Raising capital is a normal part of the lifecycle of a start-up business. In the simplest case, a company raises equity capital by issuing common stock or preferred stock directly to investors. This is sometimes called a “primary” or “original” issuance of stock. While most companies use the funds received to accelerate their growth, sometimes they use part of the funds to redeem stock from existing shareholders. For example, a company may issue convertible preferred stock to investors and redeem common stock from existing shareholders/founders. This not only provides liquidity to existing shareholders (who hold non-publicly traded stock), but it also allows them to diversify their holdings before an exit via sale of the company or initial public offering (IPO). This structure also works well for existing shareholders because they have an opportunity to obtain a QSBS exclusion.
Another popular way for companies to provide liquidity and diversification for its existing shareholders is to allow them to engage in secondary sales of stock to investors in conjunction with the company’s primary issuance of stock. In secondary sales, investors purchase stock from existing shareholders rather than from the company itself, so the new funds flow directly to the shareholders, rather than to the company and then from the company to the existing shareholders in a redemption transaction. While the form of these two transactions is different, they both achieve an economically-similar result vis-à-vis the selling shareholders (and the tax issues discussed in this article apply to both forms of the transaction).
