Share types: Primary vs Secondary offerings

valuation of a SaaS startup

Whether you are looking to sell or buy equity in a business, there are generally two ways to go about it. You can either have a company issue new shares in a primary offering, or offer already issued shares held by existing shareholders in what’s called a secondary offering. As the names would suggest, the former involves a primary sale of primary shares in a primary market and the latter a secondary sale of secondary shares in a secondary market. There are important differences with implications on both sides of the transaction that the seller and buyer should be aware of when choosing which type to pursue. Let’s dive into the details of what, how, why and when of both cases.

Primary shares 

What & How

In an equity offering, primary shares refer to newly issued shares of common stock. As such, when primary shares are issued and sold to a third party in what’s sometimes referred to as a “primary” short for a primary sale, it dilutes any existing shareholders' stake of ownership in the business. Moreover, the proceeds from a sale of primary shares befalls the issuer, i.e. the business, and not any of the stakeholders personally.

To illustrate these points let us take an example of a business with 1,000 shares split between two co-founders, i.e. each founder owns 500 shares equivalent to 50% of the equity in the company. If they were to onboard a new business partner who wants to invest $250K in the business in order to obtain 20% ownership, they could issue 250 new shares and sell them to her in a primary transaction. This would dilute the business ownership of each co-founder by -10%. Hence each of them would effectively have a 40% net stake left in the company after the sale given their existing 500 shares respectively out of 1,250 shares in total post issuance. However, their business would now have a quarter million dollars at its disposal. This is the most important distinction to remember when compared to the sale of secondary shares.

Why & When

As a founder it makes sense to issue and sell primary shares when the intention of a sale is to raise capital to run and grow the operations of her business. The ownership that the business owner forgoes by diluting her stake via the issuance of primary shares also means that the funds raised will be earmarked business purposes. This could be to pay salaries or increase marketing spend.

Equally, primary shares make sense for investors to buy if they want their capital to be put to work in the business. This is a typical strategy deployed by growth investors that pump money into early stage startups and unprofitable businesses in need of a capital infusion. These scenarios describe phenomena in private markets but public companies listed on stock exchanges also issue new shares to raise capital.

million dollar payout

Secondary shares

What & How

In an equity offering, secondary shares refer to existing shares of common stock sold, most often by existing shareholders, to a third party. As the name alludes, the shares are sold second-hand, i.e. someone holds them before selling them on in what’s known as a “secondary” short for a secondary sale. In that regard, the proceeds of such a sale personally befalls the shareholder who sells them. 

To use the same example of the two co-founders, it could be that one of them was looking to retire and searching for a third party to buy them out of their stake. This could be because the other co-founder couldn’t afford to buy them out or simply due to the preference for an active business partner to replace the existing for a shared workload. The 500 shares that represents 50% of the business would be secondary shares and once sold, the proceeds of $625K would befall the retiring co-founder personally. The new partner who bought into the business would thus own half of the company and the money spent to acquire that stake was spent to buy out the existing shareholder.

Why & When

It makes sense for founders to sell secondary shares when seeking to realise a return on their asset, colloquially speaking taking some chips off the table. De-risking ownership in a profitable business via a partial buyout is a widely adopted move among successful founders as it allows them to stay invested in their company while enjoying the fruits of their labour. Founders can choose to sell a minority, no control stake in their business to a passive investor or a majority stake in order to onboard an active business partner who will support operations to optimise and scale the business in collaboration with the founder(s). In the latter case, founders can do what’s called a “double dip” meaning they sell 51% or more now and the rest once the buyer has increased the value of the company.

From the point of view of the investor who buys a minority stake can do so to collect dividends via a shared earnings agreement and/or speculate to make capital gains down the line once the business has grown. Buying in to hold a majority interest in a company can allow a professional to manage the business’ operations to scale and optimise it with the support of the founder(s). 

Useful resources: The deal Jeff Bezos got on Basecamp, A Look at Primary and Secondary Markets