Today’s topic: What happens if an early-stage investor wants to sell their shares before a company exits?

Imagine this: you’re an early stage investor who has equity in a startup company. For whatever reason, you’d like to sell your shares.

Maybe you no longer have faith in the company, or maybe you need to liquidate some assets. What's the protocol here?

Other questions that came up as I considered this scenario:

• Is there an ethical dilemma to consider?
• Do you need to wait until the next round of fundraising to do this?
• How to price your shares to potential buyers?
• How do you find potential buyers?

There’s a lot to unpack here, so we’re gonna chip away at these questions. Let’s get started.

Is this, like, morally OK?

An investor selling off shares of their portfolio company is not a great look for a startup. It could signal to other investors that something is wrong in the business.

And this might make it harder for the founders to attract new investors or employees.

So the first thing I wanted to know was: given that this process could create bad optics for the company… is selling your shares before an exit an OK thing to do?

I spoke with a number of folks about this, and the consensus is: yes. This is an OK thing to do. But. Best practice is to wait until the company has reached some level of maturity.

A pre-seed investor selling shares at the seed round is not a good look. It’s best to wait until the startup has reached a later stage (like Series A or beyond).

See, people understand that early-stage investors are taking on the highest risk. They’re writing checks before the company has been de-risked. Before customers, before revenue, before product/market fit. By the time the company has hit “later stage”, it’s not necessarily a bad signal for an early investor to sell, because those later investors can clearly see that the company has been de-risked.

Be honest with the founders

The best way to liquidate your shares before the company has exited is to be up front with the founders.

You could say something like “We still believe in this company, but now that you’re hitting the next phase of the business, we’re in less of a position to be a strategic partner to you. For that reason and other reasons unrelated to you, we’d like to explore liquidating some of our shares at your next fundraising round.”

This approach serves two purposes:

• It demonstrates respect, which is good for the relationship
• It gives the founders a narrative to lean on if they want to be part of the liquidation process

Why does #1 matter? Well, anytime a shareholder wants to liquidate her/his shares, the shareholder needs approval from the founder (or board of directors).

Technically they can’t reject your request to liquidate. But they can make it a lot harder for you to find a potential buyer. And you definitely want to find a potential buyer because… and here’s the part where you need to pay attention… the company has first right of refusal.

What does this mean, exactly?

Well, if you come to the founder and say “I found someone to buy my shares at $10/share”, the company can either approve the purchase OR opt to buy your shares at that offered price.

So you want to avoid having a founder who is mad at you for trying to sell. Because a mad founder could be a vindictive founder. Don’t ask me how I know this.

Why does #2 matter? This is related to #1.

See, it's not a terrible thing for a founder to free up space on the cap table. If you sell your shares, the founder could either swoop them for a larger ownership percentage, or sell them at a higher price than what you paid for them.

But a founder doesn’t want to say to potential investors “our earliest investors want to get out. Do you want their shares?”. No. The founder needs a better narrative. Something like “We’re looking for partners who can provide strategic help at this new stage of the business” or “An early investor is looking to free up some capital for personal reasons”.

Piggy-backing onto the next round

The best time to sell your shares is at the company’s next round of fundraising. Why? Well, a few reasons.

1. It helps with the whole valuation mess.

Companies that are currently fundraising have a clearly defined valuation. Founders who are fundraising are also more open to sharing information about their revenue, growth, and burn.

When they’re not fundraising, founders often don’t want this information publicized. So if you try to sell outside of a fundraising round, you probably won’t be able to disclose any information that isn’t publicly available.

If you want to get the best markup on your shares, your best bet is to wait until the company raises another round, then use that valuation to price your shares.

2. It makes it a lot easier to find potential buyers.

Imagine a founder is trying to fundraise from a notable investor, but the investor thinks the valuation is too high. The founder could send the investor to you for a discounted rate. This way everyone wins: The secondary investor gets a great deal, the founder gets a big name on their cap table, and you get an exit.

Here’s another scenario: The company you’re looking to exit has so much demand that the founder is turning investors away. Voilá! Here you come with secondary shares to sell.

Of course, if a startup is that hot, there’s a good chance you’ll want to stay on the cap table 🤷♀️.

There’s so much more to dig into

This information is just the tip of the secondary iceberg. There is so much more to uncover, like:

• How do you price your shares if the company has no plans to raise again?
• How do you price your shares if the company is super secretive about its metrics?
• How do you find buyers for your shares?

I’m talking with an expert about all of this (and more) next week, and excited to unpack this topic in greater detail soon.