corporate governance

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.

Private company shares were being ‘traded’ since the dawn of their existence, however thanks to Secondmarket, Sharepost and Facebook, trading private shares became a buzz word in the tech and financial communities. for a moment, a new era seemed at hand where the difference between the public and private markets would be irrelevant. The private secondary markets seemed unstoppable in their growth of participants and liquidity.

However, behind the headlines, the transformation of private markets proved short-lived and mainly driven by hype. Facebook stock made up almost half of the total turnover on these markets, followed by other hot consumer web companies such as Zynga and LinkedIn. Those last two went public in 2011, and were followed by the hotly anticipated Facebook IPO in May 2012. Since then, people have been wondering What’s next for private markets?.

With hindsight, it seems clear that private company stock achieved huge trading volumes in 2011 mainly because buyers were willing to pay anything to get their hands on hot consumer web stocks, hoping to benefit from a company’s inevitable IPO. And even in those days, the private markets did not resemble the public markets in liquidity or volume. When you buy shares on the private markets, you cannot resell them the next day, unless you want to face the risk of of breaching securities regulations.

More importantly, the red hot private company market of 2011 failed to benefit the majority of holders of private company shares. It was a typical case of a few participants (brokers from their commissions and holders of stock of a handful of companies from increased liquidity) benefiting enormously from what was a relatively small segment of the total market. Why did the market failed to expand? I believe is was because of a lack of IR coming from private companies. The few consumer web companies that did achieve a semblance of liquidity did so because they were hugely popular household names and buyers did not require any company information to be disclosed. This ended in nothing but disappointment. Bear in mind also that buyers of FB stock pre-ipo paid a 3% fee to either Secondmarket, Sharepost or another brokers, and also likely incurred additional legal fees during the transaction. They could have bought the same shares, (actually not the same ones, pre-IPO they bought ‘restricted securities’ that they have to hold until the window for selling for insiders opens) through a click of their mouse and by paying 0.15% in fees with no additional legal costs.

The private company market of 2011 is not a sustainable model that will bring liquidity to the masses of common shareholders of private companies. In the past, private shares would trade through occasional transactions between parties with pre-existing relationships, and with the participation of the private company involved. Buyers had to work hard in earning the trust of management and become long term shareholders. Information would be provided to would be buyers, and usually no broker was involved. These were old fashioned deals between people with an established business relationship. (read my other blog post on the history of private markets for more info)

I believe these ‘old fashioned’ deals are the way forward. Private shares are an illiquid and difficult to value asset class with a lot of regulatory baggage, and are best left to be purchased by experienced accredited investors or dedicated funds.

The story surrounding Airbnb’s latest funding round in late 2011 was a great example of how sometimes the interest of the common shareholders can be overlooked by private companies and their preferred controlled board.

In this case, it was rather a case of the interest of prospective common shareholders, options owning employees, that was overlooked. Essentially it seems like as part of its $100m+ funding round, the common shareholders were going to get a $22.5m dividend. Sounds like a great deal for common shareholders such as early investors and employees. Unfortunately for most of the employees, it turned out they where not holding the actual shares but rather options to purchase the shares. The founding management however did hold the actual shares. As only actual shareholders would be entitled to the dividend, this meant that founders were going to get a $21m out of the total $22.5m dividend payment, the remainder $1.5m would presumably go to early investors or the few employees who already exercised their stock options.

Read the AllthingsD article here.

It is normal for late stage funding rounds to include a secondary component, whereby shares are purchased from management and or employees, creating a form of interim liquidity for the common shares. However, in this case, the dividend structure that was chosen instead was going to only benefit the founders.

This led early investor Chamath Palihapitiya to write a letter to CEO Brian Chesky and complain about the perceived unfairness towards employees. This letter was leaked to the public, which resulted in a form of liquidity being implemented for employees that did not share in the dividend.

This is a good example of how the common shareholder (or holders of options to become common shareholders) can be overlooked by a board controlled by preferred shareholders and also shows how a more active investor relations campaign can result in mutually attractive solutions. The leaked email can be said to have been a form of ad hoc shareholder activism normally unheard of in private companies.

As successful private companies choose to stay private while at the same time seeing their shareholder or option holder base grow to close to the 2.000 ceiling, an appropriate IR program will become increasingly important.

In the case of Airbnb, it is unclear what the employee liquidity program has or will look like, however once again a liquidity program really is a form of IR for private companies. It provides information to common and prospective common shareholders on an equal basis, and forms the basis for long term relationships between the company, its shareholders and prospective shareholder. This then paves the way for controlled liquidity where shareholders deal directly with potential buyer with whom they and the company have a pre-existing relationships. Such transactions between parties with pre-existing relationships are in fact encouraged by the current financial regulations and also have the additional benefit of lower transaction costs than a broker-led liquidity program.

Happy 4th of July!

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