This
blog post is part two of two discussing equity incentives and ways for
employees to liquidate a portion of their shares while the company remains
private. Part One discussed the issuance of equity incentives to employees and
other key personnel. Focusing now on already issued and vested equity
incentives (for illustrative purposes hereof, we will focus on stock options),
this blog post discusses the potential internal transactions that can provide
liquidity to these vested employees and personnel.
The Broader
Trend to Stay Private
In
the last decade, the pre-IPO marketplace has grown significantly, being
dominated by an increase in venture capital firms and private placement agents,
brokers, and banks. With the increase in private market capital and willing
buyers of private-company securities, the trend for post-2008 financial crisis
startups has been to delay an IPO for as long as possible. High valuation
startups such as Uber, Lyft, Slack, and Zoom all went public in 2019 into an
all-time high in the public markets. When these companies go public, not only
do the founders, venture capitalists, and investment banks make money, but also
the employees who were granted stock options under the company’s equity
incentive plan. While these companies stay private longer, secondary
private-company marketplaces have evolved to purchase private-securities from
employees or early-stage investors. Given the recent market volatility
surrounding COVID-19, we expect valuations of private companies to be revised
downward, companies to remain private, mergers and acquisitions deals to slow,
venture capital deal terms to favor the venture capitalists, and cash strapped
employees looking to sell their illiquid shares to weather personal financial
volatility. The current financial markets signal that now is the time for
liquidity and financial security. Liquidity and financial security are not only
important to companies but also the companies’ employees. Conversely, with a
drawdown in valuations, some existing investors in a private company might want
to acquire more shares and provide liquidity to existing shareholders
while the markets are not encouraging a sufficient liquidity event at a
desirable valuation.
Structuring
the Tender Offer
A
tender offer is a transaction that can be utilized to allow an investor to buy a
company’s shares from employees with vested stock options or company common
stock. Tender offers are often structured in one of two ways: (1) share
buybacks by the company or (2) a secondary sale by an existing shareholder(s) to
a third-party purchaser. Under the first option, the company uses either cash
on its balance sheet or cash from a prior equity financing to buy back shares.
However, many states (for example, Delaware and California) have statues that limit
the amount of capital that a company may use to buy back its shares. Meanwhile,
these statutory restrictions do not apply to secondary sales to third-party
purchasers, which makes secondary sales often the preferred route for many
companies. Third parties who are considering initiating a tender offer should
be aware that there are strict tender offer securities rules which must be
adhered to in the conduct of any such offering.
Considerations
in Secondary Sales
Valuation: Tender offers will
always affect a company’s 409A valuation. The degree to which any transaction
will impact the valuation depends on the terms of the transaction, the parties
involved in the transaction, the size of the transaction, and the methods used
by the valuation firm.
Share
Restrictions: Restrictions
on the sale or transfer of shares, such as rights of first refusal, or state
corporate law ‘control share acquisition statutes’, are often imposed on shareholders.
Therefore, potential sellers must review the organizational documents they
signed or are otherwise bound by (i.e., the company’s bylaws, certificate
of incorporation, and shareholders agreements, for example) to determine if
there are obstacles to transfer unique to the company.
Securities
Laws: Secondary
sales must also comply with federal and state securities laws. Part of
compliance with securities laws is the proper disclosure of information to
potential buyers. When it comes to the disclosure of information, on the one
hand, sellers may have signed a confidentiality agreement with the company to
protect against the disclosure of confidential information to third parties
including prospective buyers. However, this restriction must be balanced with whether
or not the seller has material, non-public information which would impact the
transaction.
Summary: Compliance with
securities laws, a thorough review of the applicable transfer restrictions, and
the company disclosing material information will all help sellers obtain a
higher price for their otherwise illiquid shares.
Companies
wanting to hold off on a liquidity event and get through this financial
volatility while providing employees and other common stock holders an
opportunity to achieve personal liquidity should consider the avenue of a
secondary sale.
Dated April 7, 2020
Written by Stan Sater and
Jeff Bekiares
* * *
If you are a business that has questions about equity incentive plans, contact the Founders Legal team.
Jeff has worked with clients at a variety of stages: from start-ups, to emerging growth to exchange listed public companies. He specializes in organizational structuring, corporate governance, operating and shareholders agreement, multi-use and bespoke complex commercial contract drafting, mergers & acquisitions, private capital raising and all manner of transactional matters, including asset purchase, sale and leasing transactions.
The majority of his Clients operate in the technology space, but he regularly assists companies in a variety of different industries, arts and verticals—which includes representations of companies, individual angel investors or angel investor groups, accelerator programs and venture capital concerns. He also regularly represents commercial real estate development and investment groups in their capital raising efforts.
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