How can founders and early employees get liquidity in financings?

Takeaway: Founders and early employees can, in consultation with the startup, use secondary sales and stock redemptions to get liquidity in venture financings. However, the selling stockholder should weigh the benefits of liquidity against any potential loss of QSBS status for their shares.

For startup founders and early employees, one challenge can be turning equity into liquid assets. This is where the strategies of secondary sales and stock redemptions come into play. These methods can provide a valuable path to liquidity, but it's crucial to understand their mechanics and implications.

Secondary Sales

Secondary sales are transactions in which existing stockholders - like founders or early employees - sell their shares directly to a new investor. This type of sale can occur as part of a larger fundraising round, or in a round dedicated specifically to secondary transactions. The benefit is clear: secondary sales provide an immediate path to liquidity, allowing stockholders to unlock the value of their equity without having to wait for an exit event like a sale of the company or an IPO.

However, secondary sales must be carefully managed. The company typically retains the right to approve or deny these transactions, ensuring they maintain control over their cap table. Also, the selling stockholders may need to make certain legal representations about their shares, and should consult with legal counsel to understand potential implications.

Additionally, while these sales can provide immediate liquidity, one must be cautious about the potential implications for qualified small business stock (QSBS) status. Under U.S. federal tax law, QSBS offers significant tax advantages to stockholders of certain small businesses. However, to qualify for QSBS treatment, the shares must be held for at least five years. If a stockholder engages in a secondary sale before this five-year period, the QSBS status could be lost, and the tax benefits forfeited. Therefore, stockholders must carefully weigh the immediate liquidity benefits against the potential loss of QSBS benefits.

Stock Redemptions

Stock redemptions, also known as share buybacks, are another method for achieving liquidity. In this process, the company itself purchases shares back from its stockholders. This strategy can be an effective way to provide liquidity to stockholders, and it also enables the company to regain ownership of a portion of its equity.

However, stock redemptions also come with their own considerations. They require the company to use its cash reserves, which might otherwise be used for growth initiatives or retained as a buffer against future uncertainties. Also, stock redemptions must comply with state corporate law and federal securities law, including rules related to the fair treatment of stockholders and the disclosure of material information.

Although this strategy can offer an avenue for liquidity, it also presents potential implications for QSBS status. A significant redemption from a stockholder (including a related party) within two years before or after the stock issuance can disqualify the QSBS status of the shares issued. As with secondary sales, stockholders contemplating a stock redemption must balance their immediate liquidity needs against the potential loss of QSBS benefits.

Conclusion

While secondary sales and stock redemptions can provide much-needed liquidity for founders and early employees, they also entail complex legal and financial considerations including QSBS implications. Therefore, before embarking on such transactions, it's essential to consult with legal and financial advisors to understand the potential implications. By taking an informed approach to these strategies, you can reap their benefits while ensuring the long-term stability and success of your startup.