: This can be done through several avenues:

   • Secondary Market Platforms: There are specialized online platforms that connect sellers and buyers of pre-IPO shares.
     

   • Company-Facilitated Transactions: Your company might organize a "tender offer," allowing employees to sell shares back to the company or a selected group of investors.

   • Direct Outreach: Some sellers may attempt to connect with potential buyers directly through their network. (This requires significant effort and is less common.)

2. Negotiation: Sellers typically offer their shares at a discount to the implied fair market value. The discount reflects the risks associated with investing in private companies. The price is negotiated between the seller and buyer.

3. Due Diligence: Buyers often perform due diligence on the company before purchasing shares.

4. Legal and Administrative Processes: Secondary market transactions involve a legal agreement, transfer of shares, and typically go through the company's stock administration platform. These are important steps to ensure everything is handled correctly.

5. Closing: Once the paperwork is complete and payment is made, the shares are transferred to the buyer.

Potential Downsides and Considerations

• Discounted Prices: Shares in secondary markets are sold at a discount. This is because the buyer is taking on the risk that the company might not go public or be acquired at a high valuation. You'll need to consider if the potential benefits outweigh the loss of future upside.

• Transaction Costs: Secondary market platforms charge fees for facilitating transactions, which will reduce your net proceeds.

• Company Restrictions: Some companies restrict employee participation in secondary markets or require them to gain approval before selling shares. Check your stock plan and company policies carefully.

• Tax Implications: Selling shares in a secondary market triggers a taxable event. Consult with a tax professional to understand the tax implications based on your specific situation.

• Complexity: Secondary market transactions can be complex and require significant understanding of legal and financial concepts. It's advisable to seek professional advice before participating.

• Limited Buyer Pool: Finding a buyer may not always be straightforward, and it may take time to complete a transaction.

• Information Asymmetry: Buyers may have more insight into the company's performance and prospects than you do, which could lead to an unfavorable price.

Examples to Illustrate the Concepts

Example 1: The RSU Employee

Sarah works at a pre-IPO tech company and has vested 5,000 RSUs. The company has a recent valuation implying a share price of $20. Sarah needs to buy a house and decides to sell 2,000 shares in the secondary market. After finding a buyer on a secondary platform, she negotiates a sale at $15 per share, with platform fees of 2%.

• Gross Proceeds: 2,000 shares * $15/share = $30,000

• Fees: $30,000 * 0.02 = $600

• Net Proceeds: $30,000 - $600 = $29,400

Sarah sacrifices some future upside by selling at a discount, but gains needed liquidity.

Example 2: The Stock Option Employee

Mark has 1,000 stock options with a strike price of $5. He believes the company will eventually do well, but needs cash. He exercises his options for $5,000 ($5/option * 1,000), incurring a taxable event based on the current value of the shares. He then sells 500 shares on a secondary market for $12 each, after fees, despite a company valuation of $18.

• Cost to Exercise Options: $5,000

• Proceeds from Sale: 500 shares * $12/share = $6,000

Mark also has to consider his capital gains tax on the profit he made on the sale. He generated $1,000 in cash but gave up the opportunity to make more if the company’s value grows further.

Key Takeaways

• Secondary markets offer a way to access value from your equity before an IPO or acquisition.

• These markets come with both benefits (liquidity, diversification) and drawbacks (discounted prices, transaction costs).

• Research your options, understand your company policies, and seek professional financial and tax advice before selling your shares.

• Don’t feel pressured to sell if you are confident in the company’s long-term success.

Important Note: The information provided here is for general educational purposes only and should not be considered financial or legal advice. Always consult with qualified professionals before making any financial decisions. By understanding the nuances of secondary markets, you can make informed decisions about your equity compensation and strategically manage your wealth.