Why Secondary Sales Are Not Diversification

The standard advice

The conventional guidance to employees holding concentrated private equity is straightforward: sell some of it. Reduce your exposure. Diversify.

This advice is not wrong. Concentration is risk, and reducing concentration is prudent. The question is whether a secondary sale actually accomplishes what the seller thinks it accomplishes.

Most people assume that selling $1 million of private stock produces $1 million of diversified assets. It does not. The gap between what you sell and what you keep is larger than most people realize, and the implications for long-term wealth are significant.

The arithmetic of a secondary sale

Consider a senior employee at a late-stage private company with $10 million in vested equity. They want to reduce concentration and build a more balanced portfolio. A secondary sale seems like the obvious path.

Here is what actually happens when they sell $1 million of that position.

The secondary discount. Private stock does not trade at the last-round valuation. Buyers require compensation for illiquidity, information asymmetry, and execution risk. Common stock typically trades at a 20 to 30 percent discount to the most recent preferred round. In weaker markets, discounts can exceed 50 percent.

If the seller's shares are valued at $1 million based on the last financing, they might receive $700,000 to $800,000 in a secondary transaction. Call it $750,000.

Taxes. The sale triggers capital gains. For a California resident with a low cost basis, combined federal and state taxes approach 37 percent. On $750,000 of proceeds, that is roughly $278,000 in tax.

Net proceeds. After the discount and taxes, the seller has approximately $472,000 in cash.

They started with $1 million of exposure to a single company. They now have $472,000 of diversified assets. They have reduced their concentration by $1 million but increased their diversified wealth by less than $500,000.

What they gave up

The seller did not just give up $528,000 to transaction costs and taxes. They gave up the future appreciation on that $1 million.

If the company's equity doubles over the next three years, the $1 million position they sold would have become $2 million. Instead, they have $472,000 invested in a diversified portfolio earning, say, 8 percent annually. After three years, that grows to approximately $595,000.

The wealth gap is now $1.4 million.

This is not an argument against ever selling. There are good reasons to reduce concentration, and certainty has value. But it is an argument for understanding the true cost of the decision. The secondary sale is not a one-for-one exchange. It is a trade that costs substantially more than most people account for.

The diversification illusion

The deeper issue is that selling private stock often does not accomplish the stated goal.

The goal is usually described as "diversification" - moving from a concentrated position in one company to a balanced portfolio across many assets. But diversification, properly understood, means spreading a given amount of wealth across multiple investments. It does not mean shrinking that wealth in the process.

When you sell $1 million of concentrated stock and end up with $472,000 of diversified assets, you have not diversified $1 million. You have diversified $472,000. The other $528,000 is gone.

This distinction matters because it changes the framing of the decision. The question is not simply "concentrated versus diversified." The question is "full exposure to upside versus reduced exposure at a substantial cost."

Some shareholders are willing to pay that cost. They value certainty over optionality. They have enough concentrated exposure elsewhere. They need the liquidity for a specific purpose. These are all reasonable positions.

But many shareholders do not fully account for the cost when they make the decision. They see the secondary sale as an even trade - $1 million of concentrated stock for $1 million of diversified assets - when it is actually a trade at 50 cents on the dollar.

The compounding problem

The impact compounds over time.

If you sell early in a company's trajectory, you are selling at the lowest price and the highest tax cost relative to potential future value. The shares you sold at the Series D valuation might be worth five or ten times that amount at IPO. The tax you paid on the sale cannot be recovered. The upside you forfeited cannot be recaptured.

This is why the decision to sell is path-dependent. The earlier you sell, the higher the effective cost. The later you sell - assuming the company continues to perform - the more you retain.

Of course, waiting carries its own risk. The company might decline. The exit might never happen. The valuation might compress. These are real possibilities that justify some level of early liquidity.

The point is not that selling is always wrong. The point is that the cost of selling is higher than it appears, and that cost should be weighed against the actual risk being mitigated.

The alternative frame

There is another way to think about the problem.

Instead of asking "how much should I sell," ask "how much do I need to access, and what is the most efficient way to access it."

A secondary sale is one answer. It provides permanent liquidity at the cost of permanent dilution. You trade equity for cash, pay the tax, and accept the outcome.

A credit facility is a different answer. It provides temporary liquidity without permanent dilution. You borrow against the equity, preserve your ownership, and repay from future exit proceeds.

The math looks different under this frame.

Consider the same $10 million position. Instead of selling $1 million, the shareholder takes a credit facility at 10 percent loan-to-value. They access $1 million without triggering a sale, without paying tax, and without forfeiting upside.

At exit, they repay the facility from proceeds. If the company has doubled, they repay approximately $1.25 million (principal plus accrued interest) and keep $18.75 million. Net position: $17.5 million.

Compare this to the secondary sale path. They sold $1 million and kept $9 million. If the remaining $9 million doubles, they have $18 million of equity plus approximately $600,000 in their diversified portfolio. Net position: approximately $18.6 million.

The outcomes are comparable in this scenario. But the credit facility path preserved optionality. If the company tripled instead of doubled, the gap would widen significantly in favor of the shareholder who did not sell.

When selling makes sense

There are situations where a secondary sale is the right choice.

If you have no confidence in the company's trajectory and believe the current valuation is as high as it will get, selling captures value before it evaporates. If you have an immediate need for cash that exceeds what a credit facility can provide, selling is the only option. If you have already exercised and held for the QSBS period, and the company's prospects have weakened, selling may lock in favorable tax treatment before conditions deteriorate.

The question is always comparative. What is the cost of selling versus the cost of not selling? What exposure are you reducing, and what optionality are you forfeiting?

Most shareholders considering secondary sales are not in distressed situations. They are managing concentration risk and seeking balance. For these shareholders, the key insight is that a secondary sale is an expensive form of diversification. It accomplishes the goal, but at a cost that is often underestimated.

The framework

Before executing a secondary sale, consider the following:

First, calculate the actual net proceeds. Apply the secondary discount (typically 20 to 30 percent) and subtract your tax liability. The result is what you are actually gaining, not the headline transaction value.

Second, compare against future scenarios. If the company performs as expected, what would the sold shares be worth at exit? How does that compare to the diversified portfolio you are building with the net proceeds?

Third, consider alternative structures. Can you access the liquidity you need without triggering a taxable sale? A credit facility sized at 10 percent of your position may provide meaningful capital while preserving full ownership and upside.

Fourth, distinguish between liquidity and diversification. If your goal is liquidity - access to cash for a specific purpose - a sale or a credit facility might both work. If your goal is diversification - reducing concentration while preserving wealth - a sale may accomplish less than you think.

Diversification without destruction

True diversification means spreading your wealth across uncorrelated assets. It does not mean shrinking your wealth in the process.

The challenge with concentrated private equity is that the standard tools for diversification - selling and reinvesting - are expensive. The discount, the taxes, and the forfeited upside combine to create a substantial drag.

This does not mean concentration is good. It means that the decision to reduce it deserves careful analysis. The shareholder who sells at 50 cents on the dollar may be making a reasonable choice, but they should make it with full awareness of the trade.

The alternative is not to ignore concentration risk. The alternative is to find structures that address liquidity needs without triggering the full cost of a sale. These structures exist. The question is whether shareholders are aware of them when they make their decisions.

This note is for informational purposes only and does not constitute tax, legal, or investment advice. Individual circumstances vary, and readers should consult their own advisors before making decisions about their equity positions.