This article is co-authored with Ira Simkhovitch of Industry Ventures.
Startup employee stock sales were once considered “selling out” and sought only by employees who were no longer involved in the company. Today, employee liquidity is no longer taboo, and is actually embraced by some of the most innovative private companies. The real struggle CEOs, CFOs and boards of directors are having is how to deal with it.
In the past, startup companies lacking experience in secondary transactions handled these situations in a variety of ways. There were no established and reputable buyers. It was a Wild West of sorts. Some companies allowed a seller to transact with any buyer. Other companies only allowed sales to certain trusted third parties, such as secondary funds and hedge funds. More conservative companies blocked all such transactions, or even opted to buy employee shares themselves using the company balance sheet. VCs were also unsure of how to deal with the secondary market and viewed secondary sales as misaligning the interests of investors and company management. If founders and employees sold their shares, would they still be motivated to drive the business to a successful M&A or IPO exit?
There are now many companies confirming that, if handled correctly with employees continuing to hold a meaningful quantity of stock and options, secondary sales can be a powerful tool for talent recruitment and retention. With the mean time from funding to exit for a startup increasing from 2-5 years in the early 2000s to 6-10 years today, an employee may hold illiquid stock for quite some time while undergoing major life events such as marriage, the birth of a child, a home purchase or graduate education. Employee liquidity is a tool to help employees get through these events and turn paper gains into real money when needed. Phil Lubin, CEO of Evernote, said, “Why would anyone want to put pressure on the founders of a company to potentially sell [their business] prematurely? Yeah, they are kind of successful, but can’t put their kids through college.”
Fearing the potential misalignment that secondary sales could cause, some companies reacted with tight restrictions on share sales. Rather than retaining control, the “gray market” for employee liquidity that emerged resulted in some companies actually having less control of their cap table. Brokers and secondary exchanges engineered structures including share loan transactions designed to provide liquidity by circumventing restrictions. Lenders have sold these to shareholders touting tax benefits and upside sharing agreements. Companies have struggled to understand these complicated agreements that utilize share pledges and escrow provisions. Management and boards are often unaware when key employees have pledged the majority of their shares in a loan agreement.
We believe the most innovative startup companies have instead embraced employee liquidity as a standard employee benefit. First pioneered in the mid-2000s and now used by leading private companies such as Airbnb and Dropbox, liquidity programs can allow employees to balance short-term and long-term rewards on an individual basis, which ultimately improves recruitment, retention and motivation.
There are many different ways to structure an employee liquidity program, but in our experience, the most fair and transparent option is a tender process with a qualified third party. There are multiple steps, but the transaction itself is quite straightforward:
Phase I: Choosing a buyer. If a private company does not wish to use balance sheet capital for share repurchases, the company may choose one or more qualified third-party buyers to submit a tender offer for its employees’ shares. When selecting third parties, many companies consider the reputation, fund size and longevity of the buyer in addition to other factors that may impact the company and its stockholder base. The idea is to establish a long-term partner that is aligned with company interests and has the flexibility to accommodate future transactions as a trusted counterparty.
Phase II: Planning and structuring. Private companies considering tender offers by third-party buyers can have significant input into which employees participate, the limit on the quantity of shares employees can sell (e.g., 15% of vested stock), secondary pricing and structure of the transaction. Transactions can be structured as outright sales or upside sharing agreements, in which partial liquidity is provided up front with future consideration being paid to the selling employees upon a successful outcome. The potential tax impacts to the company and the employees are considered in this phase as well.
Phase III: Tender offer. Once the tender offer is launched, employees have a period of at least 20 business days during which they may elect to sell or hold vested shares and options. During this time, an Offer to Purchase, Letter of Transmittal, Depository and Paying Agent Agreement or similar documents are distributed to the qualifying employees setting forth the terms of the tender offer, process and timeline. Certain legal disclosures regarding the company, the buyer(s) and risks are included in the tender offer documents. We recommend that employees consult with tax and financial advisors to decide whether or not to participate in the tender offer.
Phase IV: Closing the deal. Shortly after the tender offer period expires, employees are paid the applicable purchase price and the tendered shares are transferred to the buyer. If the tender offer has an upside sharing arrangement, additional consideration may be payable to the tendering employees in the future.
Phase V: Managing for ongoing liquidity. The tender offer may be reopened from time to time so that employees can continue to manage their vested stock interests as appropriate.
Managed tender offers effectively provide employee liquidity in a way that gives private companies control and insight into the secondary sales process—who sold, how much and for what value. A potential consideration in a tender offer is how a sale of common shares to a qualified buyer may affect the company’s 409A valuation. We advise companies to consult with their valuation firm, understanding that a secondary sale is one of many inputs to the 409A valuation. Based on our experience spanning more than a decade of executing these kinds of transactions, it is best to use a third-party buyer to assist the company in mitigating any potential impacts on 409A valuations.
There is a fundamental shift in the way startup companies, and in particular private “unicorn” companies (those that are valued at $1B+), manage human resource rewards and stock grants to attract and retain top talent. VC investors and entrepreneurs are beginning to recognize that it is in their best interest to reward hardworking and longtime employees in successful startups with partial liquidity over a period of time. Every employee has a different personal and financial situation. By granting them financial flexibility, companies allow key employees to keep their focus on growing company value.
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