Exiting the Startup Journey: Secondary Sales for Investors

The startup ecosystem is a thrilling rollercoaster of growth, innovation, and, ultimately, exits. While the dream scenario is often an IPO or a major acquisition, secondary sales have emerged as a vital mechanism for early investors to realize returns on their investments. 

What is a Secondary Sale?

In a secondary sale, an existing shareholder (like an early investor) sells their shares to another investor, without the company issuing new shares. Unlike a primary sale, where the company issues new shares to raise capital, secondary sales provide liquidity to early investors, allowing them to exit (partially or fully). 

The Secondary Sale Process

The secondary sale process involves several key steps:

1. Identifying a Buyer: The first step is to find a buyer interested in purchasing the shares. This could be another investor, a private equity firm, or even an existing shareholder looking to increase their stake. Investment banks or advisors often facilitate this process.
2. Valuation: Determining a fair valuation for the shares is crucial. This can involve various methods, such as discounted cash flow analysis, comparable company analysis, or relying on the valuation from the latest funding round (usually the Secondary Sale is at a discounted price to the Primary Fundraise, typically ranging between 10-30%).
3. Negotiation of Terms: Once a buyer is identified, the parties negotiate the terms of the sale, including the price per share, the number of shares being sold, and any specific conditions.
4. Due Diligence: The buyer typically conducts due diligence to assess the company’s financials, legal standing, and overall health.
5. Share Purchase Agreement (SPA): The terms of the sale are formalized in an SPA, a legally binding contract that outlines the rights and obligations of the buyer and seller.
6. Closing: Upon fulfilling all conditions outlined in the SPA, the transaction is completed, and the shares are transferred to the buyer.

Key Documentation

Secondary sales require careful documentation to ensure a smooth and legally sound transaction. Key documents include:

• Share Purchase Agreement (SPA): SPA is the cornerstone of the transaction. It details the terms of the sale, including the number of shares, purchase price, representations and warranties, indemnification clauses, and closing conditions.  

Some critical terms that find their way into most SPAs:

1. Definition of Shares: Clearly identifying the number and class of shares being sold is fundamental. This might seem obvious, but ensuring precise details avoids future ambiguity.
2. Purchase Price and Consideration: This is the heart of the deal – how much the buyer will pay and the mode of payment (lump sum, staggered, etc.).
3. Representations and Warranties: This is where things get interesting!!! The seller makes statements about the shares being sold (e.g., ownership, authority, financial health, encumbrance, compliance). The warranties are classified under 3 categories, Fundamental Warranties, Tax Warranties and Other Warranties.
   
   The buyer relies on these statements for the purchase of the said securities.
   
   The seller may also ask the buyer to give Fundamental Warranties with regard to the ability to execute the agreement and the transaction and regarding its valid incorporation and tax status. 
   
   Sometimes, the company may also be required to give certain Warranties with regards to the securities offered for sale.
4. Indemnification: This clause outlines who bears the responsibility for losses arising from breaches of representations and warranties or other specific events. Indemnity further includes:
   • Sunset Period – The period for which the buyer can claim indemnity in case of a breach of warranty is identified.
   • Limitation of Liability – This includes the limit of claim. This can be uncapped i.e. the buyer can claim for any amount that can be reasonably justified or capped wherein the maximum liability of the seller is capped to a predetermined amount (usually the purchase consideration).
     
     Limitation of Liability may also include situations wherein the indemnification cannot be triggered.
5. Closing Conditions: These are the prerequisites that must be met before the deal is finalized (e.g., regulatory approvals, due diligence satisfaction, acquiring the valuation report & tax reports and acquiring requisite approvals/exemptions from transfer restrictions).
6. Closing Date: The date when the share transfer and payment will officially occur.
7. Governing Law and Dispute Resolution: Specifying which jurisdiction’s laws will govern the agreement and how any disagreements will be resolved (e.g., arbitration, litigation).
8. Confidentiality: Ensuring both parties maintain the confidentiality of the transaction details.
9. Assignment: Whether either party can transfer their rights or obligations under the agreement to someone else.

• Shareholders’ Agreement (SHA): The SHA governs the relationship between the company’s shareholders and may contain provisions related to share transfers, such as rights of first refusal or tag-along rights. Prior to transferring the securities, the Seller must ensure compliance to the transfer restrictions (if any) contained in the SHA.
    
• Charter Documents: The company’s constitutional documents (e.g., articles of association) also outline share transfer procedures and restrictions. The Seller must consider the restrictions and procedure provided in the Charter Documents to ensure a fully compliant transfer of securities.
• Transfer Instruments: Documents required to legally transfer the shares from the seller to the buyer. The most critical here is the SH4, a document giving details of the transfer securities, price and the parties. The transfer is effective and valid only post execution of the SH4. The same needs to be shared with the company by the buyer, so that the company can pass necessary resolutions to give effect to the transfer and update its Register of Members to reflect the beneficial ownership of the transferred securities.
• Regulatory Approvals: Depending on the jurisdiction and the nature of the transaction, regulatory approvals may be necessary (usually in cases where either one or both the parties are based/tax residents of a foreign country)

While the regulatory documentation and internal compliance documentation can be navigated with relative ease owing to the standardisation of the requirements, SPA is a subjective document which is unique to individual parties and transactions. 

SPA is the building block for the relationship between the buyer and seller and survives for multiple years post the transaction. In case of VC funds or otherwise as well, it is critical to carefully enter into the SPA and consider all the terms and clauses being inked as, in case of VCs, post distributing the funds to the LPs, the fund manager continues to be bound by the obligations of the SPA. 

Lets understand the difference in approaches and best practices for the most critical clauses of the SPA.

The Seller’s Perspective: Balancing Risk and Return

The selling investor wants to ensure a clean exit while minimizing future liabilities. Here’s how one may approach the SPA terms:

• Qualified Representations and Warranties: The seller must qualify representations and warranties with phrases like “to the best of your knowledge” or limit their scope to specific periods. For example, instead of warranting the absolute accuracy of all past financial statements, one might warrant the accuracy based on the information available to them. Further, sellers must seek to limit the scope of warranties to matters within their direct control.
• Narrow Indemnification Clause: The seller must aim for a limited indemnification clause with a shorter survival period and a reasonable cap on the liability. One might also negotiate for a threshold (a minimum loss amount that needs to be exceeded before a claim can be made) and a de minimis (a small loss amount that won’t trigger indemnification). The best practice is to cap the seller’s total aggregate monetary liability at an amount equal to the Consideration, with specific exceptions such as Breach of Fraud or Willful Misrepresentation. 
• Clear Closing Conditions: Ensuring the closing conditions are objective, clearly defined and a suitable period has been provided to the seller to ensure timely closure and prevent unnecessary delays. A well-organized closing process ensures the timely transfer of shares and funds.
• Clean Break: Seller must ensure the SPA clearly defines the obligations post-closing and minimizes any ongoing involvement or liability.

The Buyer’s Lens: Structuring for Security

As a purchasing investor, the primary goal is to mitigate potential risks. Below are the approaches one must consider:

• Robust Representations and Warranties: Buyer must strive for comprehensive representations and warranties covering the title, encumbrance, authority, validity and more. For instance, the buyer might seek a warranty stating that there are no undisclosed liabilities or ongoing litigation that could negatively impact post-acquisition.
• Strong Indemnification Clause: Buyers must aim for a broad indemnification clause that holds the seller responsible for any losses arising from breaches of their representations and warranties, potentially with a survival period (how long these warranties last after closing) that gives the buyers adequate time to uncover any issues. The buyer might also consider negotiating for a higher than purchase consideration cap on the seller’s liability.
• Thorough Due Diligence as a Condition Precedent: The buyer must seek a thorough due diligence on the sale securities, which includes requiring the seller to share undertaking, tax certificates (GST & Income tax), residency certificate (in case where at least 1 party is a foreign resident)  and internal authorisation to execute the documentation and give effect to the transaction. Further,  the buyers must seek assurance (through representation & warranties & independent due diligence) that the seller has clear ownership of the shares and that they are free from any encumbrances.
• Escrow Mechanism: For a portion of the purchase price to be held in escrow for a certain period can provide a financial cushion to cover potential indemnity claims.

Approaching Secondary Sale

SPA, which typically encapsulates the entire transaction, involves a degree of negotiation. Here are some common practices:

• Valuation and Other Rights & Obligations: Disagreements over valuation are most common besides other critical points such as Representations & Warranties and Indemnification which can derail the deal.
  • Sellers should have a realistic valuation expectation and be prepared to negotiate.
  • Both buyers and sellers should approach negotiations with a clear understanding of their objectives, commercially reasonable terms and be prepared to enable a win-win scenario. 

Overly aggressive demands from either party can jeopardize the deal.

• Transfer Restrictions: Existing agreements like the SHA or the company’s charter documents may impose restrictions on share transfers, such as requiring consent, approval, waiver from other shareholders. Buyer & Seller must ensure all such prerequisites are duly received post compiling with the process as detailed in such documents.
• Regulatory Compliance: Buyers must ensure that the transaction complies with all applicable regulations.
• Due Diligence Drives the Negotiation: The buyer’s due diligence findings heavily influence the scope and strength of representations, warranties, and indemnification.
• Market Standards Matter: While every deal is unique, there are general market standards for certain clauses, particularly around survival periods and liability caps, which are often considered as starting points for negotiation.
• Experienced Legal Counsel is Crucial: Both buyers and sellers invariably engage experienced legal counsel to draft, review, and negotiate the SPA to protect their interests effectively.
• Focus on Materiality: Indemnification clauses often include a concept of “materiality,” meaning claims can only be made for breaches that have a significant impact on the value of the securities under consideration.

In Conclusion

The Share Purchase Agreement is more than just a legal formality; it’s a critical document that defines the risks and rewards for both the buyer and the seller in an unlisted share transaction.

Secondary sales offer a valuable exit route for startup investors. By understanding the key terms, process, documentation, pitfalls, the different perspectives of each party, and the prevailing industry practices, investors and founders can navigate these agreements more effectively, ensuring smoother transactions realizing the fruits of the investments and simultaneously protecting their respective interests.

 

Author

Karan Gupta