Secondary Sales 101

September 11, 2023

When a tech worker joins a startup, the two sides usually strike a bargain in which the employee accepts a reduced salary in exchange for an interest in the company’s equity. This bargain is vital to the success of venture capital-backed companies. The company preserves precious cash to fuel growth, and the employee gets rewarded upon an exit (an IPO or sale of the business) — typically by exercising previously granted options that enable them to purchase shares at a fraction of their then current value and, thereby, participate in the exit event as a shareholder.

However, exits can be a long time coming. The significant growth of private capital as an alternative to seeking funding in the public markets means that, on average, companies are staying private longer. On average, they’re staying private over twice as long as in 2000. This creates a situation in which founders and employees hold a valuable but illiquid, and possibly volatile, asset. Reasonably, at some point while the company remains privately held, these individuals may want to realize some of the value of the company’s success and diversify their investment portfolio.

Secondary Sales

Company-sponsored secondary sales (we will simply refer to them as secondary sales) offer a potential solution to this liquidity problem. In a secondary sale, an existing shareholder, typically a founder, employee or early-stage investor, sells their shares directly to the investors. This is in contrast to a standard financing round, also known as a treasury or primary issuance, in which the company issues new shares (usually of a new series or class) to investors. Of significance to all parties, including the company, in a secondary sale, the company does not receive payment for the shares purchased by investors — that flows to the selling shareholders.

It is difficult to do a secondary sale outside of a company-sponsored transaction for a range of reasons, including rights of first refusal and the requirement for company approval of any share transfer. However, even when the company is supportive of a secondary sale, there are challenges to its implementation.

For one, founders and employees typically hold common shares, while investors want to acquire preferred shares. In some instances, particularly if a company is approaching an exit, an investor purchasing preferred shares from the company may be willing to also purchase some common shares from founders and employees, but this is not common.

In the United States, secondary sales are more easily accomplished than in Canada due to differences in the tax treatment of share repurchases. In our experience, U.S.-style secondary sales often consist of investors first subscribing for the desired preferred shares. The company then uses the subscription proceeds to redeem or repurchase (often by way of “tender offer”) the shares of the selling shareholders.

The Canadian tax regime often makes U.S.-style secondary sales an inefficient transaction structure. In Canada, a selling shareholder can often receive the amount of the redemption or repurchase price equal to the “paid-up capital” (or PUC, as described below) of the repurchased shares without being subject to taxation. However, to the extent that the redemption or repurchase price exceeds the PUC of the repurchased shares, the excess is deemed to be a dividend paid by the company to the selling shareholder. This deemed dividend is taxed as the shareholder’s dividend income and, for non-Canadian shareholders, is subject to Canadian withholding tax. Depending on the circumstances, there can also be adverse tax consequences to the redeeming company. This makes the idea of a company redemption or repurchase in the form of a tender offer a tax-inefficient transaction.

In contrast, where shares are instead sold to a third party (not the company), the excess of the sale proceeds over the shareholder’s “cost” is generally taxed in Canada as a capital gain. If the seller is Canadian, only half of a capital gain is taxable and may actually be non-taxable to the seller to the extent the seller is an individual able to utilize the “lifetime capital gains exemption.” Canadian resident individuals are generally entitled to net gains realized on the disposition of certain properties that can include shares of “Canadian-controlled private corporations” subject to certain criteria being satisfied. For 2023, this exemption is equal to C$971,190 and is indexed to inflation.

Thus, a sale to a third party is often more appealing and, to avoid the adverse tax treatment associated with a share repurchase or redemption, a company may, depending on the circumstances, facilitate a means by which common shares can be purchased by a third party (providing the desired tax treatment to the seller) and subsequently be exchanged by the purchaser for newly issued preferred shares.

Paid-Up Capital

This alternative transaction structure is, however, sometimes not without trade-offs due to the rules regarding PUC. PUC is a Canadian tax attribute that is based on the corporate law concept of “stated capital.” Generally speaking, PUC is an account of the amounts that a company has received on the issuance of shares, determined on a class-by-class basis. Further, PUC for a class of shares is averaged across all of the shares of that class. Effectively, while a company is able to return the amount invested free of tax, the amount available per share is determined based on the total PUC for the class, divided by the number of shares of the class. Consequently, a later purchaser of the shares at a higher price will not receive the full tax benefit of the amount they invested (if they receive returns of capital or the company liquidates), as the PUC available to them will be determined by both the amount they invested and the lower amounts invested by earlier investors.

Further, on a subsequent exchange of purchased common shares for preferred shares, only the historical PUC for the purchased shares (generally much lower than the amount then being paid for the purchased shares) is transferred to the PUC of the preferred shares. This means the third-party purchaser gives up the benefit of the full amount of the PUC to which would otherwise be created in a direct purchase from the company.

Many investors (particularly non-Canadian investors, including funds with non-Canadian partners) will want to discuss alternative tax structuring to indirectly obtain shares through a secondary transaction that would have PUC equal to the amount they paid in the secondary. In some circumstances such tax structuring can be accommodated. Canadian legal and tax advice should be sought to determine if such structuring is appropriate in any particular circumstance.

In addition to tax and legal consideration, there are other practical considerations for the company, such as which shareholders are entitled to participate in the liquidity event and to what extent.

Other Considerations

A corollary to companies taking longer to go public is the significant growth in the number of large, privately held companies. Heightened investor interest, coupled with the increased seller desire for liquidity, has created a widely recognized opportunity to provide a more institutionalized solution than company sponsored secondary sales and complex restructuring transaction. In the U.S., some third parties are finding ways to create trading markets for the securities of large private companies or otherwise enabling shareholder liquidity through loan structures. These options are less well developed in Canada and are not a common solution at this time. There are, however, efforts being made to change this, including by some large, global financial services companies. For now, company-sponsored secondary transactions remain the path to shareholder liquidity prior to an IPO or acquisition of the company.