Are you a private company shareholder looking to sell your stocks? Unlike public companies, private ones do not offer their stock to the general public, which complicates the process of selling shares. However, that is no reason to hesitate. When your stock vests or gets exercised, it becomes too valuable to sit on, so cashing it is the way to go.
This is more complex than selling public stocks, but that does not mean it has to lead to failures and dead ends. Let’s demystify the secondary sale process by exploring four common mistakes when selling private stock and how to avoid them.
Why Should You Sell Your Private Stock?
There are numerous reasons to sell private company shares. Remember, the key is timing. Some circumstances that call for this transfer are:
- Relying heavily on a few illiquid assets: Selling private shares allows you to spread risk across other investments. You can diversify your wealth, protecting your finances if the company underperforms.
- Major life events: Milestones such as buying a home, starting a family, education, etc., require cash. Selling shares can provide you with this liquidity without debt.
- Fluctuations in value: Private valuations can fluctuate dramatically; good timing can mean the difference between 2x and 10x. In these circumstances, it is best to lock in gains by selling at valuation peaks.
- Slowed company hypergrowth: Growth slows as companies mature, and you may stop driving strategic value. Here, it is best to plan an exit. Selling shares will help you benefit from your past work and reduce future risk.
Deal-Killers to Avoid
Let’s look into some things you must avoid when planning your exit.
1. Ignoring Transfer Restrictions in the Shareholder Agreement
A shareholder agreement outlines the process and conditions for the transfer. Many companies include Right of First Refusal (ROFR), co-sale rights, and board approval requirements that restrict your selling ability. You cannot bypass these terms, even as an executive or a founder. Not honoring them leads to legal disputes, delays, or the company blocking the sale entirely.
You can sidestep this blunder simply by being diligent. Review your shareholder agreement, bylaws, and investor rights documents before initiating a sale. You must also engage the company early; talk to your CFO, GC, or board on time to get the necessary approvals in place. Additionally, consider consulting legal counsel to understand the limitations and how to work with them.
2. Mismatched Value Expectations
Sellers usually shape prices around the latest post-money valuations. For instance, if a recent series was worth $800 million, you might assume your shares are worth the same amount. However, buyers want a cheaper deal, and that is where the disconnect shows up. Secondary buyers will apply discounts on account of the shares’ illiquidity, lack of control, and limited access to company information; they will seek a lower price than the last round. As a result, the deal might come to a standstill.
You must do your homework if you want to avoid this situation. Keep in mind that secondary sales rarely happen at full valuations unless the company is near IPO or highly in demand. You must be prepared to negotiate accordingly. Talk to an advisor or secondary market platform to benchmark realistic expectations and find middle ground with your buyers.
3. Overcomplicating the Deal Structure
Secondary transfers should be clean and simple. However, some founders over-complicate the details. This includes:
- Using multiple special purpose vehicles (SPVs): SPVs offer the benefits of risk isolation and tax benefits, but using too many can raise costs and complicate legal review.
- Unusual payment terms: Terms like delayed payments, contingent payouts, and earn-outs can create uncertainty and discourage buyers.
- Synthetic equity structures: Instruments such as phantom equity stocks lack clear ownership rights and guidelines. They are harder to transfer and legally enforce.
These conditions foster distrust, making buyers drop the deals. You must steer clear of them. Keep the deal’s structure simple. Use standard agreements with direct sale share, fair price, and clean documentation. Finally, you must work with experienced legal counsel and avoid unnecessary intermediaries.
4. Not Accounting for Tax and Compliance Consequences
Many sellers underestimate capital gains exposure. This might end up with you missing out on potential tax benefits like Qualified Small Business Stock (QSBS). On the other hand, failing to structure the deal will also end in compliance issues, leading to audits and penalties.
The best way to prevent this is by consulting a tax advisor who is well-versed in private equity and secondary markets. Always document the sale properly, keeping a detailed paper trail. You must also research QSBS eligibility, 1202 exclusions, and optimizing your holding period beforehand.
Endnote
Selling private stock does not have to be overwhelming. All you need is the right preparation and strategic foresight. The illiquid nature of private equity does not mean your options are limited. Seek expert guidance, engage in proactive planning, and follow the tips above to improve your chances of a smooth and successful transaction.
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