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Secondary Sales – What Stockholders Should Know

Founded in Tech Episode 7

On this episode of Founded in Tech, Dan Krolikowski joins host Mark Eckerle to go over a rising hot topic in the Tech industry: secondary sales. What counts as a secondary sale? What should stockholders be aware of when dealing with secondary sales? Dan weighs in on all that and more.

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Mark Eckerle:
Welcome to this episode of founded in tech. I’m your host Mark Eckerle. And today’s show is part of our tech tip series, where I sat down with Dan Krolikowski to talk about secondary sales. On today’s episode, we discussed the difference between a primary sale and a secondary sale. The planning process, when going through a secondary sale and the tax considerations to be aware of, I really got a lot out of this conversation and I hope you do as well. Hello everyone. Welcome to today’s show Dan Krolikowski is joining me today to talk about secondary sales. Hey Dan, how you doing?

Dan Krolikowski:
I’m doing great. How are you doing, Mark?

Mark Eckerle:
I’m doing good. I’m doing good. Can’t complain.

Dan Krolikowski:
Excited to be here. I appreciate you having me.

Mark Eckerle:
Yeah. Thanks for joining us today. So, so before we jump into what a secondary sale is, um, once you tell us a little bit of background on yourself, kind of your, your role here at Withum and then,

Dan Krolikowski:
Yeah, definitely. So I’m a senior manager here at Withum, Mark, and I’m a team leader of Withum founders and tech executive group. And, you know, we deal a lot with the executive compensation, equity compensation, helping our clients with liquidity events. Um, so, you know, we’re doing a lot of work around secondary sale and working with our clients, you know, with them all the time.

Mark Eckerle:
Yeah. It’s a, it’s a fairly hot topic right now.

Dan Krolikowski:
Yeah. And, and, you know, agile, you’ll notice when we talk about the environment a little bit, you know, there’s definitely a lot going on in the secondary market in general, so I can understand why a lot of people want to hear about it and listen to me and you talk about it.

Mark Eckerle:
Definitely, definitely. So, so let’s jump right into it. What, um, starting all the way back at the beginning, what is the secondary sale and how is it different when you think of your standard primary sale, where you’re issuing series a series B preferred shares. So kind of tell us the difference in what is a secondary.

Dan Krolikowski:
Yeah, definitely. So, you know, in order to talk about a secondary, I think, like you said, maybe we’ll first talk about primary sale and typically in a primary sale company will issue new shares to investors. And then the proceeds of that sale go directly to the company. And a secondary sale is a little bit of the opposite where the company actually effectuates around the financing. And then in conjunction with that financing employee shareholders of the company actually sell their stock to either existing and new investors. Um, so the cash is actually not going to the company it’s going to go, um, to the employee shareholders

Mark Eckerle:
Got existing shareholders would be selling to new investors, essentially. Exactly. Okay.

Dan Krolikowski:
And again, the main difference is that it’s not new shares that are being issued. Um, it’s all chairs, so you’re not diluting the cap table. And then again, the cash isn’t going to the company, it’s actually going to the shareholders, which is a big benefit to them.

Mark Eckerle:
So, so what makes this such a hot ticket item right now? Why is it so popular? I mean, I’ve been hearing it pop up left and right. Um, I don’t work directly with secondary sales, so I’m not necessarily in the know, but kind of tell us why this so popular right now.

Dan Krolikowski:
Yeah, definitely. So, you know, the main reason is it’s just the environment that we’re in. Um, there’s a lot of private companies out there and the companies are staying private longer. So their value is increasing while they’re private and they’re not IPO-ing. Um, and the other reason is just because of all these private companies, there’s a lot of, I guess, money that’s being invested in being put aside to invest in these private companies at an earlier stage. Um, so because of, of all the, the hot environment, um, and because there’s so much money in this, in the private, uh, industry right now, these companies are actually looking for ways that they can reward their shareholders, reward their early employees sooner than later, um, for all their hard work and the value creation that they’ve done for these companies throughout the years. Um, so, so you, you know, right now I, you know, there’s a ton of secondaries going on.

Mark Eckerle:
Gotcha. So you mentioned that these are rewarding employees, [undetermined]. How does that kind of come into play? What, what role does a company have? If, if I think about it from a high level, um, I’m a, I’m an employee shareholder I want to sell to a new investor. What role does the company have in that? Do they have to give me authorization to sell my stock? Or what does that look like?

Dan Krolikowski:
Yeah, definitely. So it just could depend on the situation. And a lot of times, you know, when you have a secondary, uh, opportunity that happens, um, it could be limited to a certain amount of shareholders are allowed to sell, um, or it could be opened up to, you know, the entire employee base, typically there’s, there’s restrictions on who’s able to participate in one of these secondaries.

Mark Eckerle:
Okay. And what are the, what are common restrictions that you see there?

Dan Krolikowski:
Yeah. So, you know, some of the common restrictions that you would see, are, you know, just transfer restrictions in general, sometimes you need board approval on company repurchases that the company is actually buying the stock from you and not an outside investor. Um, sometimes there’s what we call right of first refusal, which means, you know, a lot of times these shareholders are going out and trying to find buyers for their stocks. Sometimes the company’s not doing it on their behalf. And then the company then has the right. Once the shareholder finds a buyer to say, Hey, you know what, we’re actually going to buy the stock from you. So you could go through all this effort and not be able to sell to an outside buyer may have to sell back to the company. So there can be restrictions there. And then a lot of times, um, you know, with all the tender offers or things that are opened up to a wider range of employees, there’s a lot of times a limit on what you can actually sell. So you may only be allowed to sell 10% of your holdings or 20% of your withholdings of your total holdings. Um, so a lot of times you can’t just say, Hey, I’m going to sell everything I have right now. So while they want to reward their employees, they also want them to have that long-term goal still in sight.

Mark Eckerle:
Gotcha. That makes sense then. Yeah, I wasn’t, I wasn’t aware of certain restrictions there and kind of the company’s role. So it definitely helps clarify a little bit.

Dan Krolikowski:
Yeah. And you just see, depending on the company, sometimes they’ll actually help you look out for the sh for certain buyers and then sometimes, you know, the shareholders on their own and try and figure out that market themselves.

Mark Eckerle:
Yeah. Nice to see that they’re, got you have your best interest in heart as well, right? Not, not, everyone’s always watching your back a little bit, so.

Dan Krolikowski:
Exactly.

Dan Krolikowski:
And I was going to say too, a lot of times, Mark, um, you know, the, the actual secondary can be structured differently. I mean, typically a new investor, you know, will put money directly in the company in exchange for preferred stock. Um, and then the company will use some of that, the dollars that they brought in to kind of redeem existing shareholders. Um, other scenarios actually involve cross sales where a new investor, um, would actually purchase a sale directly from existing shareholders. So, you know, that’s just two ways that you, you typically see secondaries. Um, so depending on the structure, um, you know, there can be different restrictions involved or different opportunities involved. So it just depends.

Mark Eckerle:
Okay. Yeah. It seems like there’s a lot of, kind of different factors that go into play here. Um, and each, each case is a little bit different or a little bit more or nuanced. Exactly. So, so you’re the team leader of Withum’s founders group. You, you have worked with the extensive list of founders tech, exit tech executives as kind of a part of that role. And what have you seen or what, what tips would you give for someone to be proactive in planning for a future secondary sale? Is there anything that someone could help prepare themselves with besides being the standard organized and having good records? Is there anything else that someone can kind of keep in their back pocket to be proactive in planning process?

Dan Krolikowski:
Yeah, definitely. Um, and it’s funny you say that, cause it, actually, I think the main thing that they sh that everybody should be doing is starting now and getting organized now kind of understanding what their holdings are. So a lot of times what I see is, um, individuals will come to me when there’s actually an imminent deal in place. So there’s not a lot of playing that you could do. So I think, you know, what you kind of got to figure out now is what are my holdings and then, you know, kind of plot out what the future’s going to hold it for you. So think about, are there actually going to be liquidity events in the future? And then if there are, you know, what do they look like at different fair market values? Um, whether the price is going to go up and down, um, right now the tax code kind of favors individuals that take risks and start the holding period now of the stock. Um, and then if they sell it in the holding periods over a year, there’s typically a tax benefit. Um, so you can’t really decide if you’re going to take that risk or not, or really make organized decisions. If you yourself don’t know what you have. Um, and there’s other, you know, breaks along the tax code, you know, that can go along with that. But again, a lot of it is just figuring out what do I have and then trying to figure out different planning opportunities from there.

Mark Eckerle:
Okay. And you said, you said start the holding period. What, what does that mean? Is there a file that has to be a form that has to be filed to, to kind of kickstart that, that time period? Or when does that, is that just upon issuance?

Dan Krolikowski:
Great question. Um, so typically if you have either stock options or you get some kind of stock, even if it’s restricted stock, the first thing that happens is you’re granted these options you’re granted these shares, right. Um, so typically, uh, if you just, if you were to be granted, um, stock options, nothing really happens until you exercise those stock options. So when you exercise your stock options, that starts your holding period. If you were then just to actually buy into a company, um, and get common stock in return for cash or services, you could theoretically start your holding period at the time that you received that stock, unless, um, that stock was subject to certain restrictions or a vesting schedule. Then at that point in time, um, you actually don’t can, you’re not considered holding that stock until the restrictions lapse or the vesting starts.

Dan Krolikowski:
Um, there is something called an 83 B election, where sometimes in those instances you can actually speed up, um, the vesting period I’ll call it, um, or the restriction period. And actually you make that 83 B and you’re treated as owning, uh, or holding that stock, um, on the grant date instead of the vesting date or the restriction lab date. So, you know, there is some planning involved with there and depending on what you’re holding is your holding period can start at different times. So again, it’s just something to really get organized and start thinking about now.

Mark Eckerle:
And what is, if someone were to elect that 83 B election, what goes into that very quickly? Like, is that a another tax form? Is that something they submit to kind of break that down for our audience?

Dan Krolikowski:
Yeah, definitely. So you typically make an 83 B election, um, you know, whenever you have either stock options or restricted stock that is subject to either vesting or restrictions like we were talking about. Um, and what you’ll do is within 30 days of grant, you actually have to file this 83 B election with the company that you work for. And then also with the IRS and, you know, that’s really all you gotta do. You just gotta make sure that it’s timely filed and, and you’re good. Um, sometimes there’s an exercise, a strike price, which we call it that you’ll have to pay to actually early exercise, um, those shares. Um, so you may actually have to come out of pocket a little bit for that cash and then separately, whatever the fair market value is on that. Um, the date of grant, um, less, whatever your strike price is, whatever cash you actually have to pay for those shares is going to be income to you. So, you know, there can be different effects for you actually making that 83 B election, um, but administratively that’s how you do it.

Mark Eckerle:
Okay. That makes sense. And yeah, I wasn’t, I wasn’t too sure how that came into play here. So that, that makes some sense now. Um, so we, we talked about being organized and making sure you have good record keeping, um, kind of very understanding your holdings, right? That’s, what’s one of the proactive methods. What, what would be the next step in this approach or in this, this planning phase to understand your secondary sale or kind of getting out ahead of it to see what your future holds when’s the right time to strike? What what’s, what would be the next step in this?

Dan Krolikowski:
Yeah, definitely. So I think it’s just really like realizing that taxes are only one part of, you know, whatever the plan is for these holdings, right. Um, obviously tax savings may be a big part of it. The, you know, when we start talking about rates, um, you know, the difference between long-term capital gains rates and what the current highest marginal tax bracket is right now can be basically 15 to 20% taxes. So, you know, while that is, you know, can be a significant factor in what your decision-making is. It shouldn’t be the only factor. Right. Um, so you should actually think about your overall financial plan set goals. And then, like I said, kind of figure out, you know, using projections, um, whatnot, different fair market values and what you’re comfortable with, whether it’s cashing out or whether it’s actually, you know, exercising stock options and including that in part of your total holdings. Um, so I think it’s just really like having an overall financial plan, you know, when you’re considering, um, whatever equity that, or, you know, equity or holdings that you have, um, that you’re thinking about signing a secondary.

Mark Eckerle:
Okay. So that, that would all be, I guess, lumped in with, with understanding your holdings and just kind of planning out your future, having a financial plan, figuring out which method is best for you cashing out or, or the conversely you should say getting stock. Right.

Dan Krolikowski:
Okay. Exactly. Yeah. And I think, you know, the best thing to do in, in, in these situations is to actually run a stock option projection, you know, one do it as soon as possible. Um, so you can be prepared for these liquidation events and these secondary sales, but then also, you know, kind of understanding, you know, the mechanics of taxes in general, um, any compensation that you receive in the secondary sale is going to be subject to income tax withholding and FICA taxes, and typically compensations tax at the highest marginal brackets, the ordinary rates, which can be as high as 37%. Um, many times the income taxes would tell it to what we call the supplemental rate, which can be lower than what your effective tax rate is. So a lot of times in these secondary events, individuals think, Hey, I paid all my taxes upfront, but really they may end up paying some taxes on the back end when they filed their tax return. So just really understanding that. And then also if it’s not compensation, it’s probably going to be kind of some kind of short-term or long-term capital gain income, um, you know, on the secondary sale. So realizing that there is no withholding on that kind of income and then short-term, and long-term capital gain are taxed at different rates. So just really figuring out at the end of the day, you know, what do I have and what’s going to happen to me in the secondary sale.

Mark Eckerle:
All right.

Mark Eckerle:
So, so we touched on the taxes a little bit, um, and it seems like it’s more of a timing game. You talked about effective tax rates, long-term short-term capital gains. Can you quickly go into the difference between those, um, I know it’s all part of the financial planning process, but what, what would be some advantages from a tax perspective that someone could take of? Um, is there any tips or tricks that you come across during the, during your experiences in working during this, um, with various clients, what, what would be some, like I said, tips that you would recommend or things that people may not have thought of, um, that you would, they would recommend?

Dan Krolikowski:
Yeah, definitely. Um, so the first thing that we always talk about is, you know, what kind of income is it going to be that, you know, we touched on is it compensation, is a capital gain income, and really figuring out, um, what would happen in a specific transaction for you. So a lot of times there’s, you know, when a secondary sale happens, whenever you’re you’re, the company is issuing compensation, like stock options, um, they’re doing a 409a evaluation every year. And what that 409a basically tells you is this is the fair market value. Well, we think the fair market value of our stock is now when you have a secondary sale, a lot of times the fair market value may change somebody coming in value in the company, what they think it’s worth and then going to buy stock. So that fair market value can actually possibly change the 409a valuation, but then it also gets in to the kind of consideration, um, you know, what kind of income is this?

Dan Krolikowski:
Right? So a lot of times, whatever, um, the difference is between the actual fair market value that somebody is willing to pay in the 409a valuation. There’s a discussion is that compensation is that capital gain income. So there’s, you know, you’ll see a lot online and that’s really one of the biggest, uh, you know, just issues in general that everybody’s trying to figure out. So I think there can be a lot of work that’s put on, on both the company side and the shareholder side to kind of figure out, you know, is this going to be compensation? Is this going to be capital gain? Um, you know, so everybody can, can kind of figure out for their own tax purposes, what’s best for them. And as a company, you know, you kind of want it to be, um, compensation. So you get, you could possibly get a deduction for it as a shareholder. Um, you know, you kinda want it to be capital gain. It can be taxed at preferential rates. If it’s qualified small business stock there, it can actually be zero. Um, and there’s a lot more planning that you could do for capital gains than, than compensation.

Mark Eckerle:
Got it. Okay. Yeah, that definitely helps paint the picture for, for our listeners from both a company’s perspective, as well as the shareholder and which ones may be a little bit more preferential. Um, but the one thing that I think would be important for people to understand is you, you talked about investor coming in with possibly their own valuation, separate from the valuation stated in a 409a, um, so what would that look like? Can they come up with an arbitrary number that they determine maybe creating their own 409a valuation of the company? Does the board have to approve that figure? Um, or is it something that maybe an employee shareholders just comfortable with selling at that price? What would that look like as far as that valuation? Because I think that’s dependent on a lot of peoples, whether they’re going to sell or not. Right.

Dan Krolikowski:
You’re absolutely. And that’s, you know, everybody has their own price, right. And whether I’m the one selling it, or I’m the one buying it, you know, you’re not going to actually have an agreement until everybody reaches that agreement. So depending on how the deal is actually structured, you know, kind of depends. Um, like again, if the company, if, if the secondary is going through the company, a lot of times the company is going to be working on the shareholder’s behalf to kind of help them get the best deal. Uh, but if you’re just the founder shareholder, and you’re kind of going out there, you know, trying to find your own deal, you know, it could be a lot harder in that instance. Um, and it really just depends. Um, sometimes, you know, there isn’t a deal at the end of the day, sometimes there is. Um, so it just, it really depends, Mark.

Mark Eckerle:
And, and for that valuation, if a company is working with you, um, is that, is that standard practice, I guess, with, with our companies kind of working in the process?

Dan Krolikowski:
Yeah, definitely. So the company is going to do a 409a every single year, and they’re going to need to do that in order to figure out, you know, what their compensation, if it’s valued correctly, especially, you know, if they’re giving stock options, so employees and things like that. So that’s something they’re doing anyway, what an actual buyer is going to come out and say, the stock is worth, could be totally different.

Mark Eckerle:
So if the say we’re six, six to eight months removed from their most recent four, nine, eight evaluation, would a company ever perform an interim 409a at the benefit, because say that the buyer goes with their own valuation and they, and a company wants to fall back on a, a good number from evaluation from that’s defined in a 409a evaluation. Would they ever go out and perform an interim calculation or would they fall back on the existing one?

Dan Krolikowski:
Yeah, to my understanding, you know, they would only really do the 409a for internal purposes, not external purposes. So I don’t believe that they would redo 409a’s.

Mark Eckerle:
Gotcha. Okay. That makes sense. Yeah. I was just curious, because I know the valuation figure and like you said, everyone has their own number, right. To buy and sell. So it’s, it would definitely be important to just see it from both perspectives, um, and what that figure and ultimate end result would look like. Totally get it. So, so what other considerations, I guess, is we’re, we’re coming to a conclusion here. What other considerations may be important or critical for, for founders shareholders to be aware of? Um, anything that we haven’t really touched on that you think would be important to share with our audience?

Dan Krolikowski:
Yeah, definitely. Um, so, you know, one thing is if you have stock options that are unexercised and you do exercise them, you actually typically have to pay the exercise price, whether you pay it in cash yourself, or you sell shares, you know, to cover the taxes and to cover that exercise price. So, you know, a lot of times that’s one decision that you really have to look for. Am I going to come out of pocket for this cash? Am I going to get a loan and pay for it, or am I going to sell, you know, shares, um, to be able to do that. And then, you know, something else that, you know, listeners may not be thinking of is just like general risks of investing, such as, you know, diversifying, um, to limit concentration risks. So if I’m working for a company and I own shares in the company and I have stock options in the company, you know, do want to put all my eggs in one basket, you know, some people do some people don’t.

Dan Krolikowski:
So, you know, that’s just another consideration and everyone should be making. Um, and then I guess finally, you know, what is going to happen to the stock price? I think we talked a lot about this and, and doing projections and, and really trying to understand what the future holds, but, you know, what if I exercise stock options now, um, and I sell some in a secondary and I’m going to hold for the future. What happens if the stock price goes down? What happens if it goes up? So, you know, really just again, thinking about what the future holds and what the fair market value of the company, um, is going to hold.

Mark Eckerle:
Yeah. It all comes back to financial planning, right? It’s, that’s the biggest driver in this.

Dan Krolikowski:
Exactly. And like, you know, even if I decide to cash out now, what am I going to do with these net funds? Am I going to go buy a house? Am I going to reinvest it in something else? Am I going to throw a big party? Or am I actually not going to sell, am I going to continue to hold? And I’m real bullish on the future. So these are just all, you know, considerations. And I think, you know, tax planning can help you come to a conclusion that you should do, but at the end of the day, you know, you should do what you want to do because it makes you happy. It makes you meet goals. It makes you live a certain lifestyle. So it shouldn’t all just be about, you know, the tax plan.

Mark Eckerle:
Yeah, no, I totally agree. So, so to wrap up here, I ask this question to all of our guests, um, and it’s kind of a good tidbit for our listeners and what you’ve come across during your, your experiences in working in this industry. So what, what is one common misstep or a tidbit of information that you’ve seen, um, during your experience that you think a founder or employee shareholder wished they had known at the beginning? Um, whether we, we talked about planning, we talk a little about a lot of things that, uh, founders and employee shareholders should be aware of, but is there anything that you’ve come across quite commonly, um, that people wish they had known sooner?

Dan Krolikowski:
Yeah. And we keep like harping on like getting an early start, but I think what happens is a lot of companies could qualify as a qualified small business stock. And if you actually were to exercise, um, options and hold, and, and whenever the company is a qualified small business stock, you can actually also have qualified small business stock. So you don’t necessarily have to be a founder to give what we call founders shares. So I think that, you know, in general, early on, um, everyone should be thinking about whether the company is a qualified small business or not. And then subsequently, um, everybody should think about what we would stock options and 83 B election. It may not make sense to make it, but a lot of times, especially at the truest startups, um, the fair market value of the stock now could be equal to the strike price. Um, so you really could have no income to recognize, um, when you actually go to exercise these stock options with maybe three day, obviously you still have to come up with the exercise price out of pocket. Um, but that can really, really save in the long run. Um, if, if you were to consider those two things.

New Speaker:
Yeah. So

Mark Eckerle:
Paying penguin upfront costs may help you in the longterm. Um, yeah, no, that, that makes sense to me. So, so that wraps up our discussion on secondary sales. Thank you, Dan, for joining me today. If you’d like to learn more, please visit with them.com for more information and check out our specific founders team page landing page for more information, thank you for tuning in. If you liked, it wanted to hear more. You can follow us and subscribe and we’ll see you next time on founded in tech.

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