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Why Late Stage Startups Need Aligned Liquidity

Ten years ago, most successful Silicon Valley startups spent their first seven years getting to $100 million in revenue. At that point, they’d go public or get acquired, and their early employees would cash in on vested stock options, amassing considerable wealth before facing major personal financial obligations.

The market has changed, and those days are in the industry’s rear-view mirror.

Today most startups performing well enough to pursue a public offering or acquisition—those we at Founders Circle have identified as breakaway-growth companies—are staying private and independent until an average age of 11 years. While this elongated timeline has been arguably good for the business, it’s reduced the effectiveness of stock option programs, designed to incentivize the team to continue building the company with patience, and added challenges to retaining employees.

For the people building large and fast-growing startups, the need for liquidity progressively builds up over time. As life pressures mount—hosting a wedding, buying a home, paying school tuition—and get jammed up against company policies and squeezed ever tighter by mandated expiration dates, employees might find themselves financially immobilized and tempted to pursue a solution outside of or otherwise at conflict with the company.

Company managers and directors might be making a rational decision in putting off the company’s IPO. But shifting the expected exit window from 7 years to 12 years is like getting runners through a 10K race, only to extend it to a full marathon. To get the runners to the new finish line, they need a water station—a tangible sense of replenishment—at Mile 21 in the race.

Many late-stage private companies have been helping early employees execute secondary sales of their vested stock, realizing that giving these employees some liquidity orients everyone toward long-term building. In doing so, they’re challenged with aligning the needs of all stakeholders: the company, the board of directors, outside investors, and employees.

Our term for what these late-stage private companies seek is “aligned liquidity,” a balancing of all stakeholder needs through a carefully designed and implemented program.

We’ve teamed together with our partners at Nasdaq Private Market, SVB Analytics, Cooley, and Andersen Tax to provide you with a collaborative perspective on why successful private companies should pursue aligned liquidity.


 
 
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A Liquidity Sea Change

A decade ago, high-performing late-stage private companies had plenty of reasons to go public or sell themselves at year 7, and few of them revolved around employee liquidity.

Some startups didn’t have enough capital to continue growing privately. Others reached a legal limit of 500 shareholders for privately held companies, requiring them to file public reports. And yet others had early investors that needed to drive proceeds back to their limited partners before raising a new fund.

Several market dynamics today are driving similarly positioned companies to remain private longer and, in some cases, indefinitely:

  • Updates to the JOBS Act: On March 27, 2012, Congress amended the Jumpstart Our Business Startups Act to increase the allowable shareholder limit for a private company from 500 to 2,000, excluding employees. Private companies can now continue to grow much larger without being forced to start publicly reporting their financial results.
     

  • An Abundance of Capital: As more companies remain private longer, public-market investors are shifting a portion of their capital pools to the private markets. On top of investments from incumbent growth-stage investors, private companies have seen an influx of investments from public-market investment funds, corporate funds, and institutional investors. They’re now much less dependent on the public markets to fuel ongoing growth.
     

  • Costs of Going public: The very resource-intensive process of complying with regulations governing IPOs is enough to turn most companies away from going public.
     

  • Resources Required to be Public: Managers of private companies can focus on operations; managers of public companies cannot hop off a 90-day hamster wheel of quarterly earnings announcements.

Years from now, when we add up the market capitalizations of the more than 150,000 private technology companies in operation today, the vast majority of value will have been created by fewer than 500 of them, or just 1 percent of all startups. These companies have achieved an enviable level of business performance. It’s what we call the “40 Rule”: a minimum of $40 million in annual revenue, along with a growth rate and gross margin that exceed 40 percent.  

Although these top-performing private companies have the ability to go public today, their management teams and directors are increasingly embracing secondary stock sales as a means to remain private for as long as they deem fit.

Over the past two and a half years, 82 companies conducted employee tender offers, cumulatively worth more than $3.6 billion, on the Nasdaq Private Market platform. In the past six months, the average deal size was $43.9 million, with 113 sellers.


 
 
 

Misalignments in the Building

Staying private longer enables breakaway-growth companies to work out inevitable kinks and wrinkles in the business, while expanding the revenue base and improving the growth trajectory. During this period, investors benefit from riding the growth curve before entering public life, and founders and employees accrue greater wealth.

But as breakaway-growth companies stay private longer today, several scenarios can tear at the fabric of their stakeholder alignment, causing significant distractions, or undesirable decisions and consequences.

  • Founders and Executives: Founders and early executives might have been with the company since they were single—and living, almost literally, at the office. Now past their seventh year at the company, they are more likely married, raising kids, and juggling meaningful obligations outside work. They have a deep desire to put a roof over the heads of their family, to place their little ones into the best schools possible, to retire an amassed burden of debt and tax obligations, or to take care of the health needs of an extended family member. In absence of liquidity, founders might find themselves entertaining acquisition overtures, or executives might succumb to the recruiting enticements of a public company.
     

  • Employees: Employees whose stock options have fully vested, often a very large group, experience their own life moments. Lacking liquidity to pay big bills, they might find themselves drawn to an employer dangling higher compensation.    

    Very early employees, who have been patiently waiting for the company’s exit to exercise their options and sell their shares, might also be approaching a federally mandated 10-year option expiration wall. As the deadline nears, they might feel compelled to engage with an outside buyer offering a synthetic loan agreement to exercise their options and pay the corresponding tax.
     

  • Early Financial Backers: Original friends-and-family investors might begin seeing the current value of the company as an investment success and an ideal way to fund Junior’s college education or a long-awaited house addition. Seeking a financial windfall, they might start advocating for a sale.

    Likewise, a boutique investment firm that might have been the company’s first investor could be pushing against the end of its fund’s life. Feeling pressured to distribute gains to its own institutional investors, or simply show a portfolio profit mark to help raise a new fund, it might pressure the company to sell.
     

  • Former Employees: Former employees typically face a 90-day expiration window, mandated by the company, to exercise their shares and pay the corresponding taxes. On a case-by-case basis, companies will extend this expiration timeline for exiting employees. But for the most part, former employees are held to a 90-day exercise period, during which they might seek buyers—possibly neither known by nor approved by the company—for their shares.
     

  • Brokers: In all these scenarios, brokers could seek ways to get their hands on a company’s common shares and represent them on the open market. When shares hit listing sites, company executives might not have any insight into who is posting them, selling them, or buying them. And they have little ability to claim those shares as their own, nor control who buys them.

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Running Out of ‘Options’

Early employees of late-stage private companies—be they founders, executives, or among the rank and file—particularly feel the mounting financial pressures associated with life moments. Many of them, having expected a major liquidity event at year 7, now face harsh realities about their stock options:

  • Policies: Most companies (via bylaws and employment agreements), as well as their investors (via term sheets), have implemented policies around restricting secondary stock sales. To avoid the “Wild West” represented during Facebook’s pre-IPO secondary stock sales, these policies typically require board approval for the sale of any employee shares, whether individual transactions or broad-based programs. They place punitive penalties on employees who attempt to sell or pledge their shares without company consent. And they  give the company the right of first refusal, or ROFR, with respect to the purchase of any available employee shares.
     

  • 90-Day Expiration: When employees need to (or are asked to) depart from a company, they have 90 days to acquire their vested stock options. If they have not exercised that right within the 90-day window, the options typically expire and are absorbed back into the company.
     

  • 10-Year Expiration: Via a law passed in 1981 (U.S. Code § 422 - Incentive stock options), employee stock options operate under a federally mandated 10-year expiration period. If employees have not exercised their vested stock options within 10 years of being granted them, the options will automatically expire and get absorbed back into the company. There is nothing a company can do to change its bylaws to extend this timeline.
     

  • Liquidation Preferences: Companies continuing to raise money privately are often pressured by late-stage investors to take on liquidation preferences where, upon the company’s exit, they get paid before, and sometimes in multiples to, earlier preferred investors and common shareholders. Each liquidation preference can meaningfully limit an employee’s wealth opportunity. Often, employees are completely unaware of the existence of these preference overhangs and the implications to their personal finances.

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Lacking the Cash

These employees might have reason to exercise their options and sell at least some of their shares. In many cases, though, they simply don’t have the disposable cash on hand to pay the associated costs.

  • Exercise Price: Employees must cover the preset exercise price, or “strike price”, of each share of common stock they were granted. Depending on the company’s value at grant date, a share’s exercise price might be an insignificant dollars-per-share.
     

  • Taxes: The taxes associated with exercising one’s options, by contrast, can be a breathtakingly high dollars-per-share figure. Acquired options are taxed immediately upon purchase and again upon their sale after the company’s exit.

    The tax to acquire the vested options is assessed on the difference between the strike price and the 409A price, or the auditor-assessed value of the company. If the vested options are exercised during years 7 through 12, when the company’s valuation is skyrocketing, this usually amounts to hundreds of thousands of dollars of tax obligations on illiquid stock that can’t be sold due to company policies.
     

  • Taxes: The taxes associated with exercising one’s options, by contrast, can be a breathtakingly high dollars-per-share figure. Acquired options are taxed immediately upon purchase and again upon their sale after the company’s exit.
     

  • Fees: Then, if a broker is involved, sanctioned or not, there is often a 5 percent broker commission on the ultimate sale. This operates much like when homeowners pay their real-estate agent upon the sale of their house.

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Empathy & Action

Company managers and board directors are not blind to their employees’ liquidity struggles. They can plainly see that their choices are few and deeply disconcerting: wait years for the company’s eventual exit while enduring life’s pressure valve; risk near financial ruin to exercise their vested options; or lose their potential wealth, if they are unable to fund their acquisition.

Despite a company’s empathy for the situation of their team members, loosening the reins on secondary sales proves challenging. Here are a few reasons:

  • Investor Control: High-performing companies have the luxury of thinking very carefully about whom they invite to invest. They want to ensure that their shareholders are aligned with the company’s vision and development path. Having unknown shareholders on the cap table is antithetical to the company’s desire for control.  
     

  • Team Resources: Facebook’s 2010 pre-IPO secondary stock sales demonstrated the chaos that can descend upon a company if it freely allows current and former employees to sell their vested options on the open markets. The company’s finance and legal teams could get engrossed in processing ROFR notices and dealing with individual shareholder issues. In short, resources could shift toward nonaccretive activity.
     

  • Employee Focus: Building a breakaway-growth company requires keeping a laser focus on meaningfully moving the business forward. Employee liquidity often is not at the top of (or even on) the list of priorities. While managers and board members recognize the importance of employee liquidity, many don’t want to spend internal resources educating, running, and managing liquidity programs, nor do they want employees to be distracted by the concept of ongoing liquidity. As a result, many companies simply ignore the pressure for liquidity until it bursts.
     

  • Inside Sales: Existing investors, who might feel a natural inclination to facilitate employee liquidity programs, don’t realize the potential risks. As members of the company’s board of directors, and serve on their compensation or audit committees, they possess material nonpublic information, they approve 409A valuations, and they continually buy company shares at the latest preferred valuation. Purchasing common shares from employees could greatly impact the company’s 409A valuation, which could, in turn hamper the use of stock options as a recruitment and retention tool. And if the company were acquired, shortly after the purchase of common shares, for a material increase in the price per share, the company could be vulnerable to a legal claim by the sellers.


 
 
 

Triggers for Aligned Liquidity

Management of private companies often grapple with when to start considering an aligned-liquidity program. Founders Circle has observed that any one or more of the following circumstances tend to be present for those companies that have elected to facilitate an aligned-liquidity program, whether its liquidity for an individual founder or executive or for a broad based employee tendered offer. Ultimately, they’re in search of tools to retain and recruit the incredible teams that will carry them to and through an eventual IPO.

  • 40 Rule: The companies were experiencing an exceptional level of scale and business performance. It’s something we call the “40 Rule”: when a company has reached or exceeded $40 million in revenue, and 40 percent in annual growth and gross margin. These are the companies that are the Top 1% of all startups and go on to one day comprise the majority of the technology market cap.

  • Age: Typically, the companies are five to seven years old with every intention of remaining private for another three to five years. Thus, a meaningful portion of the employee base have vested in 100% of their stock options where there’s risk that they might begin looking elsewhere to increase their wealth creation opportunity.

  • Pressure Valve: Early employees joined the team when they were single and occupying a crummy one bedroom apartment but rarely slept or ate there because they were living at the company. But, now they’re married with kids and burdened financial obligations--getting their family into a house, enrolling their kids into school, paying-off their debts, covering a family member's medical needs or, unfortunately, settle matters when life didn't go quite as hoped for--all of which is causing significant distraction at work or risk that they’ll seek out a higher compensating opportunity.

  • Poaching: When a private company has reached this level of success, its well known to public technology companies who need to feed the beast of their own growth. Whether management knows it or not, recruiters from Google, Facebook, Apple, Amazon and their ilk are wooing talent to jump ship. They’re being enticed with signing bonuses larger than their current startups paycheck, a hefty six figure salary that can pay for all of their family’s daily needs and stock that they can immediately start trading.

  • Corporate Development: Just like their recruiting counterparts, the corporate development departments of those same public companies are calling on the management teams of breakaway-growth companies. Their pitch is to bolt onto a larger platform with the resources where the startup can realize its vision. And, to look at the acquisition as a wealth creation event with which the entire team could realize a payday larger than anything they’ve ever seen.     

Here are other indicators that have been observed by our partner Nasdaq Private Market that tend to trigger the onset of an aligned liquidity program.

  • Option plan vesting: A significant percentage of the employee base has arrived somewhere between the company’s standard fourth-year vesting period (or 1.0x of the vesting period) and its sixth year (or 1.5x of the vesting period)

  • Equity grants: The company has granted equity (including ISOs, NSOs, and RSUs) to at least 100 employees

  • Valuation: The company’s valuation is at least $500 million

NPM does not buy or broker employee stock. Rather, NPM provides the leading technology platform, that sits in between seller and buyer, for transacting employee tender offers. Employee tender offers are one of the many aligned liquidity use cases that companies consider.


 
 
 

Typical Profile

Furthermore, for the employee tender offers that Nasdaq Private Market has facilitated with its transaction platform, the following represents a typical profile of those companies they’ve assisted. From 2014 through 2016, NPM facilitated an aggregate value of $3.6 billion in employee tender offers across 82 companies. On average, these companies had been operating in the software industry for eight years with 436 employees, having raised $363 million, and having reached a valuation of $2.1 billion.

Company Profile:
Age: 8   Employees: 436   /  Funding: $363M   /  Valuation: $2.1B   /  Industry: Software

The average deal size of an employee tender was just under $44 million among 113 sellers where 47% percent of the buyers were trusted third parties like Founders Circle. With 27% of the transaction volume being recurring programs, many late-stage private companies choose to offer employees liquidity through a private tender offer once every 12 to 18 months.

Program Profile:
Avg. deal: $43.9M   /  Avg. # of sellers: 113   /  3rd-party buyer: 47%  /  Recurring: 27%
 


 
 
 

It’s A Marathon

During the marathon of life at a startup, some runners won’t make it beyond Mile 22. Some will get to the liquidity exit—the finish line—a bit exhausted and wobbly. Some will stride into it with ease. And some will keep running.

Regardless of their preparation, pacing, and luck, all runners need a proper, marathon-facilitated water station at Mile 21. They all need an extra boost of hydration to get to the finish line—and beyond—with strength.

At Founders Circle, we are proud to provide employees liquidity at those water stations. When thoughtfully designed and effectively implemented, aligned-liquidity programs can orient all stakeholders toward longer-term company building.

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How to Manage an Aligned-Liquidity Firm
 

 
 

Successfully Aligned-Liquidity Programs

Over the last four years, Founders Circle has worked with breakaway-growth companies wrestling with how to conduct an “aligned liquidity” program that balances the needs of their own company, their board directors, their early financial backers, and their employees.

As these companies stayed private longer, they needed new tools to recruit and retain talent, to augment their long-term incentive programs, and to better connect equity compensation with their ongoing work. The ultimate company goal of any aligned-liquidity program was to instill more patience in the building, helping employees to relieve life’s pressure valve, and help re-energize the team’s commitment to working toward (and through) an IPO.    

Together with our partners at Nasdaq Private Market, SVB Analytics, Cooley Law, and Andersen Tax, we have identified and detailed seven steps to facilitating a successful aligned-liquidity program, from identifying the best type of buyer and program structure for common shares to communicating clearly with shareholders.


Step 1
Identify an Optimal Buyer and Structure

When setting up an aligned-liquidity program, a company’s key first step is identifying the right type of buyer, or investment source, for its employees’ shares. An ideal source largely complements the company’s cash position, as well as its tolerance for diluting its cap table or taking on additional liquidation preferences.

Here are a company’s typical buyer options for employee shares:

The Company Balance Sheet

A company uses its existing cash to purchase shares directly from its shareholders.

Through a stock repurchase program, a company can reduce the amount of its outstanding common shares, thereby increasing ownership among all on the cap table. And because there is no third-party involvement, companies that pursue share buybacks benefit from controlling each aspect of the process: which shareholders are eligible to participate (current employees, former employees, executives, investors, etc.), how many shares participants can sell, and at what price shares are offered.

Given the lack of third-party negotiation, share price usually requires the most consideration. A company’s intimate knowledge of financial performance and possession of material nonpublic information will likely raise its 409A valuation.  


Existing Company Investors

A company’s current investors purchase common shares from employees.

Just as these investors did when they purchased preferred shares, they typically invest out of an institutionally raised fund, and they “get paid” upon the company’s successful IPO or acquisition. A current investor submits a term sheet to purchase a certain volume at a certain price, and other existing investors are invited to participate pro rata to their percent ownership of the preferred shares. No investor is obligated to purchase any common shares.  

Companies that use this approach benefit from having buyers who already intimately know the company. Existing investors rarely require further due diligence, and they rarely take issue with waiving a ROFR (right of first refusal). However, they can be conservative in their valuation of common shares—and thus have little incentive to pay a full price—particularly if they perceive little outside competition.

There are two meaningful limitations to this approach. First, many current investors often reserve in their fund an allocation of capital for future preferred-financing rounds. There may be little discretionary capital to increase this allocation in order to purchase common shares. Second, as members of the company’s board of directors, or compensation and audit committees, they are insiders in possession of material nonpublic information about its financial performance and business risks. This knowledge could raise the company’s 409A valuation, personal and business tax levies, and legal liabilities.


Preferred Fundraising Proceeds

A company uses funds from a recent primary fundraise, selling either senior preferred or junior preferred shares, to buy back common shares directly from its employees or to fund a management incentive program.

These buyers generally come from traditional venture, growth investing, or crossover funds whose main business is private equity, hedge investing, or mutual-fund investing. With this approach, the company reduces the number of outstanding common shares and increasing the amount of preferred shares.

Companies that utilize this method combine the benefits of third-party price validation and cash reserves maintenance. They typically incorporate the capital needed to fund the tender into the total amount raised in the primary round. However, they may need to be mindful of the spread between the preferred-share price paid to the company in the primary round, and the per-share price of common stock paid to employees.

Common stock typically trades at a discount to the latest preferred share price. The size of the discount depends on variables such as time and sentiment. The value spread can widen or tighten as the company’s perceived value changes between the preferred round and the buyback.


Company-Approved Third Party

A company-approved third-party buyer—most often a fund whose primary business is investing in either preferred or common shares—tenders an offer to purchase shares directly from a company-approved list of eligible employees.

As with existing investors, third-party buyers typically invest out of an institutionally raised fund, and they “get paid” upon the company’s successful liquidity event (IPO, merger, or acquisition). They can utilize one of two structures: pay the seller the entire purchase price up front, in cash, in exchange for the particular class of stock being sold; or pay once, at the original purchase date, and again, splitting proceeds with the seller, when certain predetermined valuation targets have been realized.

Companies that are particularly sensitive about their 409A valuation tend to choose this latter structure, which pertains only to investment firms like Founders Circle that specialize in purchasing common shares (not GP or LP positions) in secondaries. They get the dual benefit of preventing dilution to the cap table and preventing the introduction of new preference on top of existing investors.  

Third-party buyers typically take longer to conclude an aligned-liquidity program because, as company outsiders, they need to conduct the necessary due diligence to have conviction about business performance and price.

Most breakaway-growth companies decide to restrict their investing partners for secondary sales to a single fund, or a syndicate of two to three funds. In all cases, the funds they add to their “approved-buyer list” must be known, liked, and trusted by management and the board of directors. Companies select these buyers based on their alignment with long-term value creation goals and their ability to add value to the investment syndicate. Selected buyers typically have the flexibility to work on small, unforeseen transactions (such as a share purchase from a departing employee) and larger firmwide tender offers.


Company-Approved Loan Provider

A company-approved loan provider executes a debt instrument to shareholders that is equal to an agreed-upon price per share. In return, participating shareholders pledge shares to the loan provider. This approach is typically used when the seller’s primary motivation is less about selling shares to pay for life’s needs and more about starting the clock ticking on long-term capital gains treatment.

Sellers realize two advantages in this approach. First, because they maintain ownership of their shares, voting rights associated with the shares are preserved. Second, they are not burdened with an immediate tax liability because the shares have not yet been sold.

Like a third-party investor, the loan provider requires a potentially time-consuming due diligence process. Sellers, meanwhile, should be aware of four obligations that accompany this structure. First, as with any loan, they need to service the debt over the loan period. Second, upon the realization of a successful IPO or acquisition, they must sell shares on the open market and then repay the loan. Third, if a successful exit has been not realized, they must repay the loan using some other source at the end of the loan period. And fourth, they understand that the lenders, or guarantors, typically have also negotiated a right to purchase a certain number of shares at a previously agreed upon price per share.
 

Sanctioned and Unsanctioned Brokers

Brokers identify individual common shareholders seeking liquidity and, upon locating a willing buyer, negotiate a transaction directly between the employee and the investor. Brokers get compensated through fees for their intermediary services.

Once the broker and seller have reached an agreement on volume and price, the broker approaches the company to seek a waiver on the ROFR it typically holds. With a waiver in its pocket, it then matches shareholders with individual investors or other types of buyers. When numerous buyers are involved, the broker sometimes organizes them into a single special-purpose vehicle. Sellers taking this approach rely on the broker finding and effectively managing willing buyers to close the intended transaction.

Companies taking a hands-off approach to help maintain a lower 409A valuation sometimes sanction the involvement of specific brokers. In authorizing separately brokered transactions, they indicate that they have no intention of exercising authority over participants, selling volume, or price (even if that price varies from seller to seller). Subsequently, they have no intention of sharing company financials with either the seller or the buyer, which ultimately results in uninformed purchase decisions.

More often, unsanctioned brokers utilize opaque means of matching sellers and buyers, including derivative instruments and online marketplaces, to secure transactions without company knowledge or approval. The company then struggles to identify the parties involved, prevent further transactions, and regain control of the shares.

Should the company learn the identities of the unsanctioned sellers, buyers, or brokers, it could take a number of legal and punitive measures against the participants. For example, citing a seller’s signed employment agreement, it could revoke all of the seller’s vested and unvested shares, rendering his wealth opportunity $0.


Step 2
Set eligibility and restrictions

When facilitating employee tender offers, companies are able to establish and control the program participants, sale parameters, and share price. They can ensure that secondary share transactions align with their goals.

Here are the typical rules Founders Circle and its partners, while helping execute scores of aligned-liquidity programs, have observed around eligibility and restrictions:

Eligibility

Eligibility rules vary based on the types of shareholders and outstanding securities. There are four main types of shareholders eligible to sell shares in a private tender offer:

  • Current founders or executives

  • Current non-executive employees

  • Early financial backers (friends and family, angels, boutique venture firms)

  • Former employees

Companies typically establish different sales limitations for each of these shareholder groups based on shareholder expectations and the total number of shares they plan to sell through the program.

When buyer interest is in the range of $10 million to $50 million, companies generally favor limiting eligibility to current employees (founders, executives, nonexecutive employees). For programs in excess of $50 million, companies generally open the offer to all shareholders, including early financial backers and former employees.

Some companies have also run initial programs for former employees, to prevent an array of unsanctioned brokers from representing shares to unknown and untrusted buyers. In some cases, their finance and legal teams were already processing ROFR notices and dealing individually with shareholder issues. In short, they felt a need to shift resources back toward accretive activity and wrestle back control of former employees’ shares.
 

Selling restrictions for founders and executives

While the absolute dollar volumes of shares that founders and executives generally sell tend to be quite high, they generally are restricted to selling a smaller percentage of their vested equity than other shareholder groups.

Enforcing limitations on founders and executives can send a positive signal to nonexecutive employees. Companies typically limit share sales of founders and executives to 10 percent of total vested holdings. They often also place an absolute dollar limit across tender offer participation.
 

Selling restrictions for non-executive employees

Companies that allow current employees to participate in private tender offers typically set selling restrictions at 10 percent to 25 percent of vested options and common stock. Allowing employees to sell up to a fourth of their vested equity can provide meaningful liquidity without skewing the incentive structure of equity grants.

Current employees typically receive preference over other groups of shareholders in cases where the tender offer is undersubscribed (i.e., more shares are offered than there is demand to buy them). In this scenario, current employees are generally able to sell all of the shares they choose to tender, with proration imposed on other shareholder groups.


Selling restrictions for former employees and early financial backers

Former employees and early financial backers see the most variation when it comes to selling limitations. The majority of companies Founders Circle works with enforce an all-or-nothing requirement on these groups of shareholders, allowing them to participate only if they sell 100 percent of their vested equity holdings.

Before the JOBS Act removed the 500-shareholder limit, companies strategically used all-or-nothing requirements to decrease the number of shareholders on their cap table. Despite regulatory changes, these aligned-liquidity programs seem to remain a popular way to replace shareholders who no longer have a vested interest in the company and might be looking into other ways to sell their shares.

For aligned-liquidity programs that do not impose the all-or-nothing sale limitation, the restrictions for former employees and early investors range from being ineligible to participate to being limited to sell 50 percent of vested holdings.


Step 3
Set a Price

Establishing a value for common shares is the cornerstone of any aligned-liquidity program. An overly simplistic framing is that pricing is banded with the 409A valuation as the floor and preferred-stock valuation as the ceiling. Then, using public company comps for revenue or earnings multiples, price could be set by applying these multiples to the private company’s forward projections.

Not surprisingly, the actual “algorithm” is more nuanced.

Just like investors who are considering buying preferred shares, investors considering common shares generally weigh the share price against the company’s market conditions, business model, competitive moats, and management quality. But buyers of common shares must take into account other factors:

  • Degree of financial information disclosure provided by the company

  • Actual financial performance of the business

  • Probability of performance sustainability

  • Existence of liquidation preferences held by current investors

  • Probability of future preferred fundraises

  • Sensitivity to influencing the 409A valuation

  • Amount of time since the last 409A audit

  • Amount of time since the last preferred financing round

  • Amount of time until the likely IPO or acquisition liquidity event

  • Current revenue or earnings multiples for comparable public companies

The reason for such scrutiny is because buyers of common would rest at the bottom of the cap table below senior debt and preferred shares. The implication is that, in austere circumstances, debt holders and preferred investors will get paid first where it’s possible that the value of common could be rendered worthless.

Regardless where price gets set, there is the opportunity to enhance the seller’s overall price/share through various profit-sharing mechanisms (e.g., straight splits, appreciation rights) based upon multiple thresholds realized upon a successful liquidity event.


Step 4
Investigate impact on the 409A valuation

Each buyer type and associated price offered for common shares renders a different impact on a company’s 409A valuation, which in turn helps establish the price of common stock. Because companies use common stock to retain and recruit employees—the lower the 409A, the higher the number of shares a company can offer each recruit—company managers highly consider how an aligned-liquidity program might impact its 409A valuation.

According to our partners at SVB Analytics, the market share leader in 409A audits, how a company lines up with respect to each of the 10 variables charted below helps determine the impact of an employee liquidity program on its 409A. A company’s unique fact patterns result in a combination of “Lower Impact” and “Higher Impact” determinations.

CHART TO COME

A few of these variables have been plotted along the simple graphs below. A particular decision might have a lighter or heavier impact the 409A valuation.  

These graphical representations provide only directional guidance. Plotting a company’s situation along all 10 variables is like handling a Rubik’s Cube; each turn can have a lighter or heavier weighting on the 409A.

One example is the nuance around whether a buyer is an outsider or insider. Insiders generally have a greater impact on the 409A valuation, given their access to material nonpublic information. However, if an insider’s motivation is to buy more ownership at a price lower than what it paid in the last round of preferred, while an outsider’s motivation is to simply to get into the deal at any price, then an auditor might determine that the outsider would have a greater impact on the 409A.

To properly analyze the matrix of 409A influencers, companies considering aligned-liquidity programs should engage with qualified counsel. The American Institute of CPAs and the Equity Securities Task Force have developed a Practice Aid that provides “patterns of trades” guidelines for weighting the impact of an employee liquidity program on the 409A. It guides 409A auditors along three broad levels:

  • Level 1: absolute data + corroborative market evidence = fair-market 409A value impact

  • Level 2: observable data (not directly applicable) = de minimis 409A value impact

  • Level 3: unobservable data (can’t be corroborated) = maintain 409A value

Level 1 is the significant threshold of interest to company management. A company might expect to have crossed the Level 1 threshold, where the 409A would likely be marked up to fair-market value, if an employee liquidity program is deemed as:

  • organized in an orderly manner by the company

  • priced and led by current preferred investors who have full access to company information to conduct robust due diligence

  • part of a recurring program of consistently priced employee tender offers

Most employee liquidity transactions tend to not reach the Level 1 threshold, as the characteristics are typically limited by the number of sellers, frequency of sales, and repetition of price.


Step 4
Prepare Required Company Disclosures

In 2015, Congress signed into law Section 4(a)(7) of the Securities Act of 1933, a new federal safe harbor for resales of restricted securities. For a resale to be eligible for exemption from the registration requirements outlined in Section 5, a company must provide the following 12 disclosures about itself to transaction participants:

  • Business definition: description of business, products, and services

  • Business address: address of principal office

  • Historical financial statements: a P&L for the past two years, prepared in accordance with U.S. GAAP or IFRS

  • Current financial statements: a P&L dated within six months of the transaction date

  • Shares outstanding: total number of shares outstanding as of the most recent fiscal year

  • Security type: title and class of security

  • Security maturity: affirmation that the class of security being sold has been outstanding (and not offered by any form of general solicitation or general advertising) for at least 90 days

  • Security value: par value of the security

  • Issuer identity: exact name of the issuer of common shares, distinct from the seller, and where the seller is neither a direct nor indirect subsidiary of the issuer; where the seller is a control person of the issuer (director, officer, holder of 20 percent or more of voting securities) the company is to provide certification stating that it has no reasonable grounds to believe that the issuer is a bad actor

  • Fiduciary identities: names of officers and directors of issuer

  • Buyer identity: name and address of “accredited investor,” as defined in Securities Act Rule 501(a), and name of broker-dealer or agent (if involved) paid for transaction participation

  • Transferring agent identity: name and address of transfer agent or person responsible for transferring shares and stock certificates

In more than 75 percent of aligned-liquidity programs facilitated on the Nasdaq Private Market, participants were provided with U.S. GAAP financial statements and basic company information. Companies offering programs through Nasdaq’s technology platform generally provided at least Rule 701-level disclosure to participants.

Disclosure requirements aim to ensure that a company is not exploiting any potential information asymmetry between seller and buyer. By ensuring that all participants access the same information, disclosures significantly reduce the company’s legal liability.


Step 5 
Provide Access to Information for Due Diligence

Most professional investors require access to business structure and performance information before submitting a term sheet. Those who do not require this information, more often than not, intend to offer a deeply discounted price for common shares to offset their risk of making a blind purchase.

Access to the following information sources typically enables investors to conduct sufficient due diligence on the investment opportunity:

  • Investor presentation

  • Current board presentation

  • Charter, bylaws, and investment agreements

  • Financial statements (P&L, balance sheet, cash flow)

  • Capitalization table

  • Access to CEO and/or CFO


Step 6
Determine the Legal Implications

Given that a seller of common shares is seeking to sell restricted stock, meaning stock that is registered with the Securities and Exchange Commission and applicable state authorities, there are three main legal considerations that a company needs to manage in order to minimize the probability of a future legal claim by the seller or buyer.

Stock Transfer Restrictions & Rights

  • ROFR and Co-Sale: These mechanisms are held by both the company and the senior preferred investors and are designed to control, and sometimes block, the transfer of shares. The Right of First Refusal (ROFR) allows the company, first, and then the current investors to match or exceed the price offered by an outside investor and then become the purchaser of the seller’s common shares. The Co-Sale allows the company, first, and then the current investors to sell a prorata portion of their preferred shares to the outside investor at the same terms offered to the seller of common shares.

  • Regulation D, Rule 501: Allows seller of restricted stock to resale shares if sold to an accredited investor.

  • Rule 144: Allows seller of restricted stock to resale exercised shares if held for at least one year after the exercised date. Also allows buyer to purchase restricted stock after receiving current company information.

  • Section 4(2): Waives registration requirements of restricted securities if sold to an accredited investor.

  • Registration Rights: Gives investors the power to require the company to register the common stock issuable upon conversion of the investors’ preferred stock with the Securities and Exchange Commission

  • Preemptive Rights: Refers to the shareholder’s right to purchase a company’s new shares, prorata to their ownership with other investors, before they are offered to anyone else. This right can be transferred between seller and buyer in an aligned-liquidity program, but, must be expressly requested in a separate transfer agreement.

Information Sharing / Buyers Beware

  • Current Investors: Preferred investors, who currently sit on the board of directors, should exercise caution when purchasing employee’s common shares or an early financial backer’s junior preferred shares, particularly if they are not privy to material non-public information (MNPI) about the company. For instance, if the purchasing board member has knowledge of a possible offer to acquire the company or a likely material strategic partnership will be formed by the company, they place themselves and the company at significant risk of a legal claim by a seller should these events come to fruition and meaningfully increase the value of the price/share. Optically, this risk still exists even if there was no MNPI at the time of purchase but an event of this nature occurs within a reasonably short time period after the purchase.

  • Brokers: Federal and state laws require brokers to be properly registered. When brokers are utilized in an aligned-liquidity program, and they unliscensed, a seller can lodge a legal claim that would likely result in the rescission of the sold common shares which would, in turn, likely lead to damages law suits by both the seller and buyer against the broker and the company.  


Step 7
Determine Tax Implications for the
Company & Participants

Companies facilitating aligned-liquidity programs generally steer away from giving—or appearing to give—tax advice to their employees. Instead, they hire specialists such as our partners at Andersen Tax to help companies and interested participants consider the taxation issues around each type of stock issuance:

  • Incentive stock options: ISOs, typically given in a startup’s early days, have comparatively favorable tax treatment and flexibility to other types of options. At the time you exercise your options, you pay only the exercise price, regardless of how much the market value has risen. This gives employees time to plan. But because companies are generally allowed to issue only up to $100,000 in ISO value per year to an employee, they can’t issue very many ISOs beyond their early days before reaching that cap.

    • Employee implications: If you are given ISOs, have the money to pay the exercise price, and are bullish on the company, it’s no-brainer to exercise at any time.

  • Nonqualified stock options: If the market value exceeds the exercise price of your NSOs, then you have to pay corresponding taxes. As a result, employees very rarely exercise these options as company value is rising before a liquidity event such as an IPO or acquisition.

    • Employee implications: If there is little difference between the exercise price and fair-market value, and you have the money to exercise, it’s a no-brainer to exercise early. Otherwise, you’ll likely wait for an IPO or acquisition.

  • Restricted stock units: Once RSUs vest (the standard vesting time is after four years), they are treated as compensation subject to taxes. When the company’s stock becomes liquid in an IPO or acquisition, employees can sell them on the public market.

    • Employee implications: You must wait until the stock is liquid to do anything with your RSUs. And once they have vested, you pay taxes on them.

  • Restricted stock: In general, restricted stock comes with favorable tax treatment and flexibility to options. Like ISOs, however, companies are generally allowed to issue only up to $100,000 in restricted-stock value per year to an employee. As a result, it is usually issued only to founders but sometimes also to early employees and advisers.

    • Employee implications: Your company probably won’t require you to pay the exercise price (as you would with an option) but will require you to pay the associated taxes.

Companies facilitating these programs also must consider the following high-level questions, with respect to taxes:

  • Is the company properly accounting for the exercise and sale of NSOs (nonqualified stock options) and ISOs (incentive stock options) on its books? It must have people in place who can handle potential issues, such as expenses related to pre-IPO exercises of NSOs, and help employees understand the tax implications of what they have been issued, such as ISOs vs. RSUs. Shareholder knowledge is important.

  • Are there company restrictions around transferring stock for estate-planning purposes? Some companies, in high contrast to Facebook prior to its IPO, might go to great lengths to manage their cap table, restricting employees from transferring stock to even other members of their family. Others might create separate classes of stock, with one class having a disproportionate amount of voting control. Employees should understand the dynamics and be prepared to work with them.

  • Could a participant sell at a price above the 409A value? If so, how are amounts above the 409A value treated for tax purposes? If you sell your stock at a price that exceeds the value of the common stock, or the 409A valuation, the corresponding gains could be considered compensation income or capital gains—a point of contention among auditors and attorneys. Because these differences are potentially material, companies and shareholders should have a common understanding of how these gains are handled.

  • Would this participant qualify for QSBS (qualified small business stock) benefits? Is he fully aware of the related rules and qualifications? If you acquire stock options as an early employee in a startup, and hold them for five or more years, you could potentially exclude up to $10 million in capital gains through QSBS benefits. This is the biggest tax opportunity that someone could have at a small company. Many people at startups aren’t aware of this opportunity, a leading reason to hold off on exercising your options.

  • If this participant can sell a specific amount of shares through the program, would it be existing shares or unexercised options? What are the tax implications of each type of sale? In considering participation in an aligned-liquidity program, you want to take on the lowest tax liabilities possible. In some cases, you might face lower taxes by selling unexercised options; in others, you might need to hold off for five years to take advantage of QSBS benefits. In any case, you should be aware of your options and the ramifications of your actions.

  • Does this participant understand the rules for estimated tax payments for federal and state purposes? When participating in an aligned-liquidity program, you need to understand when you owe the taxes that correspond with the sales. Depending on when the sales are enacted, and whether you are required to pay estimated taxes, you might be able to hold off on paying them for up to 14 months, during the next tax cycle.

  • If this participant is ever audited, would she have the necessary documentation associated with this program, including stock certificates and purchase agreements? If you sell something, that means that you bought it or were given it at some point. And if you are audited, you will need documentation to support the timing, pricing, and terms of each transaction.


Step 8
Prepare for Strong Communications

Because the aim of any aligned-liquidity program is to instill greater patience among all stakeholders, thoughtful communication with potential participants is essential. Companies should seize the opportunity to further shape the vision and culture of the company. The communication endeavor has two sides: celebrating and setting expectations.

The celebratory aspect—about 20 percent of the total communication about the tender offer—involves managers and directors praising how the team has unflinchingly and exhaustively been building the company for the past handful of years. It is designed to re-energize the team and acknowledge that there is still a great deal of good work to be done; everyone needs to set their sights on the IPO horizon and beyond. It moves into an acknowledgement that “life happens” and says they’ve earned the right to ease those pressures.

The other 80 percent of the communication is about setting expectations: A private tender offer is not an opportunity to cash out and head to the beach. It’s not a value-maximizing or duty-distracting exercise, either.

Program participants, according to the expectation-setting portion of the communication, should sell only what they need. They should be sober in their understanding that they are foregoing economic upside by selling now, and that acquiring and selling comes with a tax obligation on their part. They should not expect this program to become an “annual ATM” event; it must be periodically evaluated as to whether such a program continues to align with the company’s goals.

Companies facilitating aligned-liquidity programs typically hold all-hands meetings during which they help team members understand the “market value” for their shares. Along with third parties they bring in, they ensure that employees have the information and resources to understand the balance of their decisions with the goals of the company. They emphasize that sellers need to seek the counsel of legal and tax advisers to ensure that they’re appropriately balancing their own risks.


Conclusion


by Mark Dempster to come.

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