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Faced with a 7- to 10-year IPO on-ramp, private companies are seeking alternate ways to unlock liquidity for early-stage investors and incentivize valued employees. High-profile pre-IPO companies, including Facebook, Zynga, and Twitter, have turned to private liquidity programs (PLPs) to enable investors and employees to cash out a portion of their shares.
Increasingly, cash flow positive companies in the middle private market are beginning to wonder whether they too should consider a PLP. Here are 10 questions to ask when considering such a transaction:
1. Is the company ready for a PLP? While monetizing their own net worth can be alluring for management, a company should consider whether the business is at the right stage of development for a PLP. If the company needs growth capital but lacks confidence in the fundraising environment, it’s probably not the right time to tap investors for money that won’t be used for growth. But if the company is profitable or fully funded and turning away investors who would otherwise be a good fit, a PLP may be a viable solution.
2. How will new and existing investors co-exist? The company should evaluate what rights it is able or willing to give new shareholders. Are burdensome consents from existing investors required to allow a PLP? The company should consider how existing investors will react if another institution is granted rights comparable to their own without the company receiving benefits. Some PLP structures, such as private tender offers that allow participation by a large number of employee sellers, are often easier to set up with new investors and reduce conflicts with existing investors.
3. Who can sell and how much? Companies should decide up front who will be allowed to participate in the program and whether the company will place any restrictions on the portion of shares that can be sold. Companies often elect to limit employees to selling 10-15% of their vested holdings so that they can achieve meaningful liquidity but remain committed to the enterprise’s future success. Companies should also set parameters, such as the class or series of shares that can participate, and the relative priorities of sellers in the case of an over-subscription.
4. What is the best PLP structure for my company? Choice of structure largely depends on the types of existing investors and sellers. Options include:
- Direct Secondary — Individuals or small groups of sellers transfer shares directly to third-party investors pursuant to a direct stock transfer agreement.
- Third-Party Private Tender Offer — Fixed offer terms to a larger group of sellers who can tender shares through a letter of transmittal during a 20 business day period.
- Primary/Redemption — Company issues primary “alphabet” round of preferred shares to investors and then uses all or a portion of the proceeds to repurchase stock from existing shareholders.
Each option offers advantages and drawbacks, and structures can also be combined with a primary financing.
5. Will the company be required to disclose sensitive information? To comply with securities laws, companies are often required to make certain (though limited) disclosures in a PLP. The extent of disclosure will depend largely on the facts, including the identity of proposed buyers and sellers (and what they already know about the company). These disclosures can often be made under the protection of confidentiality and in a way that limits the risk of them becoming publicly available.
6. Can option holders participate? Employees generally hold the majority of their equity in the form of stock options, and certain PLP structures offer greater flexibility to include option holders. Third-party tender offers, for example, can allow option holders to direct payment of their exercise price and tax obligations from the program proceeds, avoiding out-of-pocket costs. An advance of the option exercise price from the purchaser can also be arranged through a direct secondary structure.
7. What type of documentation will be required? Many of the documents used in a secondary structure are relatively standard. For a private tender offer or redemption structure, the documentation is often more complex than with a direct secondary, in order to address specific compliance requirements.
8. Are there any tax or accounting considerations? As usual, the answer is “yes” for both the company and the individual sellers. Companies considering a PLP should speak with their tax and accounting professionals to identify all relevant implications and select the most efficient structure.
9. How long does a PLP transaction take, and what time demands will it make on management? PLPs can be structured to limit the time demands placed on management. A direct secondary transaction, for example, requires very little of the issuer beyond processing the transfer. A “plain vanilla” direct secondary transaction can often be done in a matter of days. Transactions with a broader group of sellers may require more of a commitment from the stock and option administrator and, in the case of private tender offers, typically take at least six to eight weeks.
10. What will it cost? Transaction costs typically range from a few thousand dollars for the simplest direct secondary transactions to hundreds of thousands of dollars for the most complex PLP structures. Company legal fees generally correspond proportionately to company oversight and the number of buyers and sellers.
As the PLP market continues to develop, the process is becoming increasingly efficient. Companies such as Second Market have created online platforms dedicated specifically to facilitating PLPs through the use of advanced online trading technologies. In addition, there are opportunities for the company (and, potentially, the buyer) to pass costs along to the sellers who are receiving the financial benefit of the transaction.
Given the market drivers for pre-IPO liquidity and the flexibility of combining transition structures to meet the needs of both issuers and investors, private liquidity programs are likely to continue to grow in popularity. Careful planning can make these transactions an appealing option for companies looking to differentiate themselves in attracting and retaining talent while maintaining control over trading in their own securities.
Jamie Hutchinson and Breck Hancock are partners at Goodwin Procter LLP. They have represented investors and companies in some of the highest profile private liquidity programs, including those conducted by Facebook, Dropbox, Zynga, and Twitter.
[Top image credit: Lisa F. Young/Shutterstock]
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