The news surrounding Twitter’s latest secondary transaction shone some light on the current state of the private company shares market. Predictably, the market has moved away from unsupervised transactions between individual shareholders and investors and towards large ‘arranged marriage’ type of transactions where the company builds a relationship with a large investor who then puts out a tender offer to employees.

Twitter build a relationship with Blackrock, presumable ‘opening the kimono’ and granting detailed financial information, determined a fair price for it’s stock and finally let Blackrock make a tender offer to it’s employees. This is very different from the pre-Facebook IPO ‘bubble’ in private stock, when shares were traded in an opaque market where prices were set more by hype then financial information. The post-IPO fall in Facebook shares However, has dampened enthusiasm for private start-up stock among private investors. What Twitter has done is in fact not different from what Facebook itself did in earlier days. Before the 2011 frenzy in private stock, .

Private company’s and their investors, trying to avoid the headaches that unsupervised private transactions gave them, have taken back control over their shares. Expect to see more of these pre-arranged transactions were large and sophisticated buyers supply liquidity to early employees via tender offers, after having first gone over the books and build a relationship with the company in question.

I recently came across a very interesting academic article about the uniqueness of start-up corporate governance. For US corporations, the default is that the common shareholders ‘control’ the company. This means they collectively could outvote any other class of shareholders, and are represented by a majority of board directors.

Common shareholder control is seen as beneficial for the company as a whole, because as commons only have a claim to the residual value of the company, they are the most incentivized to maximize total shareholder value. Creditors or preferred shareholders in comparison have have an incentive to choose lower-value, lower-risk investment and exit strategies over higher-value, higher risk strategies.

Venture Capitalists invest in a start-up through preferred shares and usually negotiate for control of the company through board representation, information rights and veto power over key decisions. So-called ‘drag along’ rights also give them the right to compel the common shareholder to accept any exit that is chosen by them. In such a case, they are in full control of the company.

This set-up is seen as necessary to reduce the tremendous risks that VC undertake when investing in a start-up. The other side of the coin is that it leaves common shareholders (founders and employees) vulnerable to so-called ‘preferred opportunism’. This is the kind of risk averse behavior that benefits the preferred shareholders but destroys total shareholder value. A good example is a VC pushing for a low ball exit whose limited value will only create a pay-out for them. This could happen to a start-up that is facing some difficulty. In such a situation the common shareholder have an incentive to adopt high-risk strategies that could turn the company around and result higher value over the long term, while the preferred shareholders will tend towards a low-risk ‘cut your losses’ strategy.

Preferred shareholders, when they control the board, can indulge in opportunistic behavior without having to fear any legal complications arising from that behavior. Delaware courts have adopted a doctrine of ‘control primacy’, which entails that whatever class of shareholders control the board have no fiduciary duty to the other classes of shareholders. A preferred controled board can freely indulge in opportunistic behavior without having to take the interest of the commons into account.

Is this in the interest of the start-up ecosystem? Who can tell… On the one hand VCs will argue that their control of start-up is necessary to mitigate the already tremendous risk they are willing to take on. On the other hand, we have all heard stories of visionary ‘trouble makers’ founders being replaced for a dull CEO by the preferred controlled board, almost never resulting in long term value creation.

Perhaps all this is changing now that there is a subtle trend towards founder control. Founders are common shareholders in start-ups, just like any employee who owns shares.

What are the financial regulations that a start-up needs to take into account when issuing equity based compensation, whether stock options or RSUs?

It turns out there are quite a few. I will discuss one, which allows private companies to issue securities to their employees without registering the offer with the SEC.

A general rule in US financial regulations is that one cannot issue or sell securities without first registering them with the SEC, unless an exemption applies. We have looked at this before in the context of selling private shares.

The first way to avoid registering securities issued as compensation is by ensuring that the employee who receives the grant is an accredited investor, a director or an executive officer. So that covers your most senior employees. What about everyone else?

The other way to avoid registration is by ensuring that the issuance is ‘non-public’. (remember the section 4 (1 1/2) exemption for selling private shares?). However, determining what a ‘non-public’ offering is can be very difficult. It involves assessing the financial sophistication of the employee and providing information typically found in private placement offerings.

In order to help out, the legislator came up with something called Rule 701 of the Securities Act of 1933.

How to sell up to $1M in stock compensation?

Rule 701 makes is possible for private companies to sell up to $1M in ‘securities’ to their employees as part of a compensation plan (and more than $1M under certain calculations that I am leaving out here). There are some simple requirement such as that the issuance must be made under a ‘written’ plan. This basically means that you must have a contract or other piece of paper which sets out the terms of the plan. So far so good.

How to sell more than $5M in stock compensation, and how not to do it?

If you are a rather large private company and want to issue more than $5M in securities to your employees, things get a little more complicated. In that case, you will need to make certain detailed disclosure to your employees, including financial results. I am not going to go into the details of those disclosure requirements, but let’s say that if you feel that this is too much for your taste, you are not the first. Google chose to ignore those requirements back when it was private, because it ‘viewed the public disclosure of its detailed financial information as strategically disadvantageous’. This became a problem when the company went public and the SEC started looking more closely at the company’s compliance history.

This resulted in a SEC’s cease and desist order in 2005, which also provides a detailed account of Google’s compliance policies and failures.

Google’s path to an IPO, and the $80m in securities issued in the meantime

In it’s first years of existence, Google coud easily rely on Rule 701 as it’s stock option issuance did not reach levels requiring detailed disclosure to recipients. This changed in late 2002, when the company first became aware that it soon would reach such levels as would mandate additional disclosure to employees. The company temporarily stopped issuing stock options because it ‘viewed the public disclosure of its detailed financial information as strategically disadvantageous, and the company was concerned that providing option recipients with the financial disclosures required by Rule 701 could result in the disclosure of this information to the public at large and, significantly, to Google’s competitors‘.

In early 2003 the company wanted to resume issuing stock options. The general counsel, David C. Drummond, came to the conclusion that Google could avoid the additional disclosure that would come from issuing more options by not relying on Rule 701 but instead on more esoteric exemptions(yes the ones mentioned above who are notoriously complicated). If this turned out to be wrong, the company could simply repurchase the issued options under a ‘rescission offer’ as per Mr. Drummond.

Google started issuing stock option again, ultimately resulting in about $80M worth of securities being issued to employees and consultants without registering the offering and without providing financial information required to be disclosed under the federal securities laws. For clarity, when issuing securities you either have to register them(basically go public) or rely on an exemption from doing so(which would be Rule 701 or one of the more esoteric exemptions in this case).

As it turned out, the SEC came to the conclusion that those esoteric exemptions were not available to Google, and that the rescission offer the company made in 2004 did not cure any prior violation of securities law. The company had essentially been issuing about $80m worth of stock illegally.

The lesson seems to be that larger private companies who wish to issue any form of equity based compensation (RSU, options and others) in excess of $5m should meet the disclosure requirements of Rule 701. The majority of your employees are not going to qualify as accredited investors, and attempting to avoid 701 by relying on esoteric private placement exemptions is only going to make your life more difficult and is unlikely to result in a successful exemption.

The WSJ had a very interesting article last May which told the stories of various people and their intention to buy shares of Facebook either in the IPO or before it in the secondary market. One of those stories is about someone who tried to buy shares via Sharespost. it gives some insight about how potential buyers were bidding on shares in a private company, without having access to any company information and without having a pre-existing relationship with the company. It also suggests that Sharespost was not very strict about enforcing the ‘accredited investor’ requirement for buyers on their site. This potential buyer is quoted saying that ‘between his 401K and an IRA fund and the college savings, (he found a way) to squeeze together the $100,000 minimum (transaction size) recommended by SharesPost’. That doesn’t sound like someone with at least $1M in assets or $200k in income…  While Sharespost did seem to have a close relationship with him: “Jim, I’m gonna be honest with you, you’re not gonna get it, very rarely does it sell for the minimum,” Mr. Supple says he was told by his SharesPost broker.

Here is the full excerpt:

Rockville Centre, N.Y.—Jim Supple was driving with his daughter Jade last autumn, when she turned to him and said, “Daddy, can I buy some of the Facebook company?”

Mr. Supple, 47, had been teaching Jade about investing in the stock market for years. He started putting money for her in stocks like eBay and Disney when she was a baby. But the request still took him aback. “How do you know about buying Facebook?” he asked.

“I saw in the news that they were going to be selling parts of the company,” she responded. “Can we buy some?”

Since then, Mr. Supple has been trying to find a way to take $25,000 he has saved for her college fund and purchase Facebook stock. “She doesn’t need this money for another eight years,” says Mr. Supple. “If it goes the Google route, I’ll be in good shape.”

Although he thought Facebook was a strong investment, Mr. Supple had been burned before, having lost some money in a Ponzi scheme, he says. He wanted to be sure that he was being more careful this time before betting so much on one company.

On Jan. 17, Mr. Supple tried to dive in. Two former Facebook employees were selling 70,000 shares in an auction on SharesPost Inc., one of the secondary markets for Facebook shares. The bidding started at $31 a share. He bid $32.01. “Jim, I’m gonna be honest with you, you’re not gonna get it, very rarely does it sell for the minimum,” Mr. Supple says he was told by his SharesPost broker.

Mr. Supple works for a Manhattan-based company called SNAP Interactive that creates a software application that allows singles to go on Facebook and find dates. Over a Jan. 18 dinner of burgers and beer at the New York steakhouse Del Frisco’s, Mr. Supple asked his boss, Cliff Lerner, what he thought about buying up Facebook in the secondary market.

“You know, there is a very high minimum to get into the secondary market,” Mr. Lerner cautioned Mr. Supple. Mr. Supple said he could figure out a way, between his 401K and an IRA fund and the college savings, to squeeze together the $100,000 minimum recommended by SharesPost. “Am I out of my mind?” Mr. Supple asked Mr. Lerner. “No, I think you’re gonna kill it in this thing,” responded Mr. Lerner.

Mr. Supple lost the SharesPost auction. It closed on Jan. 20 for $34 a share, less than $2 above his bid.

Just two weeks later, Facebook filed for its IPO with the Securities and Exchange Commission, driving the price of secondary market shares up drastically. The next auction was $44 a share, too expensive for Mr. Supple. Mr. Supple turned his energy away from the secondary market and began plotting how to buy shares on the day of the IPO, or shortly after.

On April 9, just after the roadshow kicked off, Mr. Supple said he was getting concerned about the frenzy and rethinking his plan to buy on the day of the IPO.

“Here in New York, it’s on every single news channel, it’s in all the newspapers that the roadshow has started and [Facebook Chief Executive Mark] Zuckerberg was here in New York,” he said at the time. “I’m going to sit on the sidelines on IPO day,” Mr. Supple decided. “We’re going to have to wait until the smoke clears.”

Now that the frenzy to acquire private shares in hot consumer web companies has quieted down , who are the guys left standing to offer a form of interim liquidity to shareholders?

These guys are in the market to buy shares from existing shareholders such as employees and founders, and usually do so in cooperation with the company itself:

Millenium Technology Value Partners: Millennium works closely with companies to implement liquidity programs designed to meet the strategic needs of management, shareholders, and Boards.

Saints Capital: Saints assists investors and founders who desire liquidity for their investment stakes and is a flexible purchaser and investor. Depending on the situation, Saints can partner with existing managers, assume future capital requirements, or purchase ownership stakes outright. In addition to providing liquidity and future capital solutions for investors, Saints also provides companies with a stable, long-term focused investor.

W Capital Partners: a private equity firm that provides liquidity in direct private equity. Since 2001, W Capital has become the leading provider of secondary market liquidity to private equity firms, mezzanine lenders, venture capital firms, financial institutions, corporations and company founders for illiquid, minority equity positions in private companies.

Glynn Capital Management: When Richard Melmon, a co-founder of Electronic Arts (ERTS), left the video game pioneer shortly after it was founded in a dispute with his co-founder, he sold a portion of his holdings to a Valley financier named John Glynn, who recalls working hard to cultivate a relationship with EA before the deal. “These were very occasional transactions, and it was done the old-fashioned way,” Glynn says. “You earned the respect and trust of the company, and they ended up wanting you as a shareholder.” (source)

Industry Ventures: a leading investment firm focused on the venture capital market. Founded in 2000, the firm manages over $1 billion of institutional capital. Industry Ventures invests with two strategies: i) secondary funds that offer liquidity alternatives for direct investments and limited partnership interests and ii) funds of funds that invest in small funds with outsized return potential.

HighStep Capital: a long/short equity hedge fund focused on successful Internet businesses and companies that have been disrupted by the Internet. HighStep also consults with large institutional investors to construct portfolios of private shares purchased through secondary transactions.

SecondMarket recently came out with info on their 1H 2012 activities, which I think are telling about the state of the private secondary markets.

“We’ve never had so many companies engaging with us,” Barry Silbert, SecondMarket’s CEO, told CNBC Monday. “They’re looking at what’s happening in the public market with the way stocks [from recent IPOs] are getting pummeled, [and] the way that the management teams getting destroyed in the press,” and want nothing to do with it, he said. CNBC further adds that ‘Silbert wants SecondMarket to be the solution for small companies wary of those IPO pitfalls to get liquidity’.

This is a very interesting view from someone on the inside of the private secondary markets. In the case of Facebook, it is probably correct to say that the stock is getting  pummeled in the public stock market, and Zynga is certainly facing <a href=’http://www.bloomberg.com/news/2012-08-22/zynga-spurning-sale-strands-owners-at-worst-web-value.html&#8217; target=’blank’>several difficulties</a> in the public markets. But can we really say this amounts to an ‘IPO pitfall’ for private companies going public?

The public markets seem to be treating the average tech IPOs well. Witness the recent IPO of Kayak and Palo Alto Networks. Both companies had great public debuts. The WSJ quoted Palo Alto Chief Executive Mark McLaughlin that Investors appear eager to buy IPOs “if you have a strong company”, who further said that “Not surprisingly, a lot of institutional buyers will take a long view on a good company. They’re not worried about what the market was doing yesterday or how it performed today”.

The FT recently stated that ‘Facebook shares have fallen despite the success of other technology public offerings this year. The other 22 IPOs from the sector in 2012 have an average gain of 25 per cent through to the end of last week, according to S&P Capital IQ, a research firm.’

Perhaps Facebook getting pummeled in the public stock market is a reflection of a disappointing current monetization strategy from the company. The price of a stock should reflects the expected future earnings. Public investors are disappointed by the current revenues of the company and therefore expect future earnings to be disappointing as well. If you disagree and think Facebook is being undervalued by the market, you can buy the stock. At least you can do so now with full knowledge of the company’s financial position.

Facebook enjoyed very high valuation on private secondary platform such as Secondmarket, and perhaps the fact that it didn’t report its results to buyers in those markets played a role. As the NYT noted as early as 2010:

“Investors are taking on substantial risk when buying shares in these private companies. Despite Facebook’s ubiquity it does not disclose its financial results.”

One such pre-IPO buyer candidly admitted to the WSJ that he thought it was a “bragging right” when he landed the opportunity to buy (Facebook) shares last fall at $31. “I accepted the fact that this was a speculative play,” he said. “But I thought the pre-IPO price was just bound to be lower than what it would be on the public market.”

Felix Salmon provides on his blog an interesting view into the 2011 frenzy to acquire private shares of Facebook: ‘it’s increasingly looking as though shares in private tech-companies are a bit like fine art prices: a place for the rich to spend lots of money and feel great about owning something very few other people can have. The minute they become public and democratic, they lose their cachet. And a lot of their value.’

So what can we deduct from all this? What is the difference between the private and public secondary markets?

The main difference between the private and public stock markets is that public companies are subject to disclosure requirements while private companies are not, and that trading in the public market is cheap and liquidity is usually plentiful, while it is lacking and expensive to access in the private markets.

If you buy stock of Facebook today, you can do so for  $10 or less in transaction cost, and you can sell it back to the market any time. If you bought shares of Facebook in the private markets, you paid 2 to 5% in commission, and you can sell your shares at the earliest on August 16 2012, when the first batch of insider lock-ups expire. Reselling private shares within the private markets themselves is almost no-go, because of legal restrictions

Before the 2011 ‘private market frenzy’, savvy professional participants in the private markets would usually build a relationship with the company before buying shares, and get access to company information. John Glynn of Glynn Capital Management, recalled in a Business Week article that “These were very occasional transactions, and it was done the old-fashioned way. You earned the respect and trust of the company, and they ended up wanting you as a shareholder.”

The key lesson would be that you should only buy private shares from a company with whom you have an established relationships and who grants you access to corporate information. VCs have access to such information via privately negotiated information rights. Professionbal secondary buyers such as DST or Millenium probably have access to company information, as they bought shares from employees with the full cooperation of the company.

The way forward

Interestingly enough, this is also the path that activity on Secondmarket  seeems to be taking. In 1H 2012, the number of ‘accredited investor’ buyers dropped by 5x to 6% of the volume, compared with 27% in 2011 FY. Also, the share of ex-employees as seller dropped by 3x. Ex-employees represented 80% of the transactions in 2011, compared with only 24% so far this year. Remember that Facebook implemented an insider trading policy preventing current employees from selling shares in 2011. Also notable is that almost 60% of shares sold in 1H 2012 were preferred shares, which means that sellers were likely institutional shareholders as opposed to employees.

These 2012 numbers point towards a more muted private market based on activity from professional participants(institutional vs merely ‘accredited’ individuals) with an established relationship with the company, and who transact with the full collaboration of the company.

This is not surprising as Secondmarket recently switched it’s model from one were participants could trade shares of any company, to one where companies control the trading of their shares on the platform, pre-select buyer and sellers and have to provide the market with a modicum of financial disclosure. Such company sponsored transaction are I think the way to go forward for the private markets, or perhaps a return to how to market operated pre-Facebook buying frenzy.

More disclosure by private companies and a direct relationship with potential buyers of their shares are the way to go forward, it could however turn out to be less lucrative for Secondmarket than the 2011 trading of Facebook shares. The WSJ pointed out :

“(…) a month before the social network’s shares jumped to the public market, SecondMarket laid off about 10% of its staff. And while it continues to trade shares of hot private companies, these deals can offer limited rewards. A majority of such companies pay SecondMarket a flat rate to manage a transaction in which the company itself has already selected those that will buy its stock.”

The WSJ goes on: “SecondMarket’s primary asset is the collection of well-heeled, accredited investors on its platform. Fund managers that specialize in oddball investments are anxious to tap into that money pool and will pay SecondMarket a percentage of the cash they can raise.”

To follow up on my posts on US financial regulations concerning private shares resale, here are the concrete steps one should take to effectuate a sale and transfer(from the seller’s pov):

  1. find a buyer for your shares. This has to be someone from your existing network. US laws prohibit ‘general solicitation’ of private shares, meaning you can only offer them to people that you already know. Also make sure the buyer is an accredited investor. This can be done by having the buyer sign a simple statement to that effect, no proof of income or assets are needed. (you need to  ‘reasonably’ be able to presume the person qualifies)
  2. When you have found a buyer, draft and execute a Stock Purchase Agreement(SPA) between yourself and the buyer. The SPA should take into account the common restrictions  found on private company shares, such as the Right of First Refusal of the company and preferred shareholders. Templates for SPA are available
  3. After having executed the SPA, if you haven’t done so already, notify the company of your intent to sell. This will trigger the Right of First Refusal procedure, which can take a few weeks or even a month. The company will have to go through the procedure and basically decide whether they want to preempt your deal and buy the shares from you or find out whether any of the preferred shareholder wants to buy the shares from you.
  4. When the outcome of the above is known, the company will notify you of it. At this point you will know whether there are any shares left to sell to your buyer, or whether all of the shares that you wanted to sell have been bought by the company and/or other shareholders preemptively. Even if the company buys all the shares, it’s not a big deal for you since they will have to pay the same price that your buyer was willing to pay. However it will matter for your buyer, and this is why your SPA should take this into account.
  5. Notify your buyer of the above, and ask him to transfer you the purchase price.
  6. When you have received the purchase price, sign a Stock Power and send it along with your stock certificate to the company, directing it to transfer the shares that you sold to the buyer. Send a copy of all this to the buyer as well. If this is required by the company, you will also need to get yourself a legal opinion about the legality of your transaction, and send it to the company as well.
  7. When the company receives all the above, they will change the name of the shareholder in their registry and issue a new stock certificate in the name of the buyer.

Done Deal!

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