Basics of Founder Compensation (Part II): Secondary Liquidity
Founders often make significant financial sacrifices in the short term to build a company with real exit potential. Some founders grind for years at below-market salaries while their equity theoretically appreciates. There is a peculiar paradox that can make a founder a paper millionaire (or billionaire) without easing the everyday financial pressures. As the average time from founding to exit has stretched over time, founders are increasingly looking for liquidity opportunities along the way.
Smart liquidity planning is important in order to keep the founding team aligned and incentivized for the long haul. Beyond the numbers, there's a human element: financial stress can impact decision-making, relationships with co-founders and investors, and ultimately, a company's trajectory. While a founder selling shares before an exit was once viewed with suspicion, it is now often seen as a healthy risk management practice that can improve founder retention and focus. As a result, the secondary market for startup equity has grown substantially, with platforms and institutional buyers creating more accessible pathways for founders to realize some value while continuing to build their companies.
This post breaks down how founders can monetize their equity before a traditional M&A transaction or IPO, such as through secondary sales to new or existing investors, tender offers facilitated by the company, and structured liquidity programs built into later-stage financing rounds.
When Does Founder Liquidity Make Sense?
Timing is everything. Pursuing founder liquidity can send negative signals to investors and employees at one moment, while strengthening commitment or improving investor relations in another.
No single factor is determinative, and this list is not exhaustive, but the following outlines several green lights and red flags relevant to the timing of founder liquidity events.
Green Lights: More Likely Good Timing for Founder Liquidity
The company has achieved product-market fit with sustainable growth metrics and clear path to profitability or next funding milestone.
The company has reached Series B or later, when the company's valuation is more established and less speculative.
The founding team has been building for 5+ years and wants to diversify concentrated wealth exposure.
Personal circumstances warrant liquidity, such as major life events, family obligations, health considerations, or other legitimate financial needs.
It's structured as part of a financing round, where liquidity is built into the deal terms with investor blessing, especially if the round is fully or over-subscribed and the secondary helps satisfy excess investor demand.
Red Flags: More Likely Risky Timing for Founder Liquidity
During active negotiations for rounds that are not fully or over-subscribed.
When the company is struggling to find product-market fit, missing targets, or in the middle of a pivot.
Before achieving key milestones that the company has previously committed to.
If the amount would materially impact how investors perceive the founder's commitment.
How Much Should Founders Sell?
There's no one-size-fits-all answer. The company's Board of Directors and investors will want to make sure incentives remained aligned so that even if the liquidity is life-changing for a founder, it is not commitment-changing.
In typical secondary transactions, founders sell anywhere between 5-15% of their total holdings. However, the exact percentage depends on the company's stage and valuation, the selling founder's total ownership percentage, the selling founder's personal financial situation and goals, and the availability of willing buyers at acceptable terms.
When assessing how much to sell, each founder should begin with their personal financial picture:
Assess needs: How much liquidity would meaningfully improve the founder's financial security?
Consider tax implications: Founders should obtain tax counsel with respect to the optimal structure of a secondary sale. For example, if the founder has held their shares for more than one year, they may benefit from the more favorable long-term capital gains rate. However, if they're a few months away from hitting the five-year QSBS (Qualified Small Business Stock) holding period, which can provide significant federal tax exclusions on gains, it may make sense to consider waiting.
Maintain alignment: Founders should retain enough equity that their financial interests remain strongly aligned with other shareholders. For example, if a founder owns 30% of the company, selling down to 25-27% would maintain significant skin in the game, whereas selling down to 20% is more likely to raise concerns.
Leave room for the future: There may be additional liquidity opportunities as the company grows, so a founder should not necessarily aim to solve all financial needs in one transaction.
Secondary Mechanics: How It Works
Transaction Structures
A secondary transaction is typically structured in one of the following ways:
Direct secondary sales: The founder sells shares directly to a new or existing investor.
Secondary + exchange: After a direct secondary sale, the investors exchange the common stock purchased from the founder for shares of preferred stock of the company, typically in connection with a financing round. This allows the buyer to obtain the enhanced rights and preferences associated with preferred stock while providing the founder with immediate liquidity.
Tender offers: The company facilitates a liquidity event where multiple stockholders (such as founders, employees, and/or early investors) can sell shares to one or more buyers.
Structured liquidity programs: Built into a financing round, where a portion of the capital raised goes to purchasing existing shares.
Valuation Considerations
In a secondary transaction, the stock is often sold at a discount to the most recent preferred stock pricing, typically 10-30%, to reflect differences in rights, liquidity, risk, and tax treatment. The price may be impacted by the following variables:
Liquidity timing: Buyers are providing immediate liquidity rather than waiting for an exit, and they bear the risk of a longer and uncertain path to liquidity.
Common vs. preferred: Founders typically hold common stock, which lacks the preferences, protections, and rights that preferred stock carries.
Information asymmetry: Secondary buyers may have less information access than primary investors.
Market dynamics: Supply and demand in the secondary market can push the price up or down.
Tax treatment: A discount to preferred stock pricing can help mitigate the risk that the IRS characterizes part of the transaction as compensatory. Because preferred stock includes liquidation preferences, protective provisions, and other rights not held by common stock, selling common at the same price as preferred can invite scrutiny that the excess value represents compensation for services, which could be taxed as ordinary income rather than capital gains.
Additionally, founders should be aware of possible 409A valuation implications. If there is a significant delta between the company's most recent 409A valuation (used for pricing stock options) and the secondary sale price, it could trigger questions from the IRS or create complications for employee equity grants. Coordinating secondary pricing with the company's 409A valuation methodology can help maintain consistency and defensibility.
Tax Considerations
Secondary transactions can have meaningful tax implications for founders, and early coordination with the company’s accountants and tax advisors is critical. How the transaction is structured and priced, and how it is ultimately reported by the company, can affect whether proceeds are treated as capital gains or recharacterized (in whole or in part) as compensatory income subject to ordinary income and payroll taxes. Founders should confirm in advance how the company intends to report the transaction for tax and accounting purposes, including whether any portion will be treated as compensation, and ensure that the legal structure, valuation support, and reporting approach are aligned to avoid unintended tax outcomes.
Navigating Approvals and Stakeholder Management
Founder shares are typically subject to significant legal restrictions, such as transfer restrictions, rights of first refusal (ROFR), and repurchase rights. Before negotiating a secondary, it is important to be aware of all restrictions, approval requirements, and stakeholder relationships.
The company's bylaws and stockholder agreements, and, if relevant, applicable grant documents and stock incentive plan, should be reviewed with an attorney. If the company has a Right of First Refusal and Co-Sale Agreement in place, it may contain a right of first refusal provision requiring the founder to offer shares to the company and/or existing investors before selling to third parties. The company's bylaws might also contain blanket transfer restrictions on stock sales that must be waived by the Board of Directors.
Even if a founder is legally permitted to sell shares, getting investor buy-in is critical. The relationship between a founding team and the company's investors (particularly lead investors and board members) can affect future financing rounds, strategic decisions, and exit opportunities. In approaching the liquidity conversation with investors, founders should consider the following:
Be proactive and transparent: Don't let investors hear about liquidity plans through the grapevine. Schedule a conversation with the company's major investors and/or board members early in the process, and explain the rationale clearly.
Emphasize continued commitment: Make it clear that the transaction is about risk management and sustainability, not an exit strategy. Founders should be prepared to share their long-term vision and explain how financial security will help them execute most effectively.
Consider timing with financing rounds: One common opportunity for founder liquidity is when the company is raising a new round. Many term sheets now include provisions for founder secondary sales as part of the deal structure. As noted above, this is typically more palatable where the round is "hot" and there is significant investor interest, and may be less acceptable to investors in an under-subscribed round.
Not every liquidity request will be approved, particularly at earlier stages or during challenging periods for the company. If investors decline a founder's liquidity request, founders have several alternatives to consider:
Wait for a better window: Timing matters significantly. A "no" during Series A negotiations might become a "yes" as part of a Series B round structure, particularly if the company hits key milestones in the interim.
Focus on the next milestone: Use the conversation as an opportunity to align with investors on what would need to be true for them to support liquidity in the future, then work toward those goals.
Revisit compensation structure: If liquidity is driven by financial stress, consider whether the company can provide a one-time cash bonus, increase ongoing cash compensation, or extend a loan to the founder. Company loans to founders require careful structuring to comply with tax and securities laws, but can provide bridge liquidity while preserving equity for a future sale. These arrangements should be documented properly and approved by the board.
Explore structured alternatives: Some founders negotiate personal loans secured by their equity holdings, though these arrangements carry their own risks and complexities.
The key is to avoid damaging the investor relationship by pushing too hard on a declined request. Founders who handle a "no" professionally and refocus on building the company often find that liquidity opportunities emerge naturally as the company matures.
Practical Takeaways: Founder Liquidity Checklist
For Founders Considering Liquidity:
✓ Review the company's governing documents for transfer restrictions, ROFR provisions, and approval requirements. Do this before starting conversations with potential buyers.
✓ Model personal financial needs and determine an appropriate sale amount that's meaningful but maintains strong alignment.
✓ Engage tax counsel early to optimize transaction structure and understand tax implications before committing to terms.
✓ Have transparent conversations with the board before pursuing transactions to avoid surprises that could damage trust.
✓ Consider timing carefully relative to company milestones, fundraising cycles, and market conditions.
✓ Document everything: Keep clear records of approvals, waivers, and transaction terms.
✓ Think long-term: This likely won't be the only liquidity opportunity, so don't optimize for a single transaction at the expense of relationships.
For Investors Evaluating Founder Liquidity Requests:
✓ Assess the full context: Is this founder burned out and checking out, or managing risk intelligently while remaining committed?
✓ Consider structured liquidity programs as retention and recruitment tools for top founder talent.
✓ Evaluate whether top-up grants make sense to maintain alignment after liquidity events.
✓ Build liquidity provisions into term sheets for later-stage rounds. Being proactive signals sophistication and founder-friendliness.
✓ Focus on outcomes, not optics: A financially secure founder who can focus entirely on building the company is often more valuable than a stressed founder with 100% of their equity intact.
The Bottom Line
Founder liquidity is an increasingly standard feature of the venture ecosystem. The companies most likely to succeed over a 10-15 year horizon are those that can attract and retain exceptional founder talent through multiple stages of growth. Thoughtful liquidity planning can play a role in that retention.
When evaluated in context, secondary transactions are neither inherently good nor bad. For founders, they require careful legal, tax, and stakeholder planning. For investors, the focus should be on structure, scale, and alignment. When structured properly and executed transparently, founder liquidity can strengthen rather than undermine the foundation for long-term success.