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
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