Thursday, July 13, 2017
By Howard Lee and Rob Ackerman
Ten years ago, there were few, if any, direct purchases of shares or securities in private, venture capital (VC)-backed technology companies. These secondary sales (as opposed to the traditional VC or “primary” investment into the company) by founders or employees were rarely permitted by VC investors or the company’s board of directors as investors believed this created a misalignment of interests between themselves and the founders; if the investors had to wait until an exit for liquidity then the founders and executives would likewise need to wait.
In addition to the perceived misalignment of interests, the company and the board also sought to avoid any negative outside perception of the company that could arise from executives and other insiders selling their shares. Typically, the VC investors and board would only allow a “de minmus” number of shares to be sold or transferred by founders or executives and only for estate planning purposes. The reality of these restrictions was that they forced employees to consider leaving the company to address their own personal liquidity considerations that arose from “life events” such as divorce, college tuition payments, or buying a house.
The restriction on selling shares also had an impact on recruiting talent. Prospective employees choosing between private and publicly-traded companies then had to take into consideration liquidity of their shares: illiquid shares in a private company with upside potential three to six years down the road, or liquid shares of a publicly traded company with limited upside. In many of these cases, private companies often lost talent to the larger publicly-traded companies.
Today, an increasing number of secondary transactions have occurred, and more are expected. The market for direct purchases of shares or securities in private, venture capital (VC)-backed technology companies has been growing over the last 10 years. There are several macro reasons for the increased interest in and volume of secondary transactions. The median time to exit at IPO in 2017 has increased to more than 8 years after first VC funding compared to 4.8 years in 2006. (NVCA/Pitchbook Venture Monitor, June 2017; Pitchbook US PE & VC Trends 2016 Report). The slowdown in the IPO Market has also contributed to this increase as there were only about half as many (39) VC-backed IPOs in 2016 compared to 76 in 2015(NVCA/Pitchbook Venture Monitor, March 2017). While H1 2017 has improved slightly with 27 IPOs (NVCA/Pitchbook Venture Monitor, June 2017), many high-profile, later-stage companies have been able to continue raising additional capital to withstand the extended time to exit. In turn, this has led to increased interest in secondary transactions. It is estimated that the private market for tradable shares has increased by more than 3 times from $11B in 2011 to $35B in 2016 and is expected to grow to $38B in 2017 (Scenic Advisement, Dec 2016). For all founder and employee shareholders in these startups, equity has value only if there is the potential for liquidity.
An emerging need is the development of a structured process by which management can provide employees with partial liquidity to alleviate external pressures from life events and to motivate staff while addressing the issues of long-term alignment of interests and public perception. The demand for liquidity driven by life events rarely lines up with startup timelines to exit and liquidity. These life events simply cannot be planned or predicted and are independent of the economic cycles. The ability to provide key employees partial liquidity in a structured and controlled manner can be crucial to achieving a company’s long-term goals.