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 liquidity from these traditional sources, companies are increasingly seeking alternative forms of liquidity 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, startups 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 options: 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 issuers 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 liquidity for their stockholders. Providing liquidity 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 limited partners, particularly if the life of the fund is winding down.
Of course, when deciding how much liquidity is appropriate, the company has to consider the signals sent by interim liquidity, which may, for example, cause some to wonder if founders and investors are losing confidence. Other stockholder rights, such as rights of first refusal and co-sale, may also need to be considered.
Although other options exist, interim liquidity is generally achieved in connection with a preferred stock 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 stockholders. 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, liquidation preferences, etc.). By purchasing existing securities—whether preferred stock or common stock—the investor will only get the rights (if any) already associated with those securities. Second, shares that are not purchased directly from the issuer (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 stock redemption: 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 stock held by one or more existing stockholders. 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 tender offer rules in connection with the redemption. 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 redemption) 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 preferred stock from the company. However, there are important tax issues to consider when employee shareholders are selling their common stock 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 stock options. This inconsistency in concurrent valuations of the common stock—the price paid in the redemption compared to the 409A valuation/exercise price of options granted at or around the same time—creates several tax challenges.
Is a portion of the redemption/purchase price “income” for tax purposes? If the redemption/purchase price is really the FMV of the common stock, then what are the consequences to recent recipients of options who may have exercise prices 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 stock options and other stock-based awards. Moreover, increasing the common stock valuation can negatively impact the company’s recruiting efforts. So-called “Series FF stock” was created to try to avoid some of these issues, but these are rare now given the importance of having a simple and clean cap table in the beginning. As a result, the company should discuss and structure any potential transactions with the prior advice of counsel.