Secondary share sales provide startup founders with an opportunity to liquidate some of their equity holdings without waiting for an IPO or full acquisition. Unlike a primary share sale, where the company issues new shares to raise funds, a secondary share sale involves founders or early investors selling their existing shares to new investors.

This article by CA Manish Mishra explores how founders can cash out through secondary share sales while ensuring compliance with relevant provisions of the Companies Act, 2013 in India.

What is a Secondary Share Sale?

A secondary share sale occurs when an existing shareholder (typically a founder or early investor) sells their shares to another party. The proceeds from this sale go directly to the selling shareholder rather than the company.

This method is commonly used in the following scenarios:

• Founders looking for partial liquidity while staying involved in the company.
• Early investors (angel or venture capitalists) wanting to exit.
• Companies undergoing funding rounds where new investors acquire existing shares.

Key Provisions of the Companies Act, 2013 Governing Secondary Share Sales

The Companies Act, 2013 sets certain legal requirements for transferring shares in private and public companies.

- Transferability of Shares – Section 56

According to Section 56, a private company must restrict the transfer of shares as per its Articles of Association (AoA). Therefore, before founders sell their shares, they must check:

• Articles of Association (AoA): Many private companies require Board or investor approval before allowing secondary sales.
• Shareholders’ Agreement (SHA): Founders must comply with agreed terms, such as Right of First Refusal (ROFR) or Lock-in Period.
• Board Approval: Some companies require Board clearance before a share transfer.

For public companies, shares are freely transferable, subject to SEBI regulations if the company is listed.

- Right of First Refusal (ROFR) & Pre-Emptive Rights

• Many private companies impose a Right of First Refusal (ROFR) clause, requiring founders to offer their shares to existing investors before selling to external parties.
• Pre-Emptive Rights allow existing shareholders to purchase shares before an outsider can acquire them.

To sell shares externally, founders must ensure no existing shareholder wants to exercise these rights.

- Restrictions on Transfer – Section 58

• Private companies can impose restrictions on share transferability through their AoA and SHA.
• Public companies cannot restrict share transfers but can enforce SEBI regulations for listed entities.

If there is a dispute over share transfer, the matter can be taken to the National Company Law Tribunal (NCLT).

- Valuation of Shares – Section 62 & Income Tax Act Implications

If shares are being transferred at a price different from fair market value (FMV), tax implications under the Income Tax Act, 1961 may arise.

For unlisted companies, FMV is determined based on:

• Net Asset Value (NAV) method
• Discounted Cash Flow (DCF) method

Under Section 62, in cases where ESOPs or preferential shares are issued during funding rounds, founders may face restrictions on immediate share sales.

- Stamp Duty & Share Transfer Procedure – Section 56 & 57

• A share transfer form (SH-4) must be executed, signed, and submitted to the company along with a share certificate.
• Stamp duty (0.25% of consideration) must be paid on the transfer.
• The company must register the transfer within two months of receiving the transfer request.

Methods for Founders to Sell Secondary Shares

- Direct Sale to New Investors

• Founders can sell shares to new investors (PE firms, institutional investors, or high-net-worth individuals).
• Requires approval as per AoA and shareholder agreements.

- Employee Stock Buyback (ESOP Liquidity)

• If the company has an Employee Stock Option Plan (ESOP), it may allow employees or founders to cash out by selling shares internally.
• Governed under Rule 12 of Companies (Share Capital and Debentures) Rules, 2014.

- Investor-Led Secondary Sales

• In funding rounds, VCs or PE firms often buy existing shares from founders to allow partial exits.
• Requires compliance with FEMA regulations if a foreign investor is involved.

- Buyback by Company – Section 68

• Under Section 68, a company can buy back shares from founders, subject to conditions:
  • Maximum buyback cannot exceed 25% of total paid-up capital and free reserves.
  • The company must pass a special resolution if buyback exceeds 10% of net worth.
  • The buyback must be completed within 12 months.

- Listing on Private Markets (Unlisted Shares)

• Platforms like CapTable, Tyke, and UnlistedKart allow founders to sell unlisted shares to retail investors.
• The process requires company consent and due diligence.

Tax Implications of Secondary Share Sales

- Capital Gains Tax

• Short-term capital gains (STCG) (if shares are held for less than 24 months): Taxed at slab rates.
• Long-term capital gains (LTCG) (if shares are held for more than 24 months): Taxed at 20% with indexation for unlisted shares.

For listed shares, STCG is 15%, and LTCG above ₹1 lakh is 10% (without indexation).

- Angel Tax under Section 56(2)(viib)

• If a founder sells shares at a price exceeding FMV, the difference may be taxed as "Income from Other Sources" under Angel Tax rules.

Key Challenges & How to Overcome Them

- Founder Lock-In Period

• Investors may impose a lock-in period, restricting founders from selling shares for a certain time.
• Solution: Negotiate exit clauses during fundraising.

- Low Liquidity for Secondary Sales

• Private companies often have limited liquidity, making secondary sales difficult.
• Solution: Founders can arrange investor buybacks or ESOP liquidity programs.

- Regulatory Approvals

• FEMA approval may be required for share sales involving foreign investors.
• Solution: Ensure compliance with RBI and FEMA guidelines in cross-border transactions.

GenZCFO Advice

Secondary share sales offer founders a practical way to cash out their equity without waiting for an IPO or acquisition. However, compliance with the Companies Act, 2013, shareholder agreements, taxation laws, and regulatory approvals is important. Contact us if you have any queries.