PART II HOW
- Step 1: Buyer & Structure
- Step 2: Eligibility
- Step 3: Set a Price
- Step 4: 409A valuation
- Step 5: Disclosure
- Step 6: Due Diligence
- Step 7: Legal Implications
- Step 8: Tax Implications
- Step 9: Communications
Why Late Stage Startups Need Aligned Liquidity
Historically, most successful Silicon Valley startups generally spent their first seven or so years getting to $100 million in revenue. At that point, they’d go public or get acquired, and their early employees could cash in on vested stock options, amassing considerable wealth before facing many of life’s major personal financial obligations.
The market has changed, and those days are in the industry’s rear-view mirror.
Today, startups performing well enough to pursue a public offering, merger or acquisition—those we at Founders Circle categorize as #breakawaygrowth companies—are generally staying private and independent for an average of 11 years. While this elongated timeline arguably has been good for the business, it has reduced the effectiveness of stock option programs, which are designed to incentivize the team to continue patiently building the company.
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 at conflict with the company’s best interests.
Company managers and directors might be making a rational decision in putting off the company’s IPO. But shifting the expected exit window from seven 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.
Late-stage private companies have increasingly been helping early employees execute secondary sales of their vested stock, realizing that giving these employees just enough liquidity to solve for life’s needs allows them to refocus on long-term company building. But, in doing so, they’ve been 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 greatly appreciate the contributions of Nasdaq Private Market’s data and points-of-view from Solium, Cooley, Goodwin and Andersen Tax.
A Liquidity Sea Change
A decade ago and longer, high-performing late-stage private companies had plenty of reasons to go public or sell themselves at year seven; solving for employee liquidity was not among them.
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.
Today, several market dynamics 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, in which one of the provisions allows for an increase in the private company shareholder limit 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 many 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 the 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, we believe that the vast majority of value will have been created by fewer than 500 of them, or just one 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. These are companies that have the ability to go public today, but choose not to do so.
But what about their hard-working team members? Management teams and directors are increasingly embracing secondary stock sales as a means to keep everyone patient until such time that an IPO suits the company.
From 2014-Q1’17, 111 companies conducted employee tender offers on the Nasdaq Private Market platform, with an average deal size of $41.5 million across an average of 109 sellers, cumulatively worth more than $3.6 billion.
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: In many cases, founders and early executives may start working at the company when they are single—and living, almost literally, at the office. After seven years at the company, they are more likely to be married, raising kids, and juggling meaningful obligations outside work. They may 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.
However, in order to avoid the Facebook “Wild West” secondary situation, most companies have implemented stringent policies restricting secondary stock sales, including requiring board approval for the sale of any employee shares, whether through individual transactions or broad-based programs. These policies often impose penalties on employees who attempt to sell or pledge their shares without company consent, and they may give the company a right of first refusal, or ROFR, with respect to the purchase of any available employee shares.
Risk: In absence of liquidity, founders might find themselves entertaining merger or acquisition overtures, or executives might succumb to the recruiting enticements of a public company.
Current Employees: Employees who are vested in some or all of their stock options, often a very large group, may also be experiencing their own life moments. However, they need to have the cash on hand to both exercise the stock and pay the associated tax obligation.
Risk: Lacking liquidity to pay big bills, they might find themselves drawn to an employer dangling higher compensation.
Long-term Employees: Current employees who joined the company early on might be approaching a federally mandated 10-year option expiration wall.
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 the date on which the options were granted, the options will automatically expire and get absorbed back into the company. There is nothing a company can do to extend this timeline.
Risk: As the deadline nears and the pressure to not lose the shares mounts, long-term employees 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.
Risk: Seeking a financial windfall, they might start advocating for a sale.
Investment firm: Likewise, an investment fund might have been an early investor in the company and could now be pushing against the end of the fund’s life.
Risk: 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: When employees need to (or are asked to) depart from a company, they generally have 90 days to exercise 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. This policy is generally applied by the company on a case-by-case basis, and the company may extend this expiration timeline for certain exiting employees.
Risk: For the most part, former employees are held to a 90-day exercise period. During this very short window they might be compelled to seek buyers—possibly neither known by nor approved by the company—for their shares. The company may then have a ROFR thrust upon them to which they or their investors need to either purchase those shares themselves or waive their purchase rights.
Brokers: In each of the above scenarios, management might authorize a broker to help a seller sell its shares on the open market. On the other hand, a broker may, through various means, get their hands on a company’s common shares without the company’s prior approval and post such shares on a variety of listing sites.
Risk: In the case of a broker that is not engaged by the company, company executives might not have any insight into who is obtaining the shares, posting them, selling them, or buying them. And the company often has little or no ability to reacquire those shares as their own or control who buys them.
Liquidation Preferences: Companies continuing to raise money privately can sometimes be pressured by late-stage investors to issue stock with liquidation preferences that, upon the company’s exit, get paid before, and sometimes in multiples to, earlier preferred investors and common shareholders. Typically, these liquidation preferences are tied to M&A exits (an IPO exit would generally wipe-out these provisions, assuming the company’s public listing achieves a minimum valuation threshold).
Risk: 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. In the event a company’s employees become aware of these liquidation preferences, retaining them could become an impossible task because the employees’ shares/options, which are intended to incentivize, are perceived to be worth less as a result.
Empathy & Encumbrance
Company executives and board directors are not blind to their employees’ liquidity struggles. They can plainly see the pressures under which their employees are operating. However, despite their empathy for the situation, loosening the reins on secondary sales often 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 usually antithetical to the company’s desire for control.
- Team Resources: Facebook’s 2010 pre-IPO secondary stock sales highlighted 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 inundated with ROFR notices and dealing with individual shareholder issues. In short, resources could shift toward non-accretive activity.
- Employee Focus: Building a breakaway-growth company requires keeping a laser focus on meaningfully moving the business forward. Often, employee liquidity 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, often serving on their compensation or audit committees, they possess material nonpublic information, they approve 409A valuations, and they often continue to buy company shares at the most recent valuation associated with a preferred round of fundraising. As discussed below, purchasing common shares from employees could greatly impact the company’s 409A valuation which could, in turn,par 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 at a price that reflects a material increase in the price per share, the company could be vulnerable to a legal claim by the sellers.
Lacking the Cash
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 disposable cash on hand to pay the associated costs.
- Exercise Price: Employees must cover the pre-set exercise price, or “strike price”, of each share of common stock they were granted. An option’s exercise price is determined based upon the company’s valuation at the time the option is granted, so an early employee’s exercise price could be relatively insignificant.
- Taxes: The taxes associated with exercising one’s options, by contrast, can be a breathtakingly high dollars-per-share figure. Incentive stock options (ISOs) are taxed at the time they are exercised, and the shares acquired through such exercise are taxed again upon their sale after the company’s exit.
The tax associated with exercising vested ISOs is assessed on the difference between the strike price and the value of the common stock at the time of exercise (i.e., the “409A price,” which represents the auditor-assessed value of the company). If vested ISOs are exercised when the company’s valuation is skyrocketing (often during years seven through 12), this can amount to hundreds of thousands of dollars of tax obligations on illiquid stock that can’t be sold due to company policies. Note that there are different tax treatments for incentive stock options (ISOs) and non-qualified stock options (NSOs) (as outlined on p. 27).
- Fees: If a broker is involved, whether sanctioned by the company or not, there is generally a broker commission on the ultimate sale (typically five percent), which eats up at least some of the cash obtained in the transaction that might otherwise offset the payment of exercise price and taxes. This operates much like when a homeowner pays her real estate agent a commission upon the sale of her house.
Attempts to be Helpful
Goodwin Procter has observed their clients explore several approaches to assisting cash-strapped employees. However, each comes with its own set of complications:
- Do Nothing: After all, the employees had years to elect to exercise their options and pay the associated taxes, particularly when both the strike price and the value of the company were low. The problem with this hard-lined approach is that the options are likely held by people who are valuable to the company.
- Cashless Exercise: A company could facilitate a cashless exercise via a company buy-back. Employees basically use some of the shares they exercise to cover the exercise price. The company could then allow employees to redeem or sell more shares to pay their taxes. But the company is basically purchasing shares at that point, which is real money coming out of the company’s balance sheet.
- Promissory Note: A variation on the cashless exercise approach is for the company to allow option exercises using a promissory note. Basically the company loans the employee the money for the exercise price and taxes. But again, the company would have to use its balance sheet for the taxes. It’s not a cash-free transaction. A further complication is that a company can’t hold its IPO if it has any outstanding loans to officers or directors.
- Give Bonuses: A company could give bonuses to employees to cover the exercise price and taxes. Again, this is cash coming out of the company balance sheet. Furthermore, a company can’t require that the bonuses be used to exercise options because that would raise a 409A problem; if an employee would rather use those funds for something else, that has to be allowed.
- Grant New Stock Options: In situations where long-term employees are about to have their stock options expire at the 10-year mark, the company could grant new stock options. But those new options must be reset at an exercise price that is equal to current market value.
- Give RSUs: A variation on the approach of granting new stock options is for the company to grant restricted stock units (RSU) for an equivalent (or lesser) number of shares as those underlying the expired option. RSUs are assigned a fair market value at the time they vest, and only then are they are considered income to the employee (as opposed to being treated as income at the time granted). A portion of the shares may be withheld to pay income taxes; the employee then receives the remaining shares and can sell them at any time.
The problem with this approach is that companies and employees often have a hard time agreeing on the terms of the conversion, namely around what is the value of a share of stock and how many ISOs equal how many RSUs.
Triggers for Aligned Liquidity
The reasons “why” aligned liquidity is important were delineated in “Misalignments in the Building”. And, in “Empathy and Encumbrance”, we describe how executives clearly see that their employees’ 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 the exercise of their options and pay the resulting taxes. And employees aren’t terribly warm to most of the options available to the company to solve for this issue, as outlined in “Attempts to be Helpful”.
This is why Founders Circle has seen a steady uptick in management and their boards wanting to authorize aligned-liquidity programs. But, next they grapple with the “when” question – when is it the right time to conduct such a program? Founders Circle has observed that any one or more of the following circumstances tend to be a trigger for companies to elect to facilitate an aligned- liquidity program, whether for an individual or broad-based:
- 40 Rule: Companies that are 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 that are most likely to go on to one day comprise the majority of the technology market cap. The average business performance of the companies Founders Circle serves is as follows (as of 6/30/17):
- Age: Typically, the companies are five to seven years old and intend on remaining private for another three to five years. Thus, a meaningful portion of the employees have vested in 100% of their stock options, and there is a risk that they might begin looking elsewhere to increase their wealth-creation opportunity.
- Pressure Valve: A sizable group of early employees (many of whom may have 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), are now married with kids and burdened with financial obligations – getting their family into a house, enrolling their kids into school, paying-off their debts, or covering a family member’s medical needs or, unfortunately, settling matters when life doesn’t go quite as hoped for. All of these situations can cause significant distractions at work or prompt an employee to seek out a new job opportunity with higher compensation.
- Poaching: When a private company has reached this level of success, it attracts the attention of public technology companies that 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. Employees are being enticed with signing bonuses larger than their current paychecks, a hefty six figure salary that can pay for their families’ 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 to pitch merger or acquisition transactions, highlighting how desirable it would be to bolt the startup onto a larger platform with the resources for the startup to realize its vision. In addition, they emphasize how a merger or acquisition would be a wealth creation event in which the entire team could realize a payday larger than anything they’ve ever seen.
Nasdaq Private Market (NPM) has identified a few more triggers that tend to set in motion aligned-liquidity programs, and in particular, employee-wide tender offers. Tender offers are one of several aligned liquidity use cases. However, given the typical volume size of this use case, we thought it might serve as something of a proxy for the other use cases.
NPM does not broker or buy the common stock underlying a tender offer. Rather, NPM provides the leading technology platform that sits in between the seller and the buyer in a tender offer, facilitating the satisfaction of the legal, regulatory and financial administration requirements relating to the tender offer. In the event that Founders Circle is engaged by a company’s management team to price and lead the purchase of common shares in an employee-wide tender offer program, the actual transactions between the sellers and Founders Circle would occur on the NPM platform.
NPM has observed the following baseline characteristics of companies that conduct employee-wide tender offers:
- 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
Furthermore, the following represents the common characteristics of the 111 tender offer programs which ran through the NPM platform from 2014 through Q1’17.
The NPM has reported that nearly half of the buyers in tender offers are trusted third parties, like Founders Circle, and just over a quarter of the transaction volume relates to recurring programs, in which a late-stage private company conducts another employee tender offer within 12 to 18 months.
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.
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 co-authors at Solium, Cooley Law, Goodwin, and Andersen Tax, and using data from Nasdaq Private Market, we 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.
Identify an Optimal Buyer & 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 may choose to use 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 the ownership percentages of all other equity holders remaining on the cap table. Because there is no third-party buyer, 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 repurchased.
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 Investor
A company’s current investors may purchase common shares from employees.
Typically, the “lead investors” in these programs are the company’s institutional investors. Just as these investors did when they purchased preferred shares, they typically invest through an investment fund, and they “get paid” upon the company’s successful IPO, merger 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 “full price”—particularly if they perceive little outside competition.
There are two meaningful limitations to this approach. First, many investors that are institutional funds reserve an allocation of capital for future preferred-financing rounds. There may be little additional 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 the company’s 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 may choose to use funds it receives from a recent private financing, in which it sells either senior preferred or junior preferred shares, to buy back common shares directly from its employees or to fund a management incentive program.
The participants in the private financings that fund these types of repurchases 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 increases the number of outstanding 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 generally utilize one of two structures: (1) make a single payment to the seller of the entire purchase up front, in cash, in exchange for the particular class of stock being sold; or (2) make two separate payments—one upfront at the time of purchase, and one later, at the time a liquidity event occurs, effectively splitting the proceeds obtained in the liquidity event with the seller based upon certain predetermined valuation targets.
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, one-off transactions (such as a share purchase from a departing employee) and larger, employee-wide 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 a third-party 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 where sellers pledge to sell their shares after a liquidity event and online marketplaces designed to secure transactions without the company ever finding out. 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, thus effectively eliminating any value of such equity to the employee.
Set Eligibility & 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 has observed around eligibility and restrictions in the course of helping execute scores of aligned-liquidity programs:
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)
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.
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 the preferred stock valuation as the ceiling. Then, using public company comparables for revenue or earnings multiples, a price is 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, including:
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 common stock rests at the bottom of the cap table, below both senior debt and preferred shares. The implication is that, in austere circumstances, debt holders and preferred investors will get paid first, and it is possible that the company’s common stock could be rendered worthless.
Regardless of where the price gets set, there is the opportunity to enhance the seller’s overall price/share through various profit-sharing mechanisms (e.g., straight splits and appreciation rights), which are based upon multiple thresholds realized upon a successful liquidity event.
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 valuation, 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 the 409A experts at Solium, the market share leader in 409A valuations, 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 valuation. A company’s unique fact patterns result in a combination of “Lower Impact” and “Higher Impact” determinations.
A few of these variables have been plotted along the simple graphs below. A particular decision might have a lighter or heavier impact on 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 small or large effect on the 409A valuation.
Within this illustration, the issue on whether a buyer is an outsider or insider is very nuanced. Generally, the sales price in a transaction in which the buyer is an insider has a larger impact on the 409A valuation, given the buyer’s access to material nonpublic information. However, if an insider’s motivation is to obtain more ownership at a price lower than what it paid in the last preferred stock financing, 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 valuation.
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 a company’s 409A valuation. 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.
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 of the Securities Act of 1933, 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.
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:
Current board presentation
Charter, bylaws, and investment agreements
Financial statements (P&L, balance sheet, cash flow)
Access to CEO and/or CFO
Determine the Legal Implications
Given that a seller of common shares is seeking to sell restricted stock, meaning stock that is not registered with the Securities and Exchange Commission and applicable state authorities, there are legal considerations for management teams and board directors to be mindful about. Cooley Law firm has considerable experience helping private companies and individual team members conduct aligned-liquidity programs in a manner that is compliant with federal and state regulations as well as making companies aware of any potential legal liabilities to which they may be exposed in connection with the program.
What follows is Cooley’s observations around three key legal considerations. However, each company’s circumstances are unique. It is in a company’s best interests to seek legal counsel on exactly how to proceed with any aligned-liquidity program.
Stock Transfer Restrictions & Rights
Private company stock is typically subject to transfer restrictions that are designed to give a private company some control over who owns its stock. Transfer restrictions are also imposed by the SEC to ensure that owners of private stock are accredited investors and, should there be a transfer of stock, that the transfer is not viewed as a company-sponsored underwriting, which would trigger registration requirements under federal and state securities laws.
The provisions for stock transfer restrictions and rights are typically contained in the investment documents or bylaws of a company, in its certificate of incorporation, and under certain SEC regulations. Below is an abbreviated outline of some typical provisions.
- 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. A co-sale right allows the company, first, and then the current investors, to sell a pro rata portion of their preferred shares to the outside investor at the same terms offered to the seller of common shares.
- Regulation D, Rule 501: Sets out the definitions used in Regulation D, which allows sellers of restricted stock to sell such shares to accredited investors.
- Rule 144: Allows sellers of restricted stock to resell exercised shares if held for at least one year after the exercise date. Also allows buyers to purchase restricted stock once they have received financial performance information from the company.
- Section 4(2): Provides for an exemption from registration requirements of restricted securities if sold to an accredited investor.
- Preemptive Rights: Refers to shareholders’ rights to purchase a company’s new shares, on a pro rata basis in proportion to the respective ownership percentages of all shareholders, before the new shares are offered to anyone else. This right can be transferred between sellers and buyers in an aligned-liquidity program, but any such transfer must be explicitly documented.
Symmetry of Information Sharing
While it is not legally required for a private company to share its financial performance with either the seller or the buyer, Cooley has observed that private companies are well-served to do so from a liability perspective. Before disclosing any such information, the company should secure a nondisclosure agreement (NDA) with all parties to ensure the confidentiality, and limit the use, of the company’s confidential information.
Management will find that different buyers will request or require different levels of information disclosure—everything ranging from no information disclosures to full disclosure (outlined in Step 6). Generally, quality buyers request more information than unsophisticated buyers.
Under any scenario, it is in the company’s best interest to provide a symmetry of information sharing to both the seller and the buyer. This way, the company establishes a fact pattern of ensuring that all parties are making an informed decision based on the same information, and that no party was advantaged over the other.
The form factor of sharing information ranges as well. It can be as simple as all parties getting the same presentation at the same time. Or, it can be as robust as providing a data room where each eligible participant is at liberty to review a range of documents (outlined in Step 4 on p.20).
Exposure to Legal Liability
- Current Investors: Preferred investors, who currently sit on the board of directors, should exercise caution when purchasing an employee’s common shares or an early financial backer’s junior preferred shares, particularly if the sellers are not privy to material nonpublic 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 involving 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 company.
- Brokers: Federal and state laws require brokers to be properly registered. When brokers are utilized by the company in an aligned-liquidity program, and the broker is not properly licensed, a seller may make a legal claim that could result in the rescission of the sale, which would, in turn, likely lead to legal actions by both the seller and buyer against the broker and the company.
Determine Tax Implications for the
Selling Employees & Company
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 Andersen Tax, to help the company and eligible participants consider the taxation issues around each type of stock issuance:
Different types of equity compensation, at different growth points, optimizes the value to employees.
- Restricted Stock: Restricted stock is typically granted to the earliest team members—founders, engineers, advisers—typically before the first round of institutional financing. The benefit of restricted stock is its favorable tax treatment. If an election under Section 83(b) is properly filed, restricted stock that is subject to vesting will be taxed at the time such stock is granted, rather than at the time of each vesting event. As a result, rather than paying tax each year as the stock vests (and as the company’s value increases), the employee pays all of the tax up front, based on the value of the stock at the time of grant. This is good news for employees because the value of the stock at the time of grant is generally in single-digit pennies/share, and as a result, the resulting tax is usually close to zero. Note that if such election is made, it must be filed within 30 days of the issuance of the restricted stock – there is no relief for late filings.
- Incentive Stock Options (ISOs): ISOs tend to be granted to employees in a startup’s early days, typically after the first round of institutional financing. Generally, companies are only allowed to issue up to $100,000 in ISO value per employee per year. Compared to other types of options, ISOs have flexible characteristics, favorable tax treatment, and allow time for financial planning. ISOs are taxed upon exercise by the employee. Employees tend to exercise their ISOs when they have a meaningful number of vested shares, have the money to pay the associated costs, see that the preferred price is meaningfully higher than the 409A price, and are bullish on the company’s long-term prospects. Note that the exercise of ISOs is not taxed for ordinary income tax purposes; however, the “spread” (i.e., the difference between the 409A value of a share and the strike price for such share) is taxable for alternative minimum tax (AMT) purposes. The exercise of an ISO is also not subject to employment tax withholding—the obligation to report and pay the tax falls entirely on the employee. When an employee exercises his ISOs for vested shares, the employee’s financial obligation is comprised of both the exercise cost (= #shares x strike price) plus the taxes associated with the exercise of the ISO (= 409A value - strike price x AMT rate). It stands to reason that the earlier an employee exercises his ISOs, the lower their overall financial obligation because generally the value of the company increases over time.
- Nonqualified Stock Options (NSOs): NSOs tend to be granted to employees somewhat later in a company’s life as the value of the company continues to increase meaningfully. Unlike ISOs, companies are not restricted in the value of NSOs it can grant to an employee. Therefore, as a company successfully grows, employees often will have been granted a blend of ISOs and NSOs. Like ISOs, NSOs are taxed at the time they are exercised by the employee. However, unlike ISOs, income from the exercise of an NSO is taxed as ordinary income, and the company is obligated to withhold employment tax in respect of the exercise. Employees tend to exercise NSOs in one of two scenarios—either very early (i.e., when there is little difference between the 409A price and the strike price) or very late (i.e., at the time of an IPO or M&A exit, at which time they turn around and sell their shares on the open market). When an employee purchases their vested NSOs, their financial obligation is comprised of both the exercise cost (= #shares x strike price) plus the tax cost (= 409A value - strike price x ordinary income rate).
- Restricted Stock Units (RSUs): RSUs tend to be granted to employees once a company’s growth in valuation has stabilized. Unlike ISOs, companies are not restricted in the amount of RSUs it can grant to an employee. RSUs have little inherent flexibility because, upon vesting, the company converts their promise of stock compensation to an employee into the actual issuance of a specified number of shares of stock that the employee then owns outright. This is distinct from ISOs/NSOs where the employee is required to purchase the vested shares in order to take ownership of those shares. RSUs are generally taxed upon receipt of the stock (typically along a four year vesting period). The employee’s financial obligation, at the time of receipt, is the tax cost (= #of shares x value at issuance x ordinary income rate).
The above describes an employee’s financial obligation at the time at which they either exercise, purchase or are issued stock and assume outright ownership. There is another taxable event, which occurs at the time that the employee sells their shares and receives cash proceeds. The decision to sell boils down to two options—either sell within one year or hold for more than a year before selling. This is true whether an employee is selling in an aligned-liquidity program or in the public market.
- Within One Year: The employee will be taxed at the ordinary income tax rate (= #of shares x sale price - purchase/issuance price x ordinary income rate). If they sell their stock immediately upon purchase/issuance, then the tax obligation is often non-existent. However, for a “high flying stock”, if the employee sells nine months after purchase/issuance and the stock has appreciated considerably, the tax bill could be meaningful.
- After One Year: The employee will be taxed at the long-term capital gains tax rate (= #of shares x sale price - purchase/issuance price x long-term capital gains rate). If the stock price remains relatively flat between the date of purchase/issuance and the date its sold, then the tax obligation is often minimal. However, for a “high flying stock”, while there will be a tax obligation, generally it will be considerably less than if the employee sold within one year.
Companies, on behalf of their employees, must also consider the following high-level questions with respect to taxes:
- Is the company properly accounting for the exercise and sale of ISOs (incentive stock options) and NSOs (nonqualified stock options) on its books? The company 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, including 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 others, even including 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 company’s various policies regarding transfers 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 an employee sells 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 the shareholder fully aware of the related rules and qualifications? If someone acquires stock options as an early employee in a startup, and holds them for five or more years, the employee 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, which is a leading reason to hold off on exercising 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, participants want to incur the lowest tax liabilities possible. In some cases, a participant might face lower taxes by selling unexercised options; in others, the participant might need to hold off for five years to take advantage of QSBS benefits. In any case, participants should be aware of their options and the ramifications of their actions.
- Does this participant understand the rules for estimated tax payments for federal and state purposes? When participating in an aligned-liquidity program, participants need to understand when they owe the taxes that correspond with the sales. Depending on when the sales are enacted, and whether a participant is required to pay estimated taxes, the participant might be able to hold off on paying them for up to 14 months, during the next tax cycle.
- If a participant is ever audited, would he or she have the necessary documentation associated with the aligned-liquidity program, including stock certificates and purchase agreements? In order for someone to sell stock, they first have to acquire the stock, either through purchase or gift. If a participant is audited, he or she will need documentation to support the timing, pricing, and terms of each purchase and sale transaction.
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. This is particularly true for employee tender offer programs. The communication endeavor has two sides: celebrating achievements and setting expectations.
The celebratory aspect is about 20 percent of the total communication about the tender offer. It’s an opportunity for companies to further shape the vision and culture of the company. Led by executives and the board of directors, the communications tend to have three key messages:
- Praise: how the team has unflinchingly and exhaustively been building the company for the past handful of years
- Re-energize: that there is still a great deal of good work to be done, and everyone needs to set their sights on the IPO horizon and beyond.
- Acknowledge: that “life happens” and they’ve earned the right to ease those pressures.
The other 80 percent of the communication is about setting expectations: that this 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 the company brings 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.
After more than thirty pages of dense material, this is no place to introduce additional concepts and content.
However, it is an opportunity to remind ourselves what all of this is about—people.
It’s about investing in the people who are building today’s #breakawaygrowth companies. It’s about relieving life’s pressure valve. It’s about helping team members realize just a tiny bit of the wealth they’ve created for their families. And, if organized in a manner that aligns with everyone’s interests, it helps to focus all on helping take the company to even greater heights.
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