Once a startup gains traction, it’s common for its investors to think about selling their shares at a profit before things could go south. If you’re a founder, you may be wondering about the pros and cons of offering your investors the option to enter into secondary transactions. What legal clauses in your formation documents could facilitate or inhibit the sale of already-issued shares in a private market? This article will cover secondary transactions in private companies.
Why Allow Investors to Sell?
There are a number of reasons why secondary transactions benefit early-stage startups. You may have discovered a misfit between you and one (or more) of your investors, and want to have the option of replacing them with better fits as early on as possible. You may want to let incoming investors set a higher valuation for your startup if leaving investors are able to sell their shares at a profit. You may want to pursue structural changes that regroup or recategorize your existing shareholders. Allowing secondary transactions may make your startup more attractive to investors who are still on the fence by giving them the option to leave if they felt like it.
At the same time, there are also a number of reasons why secondary transactions sabotage growth. Allowing investors to come and go too easily could remove your access to certain resources at critical times. Privately negotiated share prices could also impact the valuation of your startup or cause cash-flow holdups. If the clauses governing transfers are too open, then you may have to deal with incoming investors who are completely incompatible with your startup’s culture, vision, or operational style.
To determine the scope of how transfers take place, it’s best to think about how secondary transactions align with your startup’s business strategy.
Legal Clauses Of Secondary Transactions
What legal clauses should you adopt to facilitate or inhibit secondary transactions? The relevant section in your formation documents is the “Transfers” or “Transfers and Assignments” section, which typically appears closer to the end.
If your startup is a corporation, then transfers may be restricted by rights such as the right of first refusal, which requires selling investors to offer their shares to existing shareholders before they can offer their shares to a third party. Corporations may have a repurchase option, which allows them to have first dibs on the shares of selling investors through buybacks.
If your startup is a limited liability company, then transfers may be restricted by the managers. Managers may have the sole right to approve or disapprove of secondary transactions. If they are required to approve of secondary transactions that are “reasonable,” then they may have the power to control who the incoming investors are. You can adopt a right of first refusal, which would apply to a limited liability company in the same way as how it would apply to a corporation.
If your startup is a general partnership, then a unanimous vote of the partners may be required to admit new partners. And finally, if your startup is a limited partnership, then transfers may be restricted in more or less the same manner as those of limited liability company interests. The general partner could have sole discretion over some or all parts of transfers, and a right of first refusal could apply to the limited partners.
What Clauses Should You Adopt?
To draft the perfect transfer clauses for your startup, you’ll need to balance legal clauses alongside the pros and cons of allowing secondary transactions in the first place. The transfer clauses should be open enough to allow the pros of secondary transactions to shine through, while simultaneously being restrictive enough to preclude some of the cons of secondary transactions from damaging the growth prospects of your startups.
What does that look like in practice? For example, you could enforce a right of first refusal while mandating the manager of your limited liability company to let all secondary transactions through. You could also require a majority-in-interest vote of the existing shareholders to allow new shareholders in. The options are endless, and you could tinker with legal clauses in many ways.
Sum up
As with many aspects of startups, it’s impossible to predict exactly how secondary transactions will play out in the long run. If you’re unsure about exactly how to proceed with transfer clauses, it may be best to keep your formation documents generally amendable so that you can make changes down the road if you need to. With that said, you should avoid outright banning transfers or adopting transfer clauses that have no restrictions. The sweet spot lies somewhere in the middle.
