The increase in activity in the pre-IPO secondary market means that founders, early employees, and investors are receiving liquidity much sooner in a company’s lifecycle than ever before. For most startups and privately-held companies, liquidity is often an issue for stockholders, as no market exists for selling shares and/or transfer restrictions can prevent their sale. Secondary stock transactions, however, are a way to work around this problem.

Here’s a quick look at how they work and what to keep in mind, especially if you’re going through the process for the first time. (If you’re not familiar, secondaries are transactions in which an existing stockholder sells their stock for cash to third parties or back to the company itself before the company undergoes an exit; traditionally, an exit refers to an M&A or an IPO.)

Offering secondary transactions to founders is a tool VCs have been using to win deals. For example, if a VC promises that the founders will receive $1,000,000 in cash through a secondary sale from a $15,000,000 venture financing round, the founders will likely prefer that VC’s term sheet to a term sheet from a VC that does not offer that deal.

Why would a founder consider a secondary sale of their equity?
Though it may at times be taken as a lack of faith in the company when a founder sells equity prior to an IPO, it can actually be a beneficial transaction for the company.

Many founders pour everything they have into their companies and it can be straining to run them for the number of years it often takes to reach an exit. During this time, it’s understandable for founders to entertain comparatively lesser M&A offers that provide them with significant short-term gains, but which typically won’t result in the greater potential gains to be had from an exit event for a more developed company.

VC investors, other stockholders, and a board of directors all want founders to focus on massive exits, not the easy path to quick liquidity. Secondaries help to bridge this gap, providing compensation that enables founders to hold out for the years it might take until their company has developed enough to reach the larger M&A or IPO event.

A counterargument is that a substantial cash secondary payout may actually de-motivate a founder to continue pursuing an exit opportunity; if they already have cash in the bank, why keep struggling?

Each situation has its own unique circumstances and there are myriad factors that can affect the thought process of a founder considering a secondary sale. In general, though, there are at least two sides to every secondary transaction and any agreement comes down to balancing the need for liquidity against the …