Liquidity in Private Companies
- Mick Bain
Traditionally, the management and investors of venture-backed companies would begin considering an exit for the company—an IPO or acquisition—as it entered the growth phase. Today, however, more and more companies (particularly in the tech sector) are opting to stay private longer. Without from these traditional sources, companies are increasingly seeking alternative forms of for the founders, early investors and employees.
Companies are delaying exits for three main reasons:
- Availability of Private Sources of Funding: In recent years, investors increasingly want to fund late-stage companies, sometimes through secondary funds. According to investor database CB Insights, 70 venture-backed tech companies reached unicorn status in 2015 (i.e., were valued at more than $1 billion). With more cash available for growth in private markets, companies can avoid going to the public markets to raise funds.
- Lower operational pressure: As the cost of starting a company has fallen, that manage their spending well can reach profitability faster. While these companies may not be flush with cash unless they raise large amounts of outside funding, reaching profitability does reduce the pressure to raise public funds.
- Lack of attractive exit : The last half of 2015 saw the number of IPOs slow down, and the first tech IPO in 2016 did not occur until February. According to WilmerHale’s 2016 IPO Report, the 2015 IPO market produced 152 IPOs, a disappointing tally that lagged well behind the 244 IPOs in 2014. The number of IPOs by venture-backed US declined 38% in 2015 from 2014. With public markets not being particularly kind to tech companies in recent years, many companies are finding it safer to stay private for longer. M&A numbers are also slowing down—founders are more optimistic about the future of their companies, so M&A valuations may not provide an attractive exit. According to WilmerHale’s 2016 M&A Report, while deal volume increased 7% in 2015 from 2014, macroeconomic concerns have begun to depress deal flow and valuations in 2016. Microsoft’s recent acquisition of LinkedIn for $26.2 billion, one of the largest tech deals on record, could be a forerunner of tech acquisitions but that’s still to be seen.
The slowdown in exits has caused companies to seek other forms of for their . Providing can alleviate financial pressure on founders and employees who may have invested heavily to build a successful company, and also on early investors who may need to show more than just paper returns to their , particularly if the life of the fund is winding down.
Of course, when deciding how much is appropriate, the company has to consider the signals sent by interim , which may, for example, cause some to wonder if founders and investors are losing confidence. Other rights, such as rights of first refusal and co-sale, may also need to be considered.
Although other exist, interim is generally achieved in connection with a financing and structured in one of the following two ways:
- A direct sale: A new investor can purchase outstanding shares directly from one or more existing . This is perhaps the simplest approach in that it involves a single transaction directly between the buyer and the seller. However, it is not generally the best approach for a couple of reasons. First, the new investor typically wants to negotiate the rights and preferences of the securities it will own (voting rights, preferences, etc.). By purchasing existing securities—whether or —the investor will only get the rights (if any) already associated with those securities. Second, shares that are not purchased directly from the (the company) are “non-qualifying” investments, which are subject to certain limitations if venture capital investors wish to avoid registration as investment advisors. As a result, the direct sale approach is not always the best one.
- Two-step approach—Investment followed by a : Alternatively, an investor can invest funds directly into the company in an amount that exceeds the company’s current needs, and the company can then use the excess funds to redeem a portion of the held by one or more existing . The primary benefit of such a transaction to the new investor is that all of the shares being purchased by the investor in the transaction will have the rights and preferences that the investor negotiates with the company as part of the transaction. Depending on the circumstances, the company must comply with the SEC’s rules in connection with the . However, these do not usually create a significant hurdle and therefore, this two-step transaction is the more common approach.
In either case, the price at which the existing shareholders sell their shares (either directly to the investor or to the company as part of a ) can be negotiated. For example, in the two-step approach, the sellers often sell their shares to the company at, or close to, the same price as the new investor is purchasing from the company. However, there are important tax issues to consider when employee shareholders are selling their at a price that exceeds the actual fair market value per share—including if it exceeds what the board has determined to be the fair market value when granting . This inconsistency in concurrent valuations of the —the price paid in the compared to the 409A valuation/ of granted at or around the same time—creates several tax challenges.
Is a portion of the /purchase price “income” for tax purposes? If the /purchase price is really the FMV of the , then what are the consequences to recent recipients of who may have that are below that FMV? Trying to optimize the tax impact for the selling shareholders may have an even more drastic negative tax impact on recent recipients of and other -based awards. Moreover, increasing the valuation can negatively impact the company’s recruiting efforts. So-called “Series FF ” was created to try to avoid some of these issues, but these are rare now given the importance of having a simple and clean in the beginning. As a result, the company should discuss and structure any potential transactions with the prior advice of counsel.