Introduction

This practice note discusses techniques private companies may use to provide liquidity to their founders, executives, employees, and investors. These techniques enable shareholders to receive a return on their investment prior to the company's initial public offering (IPO) or acquisition. Start-ups typically use these techniques in the later stages of their development.

This practice note reviews:

  • The background for late stage start-up liquidity programs
  • Liquidity techniques that have emerged in the last decade, including:

    • Orderly negotiated secondary sales
    • Structured liquidity programs, such as private tender offers of capital stock
    • Loans, derivatives, synthetics, and other alternatives to secondary sales
  • Considerations and recommendations that you should be aware of in dealing with these liquidity methods
  • Issues that arise (particularly from the issuer's point of view) in analyzing, structuring, and documenting transactions providing liquidity to private company shareholders

Background to Late Stage Start-Up Liquidity

Historically, there were very few, if any, options for large numbers of private company stockholders to get preexit liquidity for private company shares. Stockholders and employees traditionally expected to wait until the company was acquired or became a public company in order to receive a return on their investment. Starting in the early 2000s, many companies have decided to stay private longer. A number of developments have fueled this preference to stay private, including volatile public markets in which debuting companies might face valuations at or below their last round of private company financing and increasingly burdensome new regulatory and compliance obligations, particularly with the passage of the Sarbanes-Oxley Act of 2002 and the regulations promulgated thereunder.

At the same time, because companies were staying private longer, investors have been seeking opportunities to buy shares in private companies prior to the traditional liquidity events, in the hopes of generating large returns on a relatively short horizon. These investors include large institutional investors who might normally invest in an IPO, but might not be able to get their preferred allocation of shares. In addition to established institutional investors, other investors who would normally not have access to any share allocations in IPOs have formed funds specifically to buy private company shares. Many individual investors have also sought to invest in private companies, particularly those with household names prior to their IPO (e.g., Facebook, Zynga, Twitter). Platforms like SecondMarket and SharesPost helped to connect sellers and buyers, aggregated self-collected company information (generally without company verification), and facilitated a large number of transactions between about 2006 and 2013 (known as the secondary boom). Though there is no compiled and verified data on the full scope of these transactions, it is believed that hundreds of millions of dollars of transactions were completed in this period.

Secondary market activity continues through this day, but not on the scale seen during the secondary boom. With the implementation of more stringent transfer restrictions and the use of larger and more structured secondary transactions, companies have been able to limit unrestrained trading and design pre-IPO liquidity programs to better incentivize employees and longer-term shareholders. For additional information on secondary market activity, see Secondary Market Trading of Private Company Shares.

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Originally published in LexisNexis

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.