Second is the New First

Published on
January 29, 2022

Solutions to the problem of illiquidity of private companies — Part I

The main difference between public and private markets lies in accessibility i.e. liquidity. While it is easy and inexpensive to invest in and trade in the public market, the private market is a different story. This article is Part I of a two-part series highlighting the importance of creating liquidity from the founder and company perspective. It dives into problems like dead equity and presents subsequent solutions on how to tackle these issues, including solutions involving secondary transactions in shares.

Illiquidity & its challenges

Why creating liquidity is a good thing in general

Liquidity has become increasingly important over the years as founders, employees and investors in startups have had to wait years to benefit from selling their shares and see returns on their investments, until the company exited. This is a problem as companies take longer to reach an exit than they previously did. Apart from the recent boom in public listings (fueled by the SPAC frenzy), there have been much fewer IPO exits in the last 15 years. In the second part of the 90s, there were consistently at least 300 IPOs per year in the US, a number that has not been reached again since 2020. As a result, the median time to IPO exit in 2020 has increased to approximately 5.3 years post-first VC funding, compared to 3.1 years in 2000, having peaked at 7.6 years in 2016. But this does not relate only to IPOs; the time to exit via M&A has also gradually increased, from roughly 2.5 years (from the first VC financing) in 2000 to 6.3 years in 2019.

This is precisely where secondary solutions come in, providing liquidity to early investors, shareholders and employees of private companies. There are numerous circumstances under which secondary solutions to illiquidity are sought after. For funds, perhaps they are reaching their vintage life and need to offload certain investments in order to provide returns to their investors. It could also be that they simply need to re-balance their portfolios and the way to do this is to sell down some assets on the secondary market. For employees, personal circumstances may dictate such behavior, e.g. buying a house, going through a divorce or the birth of a child are all circumstances that may require access to some liquidity.

Recent times have shown that there may even be extreme circumstances where employees of companies may be millionaires on paper but are struggling to monetize their holdings. Such an example was Facebook, which reached unicorn status in 2006, yet it took 5 more years for its shares to become public, i.e. liquid. Even after 2010 when the company was valued more than USD 35bn, the shareholders had limited ways to cash in this success while many employees tried finding private buyers for their shares. In 2010, growth equity firm General Atlantic reportedly purchased a 0.1% stake from former employees. And in July 2011 some employees managed to list their shares via SharesPost, a broker-dealer, at a valuation of USD 84bn, nevertheless it supposedly consisted only of c. 100,000 shares, so less than 0.01% of the share capital.

The fact that the paper stakes of employees in Facebook were worth astonishing amounts is shown by the curious case of a graffiti artist who was hired to paint the company’s first HQ in 2005. While he asked for USD 60k to paint their buildings, he was instead paid in equity (supposedly c. 0.2% stake at the time of IPO). By 2006 (i.e. a year later), his stake was valued at more than USD 2m and when Facebook eventually IPOed in 2012, it was valued at around USD 200m.

Source: WalrusTV video (2012)

The case of the Facebook’s graffiti artist whose stake has risen exorbitantly in value long after he had ceased to work as their graffiti artist, brings us to another situation that warrants attaining liquidity — the problem of dead equity. Dead equity occurs when a former employee or founder, who holds a significant stake, decides to leave the company and thereby ceases to participate in its daily operations.

The value of dead equity in companies has been growing, having even tripled in three years between 2008 and 2011. Note that 75% of this change was due to the increase in percentage of dead equity, not changes in company valuations. What’s more concerning is the fact that this is a problem even for the youngest of startups, which saw the biggest increase in dead equity. This can be an issue from various different perspectives. For companies, sizeable dead equity means a reduced ability to attract and retain key talent, as equity (as we saw with Facebook’s example) is a start-up’s most powerful currency and incentivization tool.

Yet dead equity can also refer to friends & family, angel investors or practically any stakeholder who bought into the company but does not actively contribute to its operations and growth any longer. Having a cap table crowded with such shareholders can also mean that a start-up is forgoing the opportunity of having participating investors who can contribute resources, knowledge and a network to the company to help it grow and are also able to support it through future funding rounds.

Having a lot of dead equity on the cap table is an issue for investors as well. Non-participating shareholders are effectively free-riding on the work and capital of others and since investors finance the future growth, they generally do not look very favorably upon this. Dead equity can nevertheless also create very practical problems during fundraisings as it is difficult to predict how an uninvolved (major) shareholder will behave. Such situations may create headaches not only for investors but also for founders still active in the business. This was the case of and one of their co-founders, Chieh Cheung, who put in about USD 19k and worked for the company but eventually dropped out. When a new investor, Mayfield, wanted to invest, they wanted Chieh off the cap table and were willing to offer USD 410k for his shares. When Chieh realized the situation, he asked for double. The other founders felt extorted; they had not had pre-defined liquidity mechanisms for departing founders and due to the pressure of the round, they ended up paying the remaining balance out of their own pockets.

Another issue, which would benefit from having liquidity options available for private companies, is the conflict between founders and founder separations. Running a start-up is no easy task, requiring a lot of sacrifice, with relationships potentially getting strained. Unresolved founder conflicts can set off-course otherwise healthy companies. Such an example is Zipcar, whose founders Robin Chase and Antje Danielson agreed at the outset on splitting the equity 50–50. However, while Robin worked full-time on their venture, Antje kept her main job and reportedly never took on a real operational role. Robin felt she should have a bigger stake for her contribution and the growing conflict escalated to Robin firing Antje even though she still owned a big stake in the company. A year later, the company has failed to raise venture funding under Robin, ultimately leading to her replacement as well, at which point Zipcar had two founders and major shareholders fully disengaged from the business only 2 years after founding. An orderly process of founder separation and having liquidity mechanisms to address that could have helped prevent such conflict escalations and surely would have been better for the company.

Anticipatory solutions

Now that we’ve looked at some problems of the illiquidity of private stakes, let’s take a look at some anticipatory solutions founders should keep in mind at the time of inception of the company.

Noam Wasserman, in his book The Founder’s Dilemma, has researched over 10,000 founders and has come up with certain anticipatory solutions to some of the problems outlined above. He mentions that over half of the teams he observed failed to anticipate future problems such as founder separations and failed to include dynamic elements in their agreements. His colleague Deepak Malhotra has categorized 3 potential types of uncertainty-related situations in contracts: 1.) ‘knowns’ (situations that are given), 2) ‘known-unknowns’ (situations where one can anticipate the event but the outcome is uncertain) and 3) ‘unknown-unknowns’ (fully uncertain, almost Black Swan events).

‘Knowns’ can be addressed using standard contractual terms. The key is to try to tackle the uncertainty, which can be done, especially in the second type of situation, with contingent terms. Such are e.g. buyout clauses whereby the founders share can be bought on pre-negotiated terms if the founder disengages from the company. In the third type of situation, Wasserman maintains that the first step in dealing with such high uncertainty events, is to identify as many as possible events and discuss how things may change if such an event would occur i.e. try to turn unknown-unknowns into known-unknowns. Here, he gives the example of Microsoft founder Paul Allen being diagnosed with Hodgkin’s lymphoma — Wasserman states that no one could have predicted this, but founding teams should plan for the scenario where one of its founders is suddenly unable to participate due to personal reasons.

Another mechanism to account for an uncertain future is to have vesting equity. Vesting terms mean that founders should earn their stakes, over time or when certain milestones are reached. And if one leaves, they lose the unvested portion. Vesting therefore serves as a strong incentive to contribute, and to a degree reduces the problem of dead equity.

In short, Wasserman’s main point is that founders should always assume things will change and should refrain from static splits by categorizing uncertainties, preparing for best and worst case scenarios and including dynamic elements like buyout terms and vesting schedules.

The Dynamic Equity Split scheme (DES)

An interesting innovation has been proposed by entrepreneur and Chicago Booth School of Business professor Mike Moyer in his book Slicing Pie — a Dynamic Equity Split (DES). It is a scheme where each partners’ share is determined by the relative value of their individual input. Every partner contributes something to the business — ranging from time, cash, connections, IP, to e.g. an office space. The relative values are assigned to the contributions based on pre-determined rules — e.g. a senior programmer’s time is more valuable than that of a recent inexperienced college grad. Shares are then calculated by dividing an individuals relative value by the total value. This split will change over time depending on individuals’ contributions — this is the dynamic element.

Below is a simplified (and maybe extreme) example of how to calculate equity using the DES model based on time contributions only. If co-founders (Andrew and John in this example), agree on their Theoretic Base Salary (TBH), i.e. their market rates, then they can recalculate their equity each month based on cumulative hours worked.

Source: Y-Productive blog (2018)

The founders of Y-Productive, a productivity tracking app, have adopted a version of DES and they actually re-calculate all their shares every month. They believe this method is fully transparent and aligns their interests so that they all are invested in the venture succeeding.

The secondary market

A more ex-post solution for those facing a liquidity issue is to engage in the secondary market. A secondary sale is when a shareholder of a private company (anyone from a founder to an employee or early investor) sells their shares to a buyer. They are different from ‘primary’ sales where the company typically issues new shares and uses the capital directly for the company. Secondary transactions may occur for a variety of reasons and there is an existing market for such shares.

Just a few years ago, the purchasing of secondary shares of VC-backed companies was unheard of. The traditional view maintained by investors was that founders selling shares did not signal long-term commitment — if you wanted liquidity, you had to wait for an exit event. Investors viewed partial liquidity as potentially creating a misalignment of interests between themselves and employees or founders. Even the boards of directors were often of the opinion that this could cause a negative perception of the company. Investors would therefore only allow a limited number of shares to be sold by founders or employees, for very specific reasons. This was a problem for employees if they had to solve specific personal liquidity needs, e.g. buying a house. The illiquidity of shares may nevertheless also impact the retention of talent because employees may see limited value in their shares/options unless there is an actual possibility to realize them (and psychologically, just having the option to sell the shares in a secondary market may be enough without employees ever taking that option).

However, this has begun to change in the past decade — the private market for such secondary shares is estimated to have grown significantly since 2011, tripling between then and 2016 to USD 35bn. And this trend is continuing as the rise of the secondary market goes hand in hand with maturing of the general VC market. Michael Joseph, Co-CEO of secondary investing fund Ion Pacific reiterates, “Over the past five or ten years, when we’ve seen this massive increase in dollars allocated to [VC], that need for [secondary] liquidity has grown.” In fact, the VC portion of the total secondaries PE market is estimated to be worth USD 70bn in 2021 (double since 2016), with direct secondaries (explained below) accounting for over 85% of this.

Source: Greenspring Associates (2021)

Secondary transactions can occur either as acquiring LP interests in funds or other GP managed entities/SPVs or as acquiring direct interests in the underlying companies, i.e. direct secondaries. Direct secondaries themselves can happen at different levels — at the fund level, where entire fund portfolios can be purchased, or at the portfolio company level, where secondary funds may purchase stakes directly from other shareholders. It is therefore the direct secondary funds that solve the illiquidity problem at private companies.

In direct secondary transactions, the sellers range from founders, friends & family, employees, to angel investors and other VCs.

Flashpoint has established a specialized secondary fund (FSF) to do just that — to provide (partial) liquidity to early investors, founders and employees. While this enables founders and employees to cover personal events or lifestyle needs without burdening the cash flow of the company, it also gives investors the opportunity to de-risk their positions and allows for liquidity planning to fit their investment horizon criteria or fund life limitations. The company can also benefit, enabling it to actively manage its cap table e.g. recycling their passive shareholder base and gaining a constructive investor with the ability to participate in further primary rounds. FSF can also offer more creative solutions e.g. help the company set up an employee incentivization scheme through a regular option/share buy-back program.

Buyers of secondary shares are nevertheless not limited to specialized secondary funds. Often it is existing investors who purchase shares from other shareholders. The reasons may differ — e.g. the wish to deploy more capital into a familiar situation with a lower perceived risk or desire to reach a certain shareholding threshold. Existing shareholders even tend to have specific legal rights to such secondary shares via right of first refusal (ROFR). While such rights to secondary shares will almost always be demanded by investors, they can ironically limit the occurrence of secondary transactions. Existing shareholders with ROFR rights can be passive as they can simply wait for others to come with transaction offers for secondary shares, while outside investors might be reluctant to make such offers if they know they can be pre-empted by existing shareholders at the last moment. There is therefore a fine balance in these rights and processes to protect the rights of existing shareholders, but also to create the desired state of increased liquidity of private shares. We will return to this topic, so stay tuned for more.

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