The European VC market is expected to see a boom in secondary sales as investors search for liquidity. But there are a few hurdles to clear in such deals.

Mathias Loertscher, partner at Osborne Clarke

There is anticipation in the European venture capital market that there will be a boom in so-called “secondaries” in 2024. Liquidity is still scarce, with routes to public market listings still largely closed and M&A transactions are uncertain. Investors needing to realise value in their portfolio are, therefore, turning to the private sales of their shares in startups.

A number of funds, such as Launchbay and Giano Capital, have been established for the purpose of acquiring these stakes, often at a significant discount to the most recent valuation.

We are however seeing an increasing number of enquiries from client companies who have shareholders agitating for liquidity and therefore interested in secondary sales. They are pressing the board to find buyers, pushing them to appoint corporate finance advisers to run a sale process and testing how the share transfer process works. We are also seeing investors exploring creative ways of unloading their stakes where there are no secondary buyers, for example trying to sell their shares back to the company.

Sellers should beware, however. While a secondary transfer sounds relatively simple, there are a number of potential legal and procedural issues which must be addressed for a secondary to be completed. These complications can add weeks, if not months to the sale process. In some cases, the existence of the pre-emption and especially co-sale rights mean the sale can fall through completely.

In the UK, most venture-backed companies have shareholders’ agreements and articles of association which are based on the British Venture Capital Association model documents (whether the historic or more recently updated versions). In either case, the articles contain a number of provisions which mean that it may not be entirely straight-forward for a buyer and seller to complete a secondary transfer.

Pre-emption rights

Under most articles, share transfers are subject to pre-emption rights in favour of all or some of the other shareholders. This means that, unless the transfer falls within a small number of exemptions (such a transfer to a group company, an affiliated fund or a family member), the shares will need to be offered to the other shareholders on the same terms before they can be sold to the buyer.

A pre-emption process usually takes at least two weeks and introduces uncertainty into a secondary transaction as the buyer will not know how many shares will remain available after the other shareholders have exercised their rights. Certain secondary investors may not be willing to complete an acquisition unless they know that they will be able to acquire all, or at least a minimum number, of the shares being offered. If existing shareholders exercise their pre-emption rights, this can frustrate the secondary transfer.

Co-sale rights

In some cases, shareholders will also have co-sale rights in relation to the proposed secondary. Co-sale rights give all or some of the shareholders the right to sell a proportionate number of shares alongside the selling shareholder. In many cases, these rights only apply where a founder or employee sells shares, but some co-sale rights also apply where an investor proposes to sell shares. Co-sale rights normally mean that the number of shares which the selling shareholder is allowed to sell will be scaled down. A shareholder’s attempt to cash out their stake entirely can therefore be derailed, particularly if a significant number of other shareholders use their co-sale rights to participate in the same opportunity.

Pre-emption and co-sale rights can, in many cases, be circumvented by designating the proposed transfer as a “permitted transfer” which is not subject to these restrictions. The board of directors, acting with the consent of a specified majority of the investors, often have the power to permit a transfer to proceed without going through either process.

However, directors of companies in the UK are under a duty to exercise their powers for a proper purpose and to act in the best interest of the company for the benefit of the shareholders as a whole. Even if an investor majority would consent to the secondary, the board will nevertheless need to carefully consider whether it is a proper exercise of their powers to approve the transaction as a permitted transfer given that, in doing so, they would deprive the other shareholders of their pre-emption or co-sale rights. If the board is aware that there are other shareholders interested in buying or selling shares, or the investors constituting an investor majority who would consent to the transfer have an interest in the transaction (whether as a seller, potential buyer or potential co-seller), this can create complicated dynamics.

Other hurdles: lockups, promotion rules

There are other potential hurdles to secondary transactions. Certain shareholders, particularly founders and employee shareholders, may be subject to lock-up arrangements, which prevent them from selling their shares for a period of time or without investor consent.

Shareholders should also be aware that offering their shares for sale in the course of business, whether verbally or in writing, may be a financial promotion and subject to certain regulatory restrictions. There are a number of exclusions which may be available to the selling shareholder which would exempt the communication from the financial promotion rules, but it is important for the shareholder to consider these carefully and take legal advice on their applicability.

While shareholders itching for liquidity may welcome the growing market in secondaries, they should be under no illusion that completing a secondary is necessarily going to be painless. It requires careful planning and consideration of the potential legal hurdles which can get in the way of a successful sale.

Mathias is a partner at international legal practice Osborne Clarke, advising corporate clients on M&A, venture and growth capital fundraisings, joint ventures, corporate reorganisations and corporate governance.