Private companies, liquidity programs and common shareholders

I believe private companies need to start building more meaningful relationships with their common shareholders. Why? For two reasons:

  1. an inexorable increase in common shareholder count. In the past, the 500 shareholder count limit forced companies from Google to Facebook to seek the public markets, as breaching the 500 limit would subject them to the oversight of a public company anyway. With the Jobs Act, that has now been increased to 2.000. This means private company will be able to ramp up their employee share ownership while staying private all the longer.
  2. the rise of the secondary market. This will further grow the number of shareholder, as each trade on average grows the shareholder base by one, assuming shareholders don’t sell their entire holding in one trade. Even if secondary markets have not reached the masses of private companies, their perceived benefits certainly have reached the masses of private company shareholders. This also creates pressure for companies to engage with their common shareholders and understand where the demand for liquidity comes from.

For companies, a rise in shareholder counts and secondary transactions create various headaches, which were very well summarized in this quora answer:

  • Increase in total number of investors (which causes securities law compliance issues and adds to administrative burden).
  • Inability to control the identity of shareholders. (Even if the company has a right of first refusal on transfers of shares, which is common, if the buyer offers a high enough price and/or the company doesn’t have the cash lying around to exercise the ROFR, the shares can end up in anyone’s hands.)
  • Leakage of financial and other proprietary information. Buyers understandably want to know as much as possible about the condition and prospects of a company before paying serious coin for a relatively risky, illiquid investment. The company is put in a tough position where it either cooperates and discloses financial information under Non-Disclosure Agreement to the potential buyer or refuses to cooperate, putting strain on some relationships and encouraging buyers and sellers to circumvent the NDA (tough to prove).
  • Messing up 409A Valuations, which the company pays real money for. By setting a new market price for the shares, secondary sales can force the company to price stock option grants higher than it would like going forward, undermining the incentive value of equity.
  • Inability to control the process. Most private companies would prefer no secondary sales be made at all before an Initial Public Offering (subject to some narrow exceptions), but as the lesser evil, the company is better off doing a controlled, structured process the way Facebook reportedly does.
  • Distraction and resentment among employees. There are always equity haves and have-nots, but it’s worse with private sales where investors usually don’t want to bother unless the block of shares is large enough. So generally top execs and founders have no trouble selling while rank-and-file employees may not have enough shares for anyone to bother, leaving them SOL.
  • Complex legal documentation and administrative burden. The standard documents used by a firm like SharesPost can run 30 pages. Selling shares in a publicly traded company requires only a couple pages in most cases. Everything has to be vetted by the company’s (inevitably overworked) legal and finance teams.

Companies can resolve these problems with IR tools. Its all about communication with your common shareholders really. First of all, employees and other common shareholders might be clamoring for secondary liquidity, but the real reason might simply be a lack of engagement and information coming from companies. An ex-employee might want to cash out on his shares simply because he now feels disconnected from the company. An IR campaign aimed at common shareholders could do a great deal to reduce demand for liquidity in the first place.

Shareholders might also feel the need for liquidity due to their personal financial situation. When they reach 30 and get their first child, the need for cash for a deposit on a house might be greater then that for an ownership stake in a risky venture. If the need for liquidity becomes a distraction for current employees, or prevents the company from competing with publicly traded rivals over talent, a private company might consider pro-actively enhancing the liquidity of its common stock.

Again, such liquidity can be achieved through IR tools as well. Back in the days that ‘secondary market’ was not yet a buzzword, transaction were occasional and conducted with outside buyers with a long standing relationship with the company. the following quote from John Glynn is telling:

“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.”

Another example is the leading role played by Millennium Technology Partners, a pioneer secondary investor in VC backed companies. Here is an excerpt from the same business week article

Millennium Technology Value Partners was among the first such investment funds, founded by two veterans of buyout firm Blackstone (BX). The fund spent the early part of the decade buying shares in startups from executives and investors that needed cash. In one of its first organized, companywide “liquidity programs” in 2006, Millennium bought shares from employees, executives, and investors of TellMe Networks, a Silicon Valley voice recognition company. Microsoft acquired the startup the following year, reaping Millennium bounteous profits. These transactions were still tame, well-orchestrated, and carefully negotiated affairs, always conducted with the imprimatur of the company in question. And then Facebook changed everything.

The frenzy that followed to acquire FB shares did not represent the dawn of a new era, which would see the private secondary market virtually replacing the public markets. It was just a blip, albeit a very big one, in the history of the secondary market.

Companies wishing to pro-actively enhance the liquidity of their common stock for the benefit of their shareholders should do so the ‘old fashioned’ way: by building relationships with one or several sophisticated secondary buyer such as Millemium.

By communicating with existing common shareholder and selected outside potential secondary buyers on an equal footing, private companies can assert control over their secondary share price, their shareholder base and the information used as the basis for transactions. This would effectively deal with the above mentioned problems, as well as with the risk of insider trading arising every time a shareholder with some corporate information sells to an outsider with none.

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