Jason Borrevik Discusses Secondary Markets for Private Company Equity Compensation
Jason Borrevik — A Principal at Compensia states that certain private companies delay potential IPO timing due to market uncertainty, while others raise significant funding (e.g., $100M+) without the perceived need for a formal public offering. When an IPO is delayed or foregone, employees may be unable to realize value from their vested equity compensation due to the lack of a public market for their shares. In such cases, many high-value private companies (e.g., $1B+ in company value or those with strong perceived growth/upside potential) have elected to participate in third party liquidity programs to enable employees to realize value prior to IPO.
In addition, secondary markets for certain companies may be facilitated without company involvement which can compel companies to proactively structure secondary offerings in more favorable ways to control the process.
Most private companies have “rights of first refusal” built into stock option programs which provide insight into the prices being offered for company stock and potentially limit 3rd party sales. Companies may also, with advice of counsel, implement other limitations on 3rd party sales (e.g., required fees, consents and legal opinions and other transfer restrictions).
To help you consider these issues, we have summarized certain market and best practice considerations culled from our experiences for company-initiated secondary offerings:
Program Timing / Individual Eligibility
According to Jason Borrevik, program timing varies depending on each company’s situation. Programs can be one-time for a limited group of early stage executives/employees (e.g., CEO/founders only), situational in connection with new financings (i.e., opportunistic when the company has a trusted, captive buyer that may be open to a larger investment) or more systematic and open to a larger group of employees (i.e., one structured offering a year on a regular schedule or tied to periodic financing events).
Where the programs are more systematic and broad-based, many companies still limit eligibility to those employees who (1) are their “sophisticated” shareholders at higher levels (those capable of understanding transaction/risks) and/or (2) have at least 2–3 years tenure.
Individual Sale Limits
Many companies limit the amount that eligible participants may sell in any offering to 15–30% of their vested/owned shares (20% is most common in our experience). In such cases, the company can ensure go-forward retention, even with vested shares, because employees cannot dispose of all of their holdings. Some companies also impose an individual value cap on sale proceeds so that more eligible participants can meaningfully participate (Value caps tend to be significant and often only limit participation by the founders/senior executives).
Buyers / Pricing
Companies often try to limit the number of new investors and keep the stock price consistent in any offering. Companies often prefer that the offering is private and with a single identified (and often current) investor. If there are multiple investors, a lead investor typically negotiates/sets the terms for all eligible investors.
Jason Borrevik states that an offering facilitated by a secondary sale entity is typically open to a greater number of investors which may make a company uncomfortable due to the increased shareholder base and potential introduction of shareholders not familiar with the industry and/or technology companies in general. The pool of potential investors in those offerings are often institutional (i.e., hedge funds, mutual funds, smaller family funds) or high net worth accredited individuals without pre-existing ties to the company.
Broad-based secondary offerings can be time-consuming (4–6 month process). Significant legal, tax, accounting and contractual issues arise in any secondary market transaction. Careful attention to the contractual language of the equity incentive plan and form of option agreement and applicable state and federal securities laws is essential. Company counsel should be brought into any discussion regarding private / third party sales of company stock early to ensure compliance and understand program flexibility.