Orrick's Founder Series offers monthly top tips for UK startups on key considerations at each stage of their lifecycle, from incorporating a company through to possible exit strategies. The Series is written by members of our market-leading London Technology Companies Group (TCG), with contributions from other practice members. Our Band 1 ranked London TCG team closed over 200 growth financings and tech M&A deals totalling $2.86bn in 2023 and has dominated the European venture capital tech market for eight years in a row (PitchBook, FY 2023). View previous series instalments here.
The venture capital investment game can often be a long one. And with the average time from initial funding to exit increasing by 2.5x since the early 2000s, and a muted exit landscape in recent years further exacerbating a market need for greater variety of liquidity opportunities, investors and founders alike are looking to secondary transactions to realise liquidity ahead of a sale or IPO.
Unlike a primary investment (where investors are issued with new shares in the company), "direct" secondary transactions involve the sale by existing shareholders (investors, as well as founders and/or employees) of some or all of their equity stake in a startup by way of transfer of shares, either to other shareholders (who are looking to increase their equity stake in a portfolio company) or to third party investors, sometimes at a healthy discount. This can take place as a stand-alone transaction or form part of a broader financing round.
Investors have faced additional pressures to return value to their LPs and have increasingly focused on managing their existing portfolios, with 35% of funds spending time in 2023 exploring these potential opportunities. We expect that 2024 will see a further uptick in secondary transactions as funds continue to feel pressure to deliver returns. Watch this space for our Deal Flow 4.0 report, which will touch on this and other predictions for the European venture capital market in 2024.
In the nineteenth instalment of Orrick's Founder Series, our Technology Companies Group offer top tips to help UK startups navigate key considerations in the increasingly popular world of secondary transactions.
1. Documenting the transfer (stock transfer form(s)).
A company's articles will often specify the transfer instrument to be used to transfer shares. To comply with legal requirements, such instruments must be "proper." They can take many forms but must be capable of attracting stamp duty (see point 9 below for more details on stamp duty).
In most secondary transactions, this would take the form of a stock transfer form (STF), but companies should review their articles to confirm.
Separate STFs should also be used, for example, where multiple share classes are being transferred.
2. Documenting a transfer (sale and purchase agreement).
The STF is the instrument of transfer through which legal title is transferred (it will include details on the seller and purchaser, number and class of shares being transferred and the consideration). The stock transfer form alone could be sufficient for a simple transfer.
For a secondary transfer, a simple form sale and purchase agreement (SPA) would often be entered into alongside the STF. This would contain additional terms and/or conditions of the sale (e.g. warranties, re-designation and provisions relating to the payment of stamp duty, see points 7, 8 and 9 below). If multiple buyers are involved, you should consider whether separate SPAs are appropriate (especially where the terms being agreed differ).
3. Consider your existing constitutional documents (articles of association and pre-emption rights).
Unless your startup has adopted Model articles (which is unlikely at the later stage of growth where secondary transactions are most common), most articles (including the British Private Equity & Venture Capital Association model form, which set the industry standard documents for early-stage venture capital investment) will include pre-emption rights amongst other provisions.
Save for "Permitted Transfers," where an existing shareholder wishes to transfer shares, pre-emption provisions require the seller (the existing shareholder) to first offer the shares to the other shareholder on the same terms as those being offered to the buyer, before they can proceed with the sale to the buyer. "Permitted Transfers" fall outside of the pre-emption regime. These can include transfers to members of the same fund or group or a nominee or custodian of the investor or transfers which have been approved to be "Permitted Transfers" (often by way of board approval, acting with the consent of a specified majority of investors).
The pre-emption process can be cumbersome, lead to protracted timelines and uncertainty for the buyer and can ultimately lead to the collapse of the secondary transaction. Therefore, you should consider whether it is possible to disapply the pre-emption provisions in the articles by way of shareholder resolutions or designate the transfer a "Permitted Transfer" to avoid going through the pre-emption process.
Consideration should be given to whether a share offer or transfer is in breach of regulatory requirements on financial promotions and arranging or dealing in investments. Exemptions exist, for example for share offers between a company and its employees, but this cannot be relied upon by parties outside of the employer and employee relationship. Investment activities are only regulated if done by ‘way of business’, and other exemptions, such as the exemption for high-net-worth or sophisticated investors are also available, but serious consideration should be given to whether the specific conditions of the relevant exemptions are met, before they are relied upon.
4. Consider your existing constitutional documents (shareholders' agreement and consent matters).
If your startup has been through at least one round of financing, it is likely that you have in place a shareholders' agreement, which governs the relationship between the company, the founders and its shareholders. Along with the articles, it often includes consent regimes (and possibly further restrictions on transfers).
The consent regimes will usually take the form of Investor Majority consent matters, which go to the heart of the economic value of the shares held by the investors, and Investor Director consent matters, which include administrative and operational matters relating to the business of the company. The transfer of shares can sometimes fall under the consent regimes. For more details on negotiating consent matters as you fundraise, read our instalment, Top Tips to Follow to Get Ready to Raise.
Before proceeding with your secondary transaction, you should review your constitutional documents for relevant consent matters. To avoid undue delays, the aim is to ensure that the individuals / investors whose consent will be required to approve the secondary transaction are on board. Address any questions they might have as early as possible to avoid bottlenecks or delays to closing.
5. Do the articles include co-sale provisions?
Co-sale rights are one of a number of additional provisions which restrict a shareholders' ability to sell their shares. They require the shareholder (ordinarily the founder or other ordinary shareholders) to allow investors the opportunity to participate in a sale in proportion to the number of shares they hold. Although rarely used in practice, these rights are intended to allow investors to participate in any liquidity event alongside founders and other shareholders.
Where a founder and/or ordinary shareholder's shares are subject to a co-sale (which has not been disapplied or approved as a "Permitted Transfer"), this will have a knock-on effect on the number of shares they are able to sell, as this will be scaled down to allow beneficiaries of the co-sale to participate.
Much like pre-emption rights, co-sale rights could be disapplied or a transfer approved as a "Permitted Transfer," but directors should ensure they consider their directors' duties when authorising such approvals (see our instalment, Top Tips on Complying with Directors’ Duties Under English Law for more tips on complying with directors' duties).
6. Beware of lock-up arrangements.
Certain shareholders, most often the founders and/or employees, could be subject to lock-up arrangements. Unless disapplied (often requiring lead investor or Investor Majority consent), such arrangements prevent founders and/or employees from transferring their shares within a certain period or at all.
Where the seller in a secondary transaction is a founder and/or employee and is subject to such lock-up arrangements, you should review the relevant provisions for, for example: (i) any carve-outs from the lock-up arrangements (e.g. for transfers by the founder / employee up to a certain percentage) or (ii) to the extent there are no carve-outs, for any consents which would otherwise have to be obtained to allow the transfer. This could be a contentious issue for some investors who would be keen for founders to retain sufficient equity (such equity often being subject to reverse vesting / leaver provisions, see our instalment, Top Tips to Follow to Get Ready to Raise) to ensure they remain duly incentivised to continue to grow the business.
7. To re-designate or not to re-designate.
The shares being sold as part of the secondary transaction will often be a more "junior" class of share or ordinary shares (being the class of shares founders often hold).
Where a later-stage investor is looking to increase their stake in a portfolio company through a secondary transaction, they might request shares of the same class as the "senior" class they hold. So what happens when the seller is selling ordinary shares, while the class of shares the investor wants to purchase is a more "senior" class?
One solution to align the two would be to include a condition in the SPA noting that the sale shares will be re-designated / converted into the desired "senior" class. This will require board and shareholder approval (75%, being a special resolution). You would therefore want to ensure you run this by your existing shareholders ahead of time, especially those whose votes will be required to pass the relevant resolutions. This will often involve commercial considerations (including around price) and is therefore something you should get shareholders comfortable with as soon as possible.
8. Limited vs extensive warranties.
A secondary transaction is not the same as a sale of the entire issued share capital of a company.
Therefore, whereas a full suite of warranties (contractual promises from the seller – and sometimes the company) to the buyer as to the health of the business might be appropriate in a sale context, the position could be quite different in a secondary transaction. As secondary transactions involve the purchase of minority stakes, we would normally expect the warranty suite to be limited to title and capacity warranties only.
This is especially so where the buyer is an existing investor who holds a seat on the board or benefits from extensive information rights and should therefore be aware of and comfortable with the state of the company.
A limited warranty suite avoids an unnecessarily extensive disclosure exercise (which would be common in a sale scenario) for the company and founders.
9. Stamp duty considerations.
Where the consideration for the transfer of the shares is over £1,000 (which it often is in a secondary transaction), stamp duty will be payable at 0.5% (rounded up to the nearest £5) of the consideration paid for the shares.
Such payment should be made and the STF(s) sent for "stamping" to HMRC within 30 days of the date of transfer. Please review the HMRC guidance on stamp duty before making any submission.
Only after HMRC “stamps” the STF(s) will the transfer take effect. At that point, the company's registers can be written up to reflect the transfer (see point 10 below).
Payment of stamp duty is normally a buyer obligation. A provision setting out this obligation should be included in an SPA where applicable to align the parties.
10. Updates to the company's registers and Companies House filings.
The final step is for the statutory registers of the company to be updated and share certificates issued to the buyer in respect of the sale shares.
If a shareholder resolution has been passed – to approve the re-designation of the sale shares or disapply pre-emption, for example – such resolutions (being special resolutions) should be filed at Companies House.
Our London TCG practice reflects London’s role as one of the world’s leading financial markets and a centre for international commerce. Nothing inspires us more than helping tech companies develop novel strategies and push boundaries. Through our extensive client portfolio, deal volume, and relationships in the tech ecosystem, we provide commercial and legal insight to each company’s strategy. We work with tech companies on all aspects of their business plans: financing strategies, protecting intellectual assets, retaining talent, securing and monetising data, and advocating for innovation-friendly public policy.
