The benefits of controlled liquidity
Offering private companies customized paths to liquidity is a way to centralize transactions, meet investor demand, and offer employees the opportunity to access their share of wealth they helped create.
U.S. venture capital firms entered 2021 with a record $151 billion in dry powder—the total capital committed by investors that hasn’t yet been invested or allocated—and investors put $79.6 billion to work in Q3 alone across all stages from seed through late stage. The record sums are great news for early-stage founders and growth-stage companies: Never before has so much capital been dedicated to the incubation and development of private companies.
Traditionally, raising capital was one of the primary reasons companies went public. Over the past several years, more types of investors have been building ownership positions at earlier stages, when companies are still growing fast and valuations are attractive. For example, private equity firms have moved further into venture investment, and they’re flush with cash. As more capital flows to the private markets, high-growth private companies are delaying their transition to the public markets. This trend has made employees and early investors in later-stage businesses increasingly eager to access the liquidity that going public would have unlocked.
We created the CartaX marketplace in response to this growing demand for liquidity in the private markets.
The rapid growth of secondary markets
As institutional investors grow their private market portfolios, the ownership targets they seek have escalated to levels that private companies can’t always meet during a primary financing. Founders and existing shareholders try to limit dilution, so some investors’ allocations are cut back and many others may be completely shut out of primary financings. These investors must direct their capital to secondary opportunities to build their positions.
For these reasons, private companies are plagued by a growing number of brokers soliciting current employees, ex-employees, and early investors to sell their equity to potentially unknown investors. Those investors may be purchasing shares with stale information or limited disclosure data. Information asymmetry, infrequent transactions, and a lack of centralized pricing data all contribute to price volatility from one secondary transaction to the next.
These ad-hoc transactions aren’t good for buyers, sellers, or companies: Each one is bespoke, unplanned, and time-consuming. While some corporate governance controls, like a right of first refusal (ROFR), help to divert shareholders from selling equity to unknown investors, a company’s legal or accounting team must still review each notice of transfer. Typically, the company then contacts trusted investors to gauge their interest in purchasing the shares instead. Even with a ROFR, each transaction requires equity administrators to process the ownership transfers and update the company’s stock record manually. Regular 409A valuations must also take each of these transactions into account when calculating the fair market value (FMV) of the company’s stock.
The problem with distributed transactions
Recent history offers a familiar example that demonstrates the dangers of disorganized and distributed secondary transactions. In 2012, Facebook went public, not because Mark Zuckerberg wanted to, but because his hand was forced. At the time, regulations required a U.S. company with 500 or more shareholders to provide quarterly disclosures and audited financial information to the public. Facebook exceeded this threshold because it did not exercise adequate control over secondary transactions.
In retrospect, it was foreseeable: As investors sought to own more of the fast-growing startup, they sourced liquidity by flocking to platforms like SecondMarket and SharesPost; these platforms had been formed to help shareholders unload their illiquid, yet valuable equity. Other investors contacted brokers who had access to shareholders or networked with individuals who had relationships with ex-employees.
These were sophisticated investors gaining access to a high-tech company. But the methods for doing so at the time were rudimentary: The transactions were recorded on paper documents that were physically mailed to stakeholders to review and sign with ink! The resulting stock transfers to new shareholders were tracked in spreadsheets by Facebook’s equity administrators and lawyers. Even though Facebook had a right to repurchase shares if shareholders tried to sell, the company did not always exercise this right, due to the burdensome manual process it would have required. As Facebook knowingly or unknowingly allowed shares to transfer to new investors, each addition counted toward the 500-shareholder threshold that ultimately led to their need to IPO. The limit of investors on a private company cap table has since been raised to 2,000, but the same problem looms.
CartaX offers controlled options for liquidity
Since our founding in 2012, Carta has been ushering in an age of transparency and simplicity for tracking and updating equity ownership, but little has changed in the way of centralizing and controlling liquidity for private companies. In January 2021, we launched CartaX to put founders, companies, and their leadership teams in control of liquidity by building a private stock market they can tailor to their specifications.
Imagine designing a custom car: First, you select the model, body, and transmission, followed by a long list of other options like color, wheels, lights, interior materials, seats, and stitching. The CartaX marketplace operates similarly: Private companies can choose the transaction framework that works best for their needs, then they can customize the characteristics of any transactions that take place on their private marketplace.
In the first step, a company selects a transaction type, such as a tender offer, an auction, or a block trade1. Then, the company can identify which buyers and sellers are eligible to participate in the transaction. They can also select the price (or range of prices) allowed for transactions, set limits on the maximum or minimum number of shares each buyer and seller can trade, decide which share classes and equity types are eligible, and choose the timing of the transactions.
As companies customize their liquidity programs, their executives are often balancing the legal, valuation, tax, and accounting considerations of each transaction. A company’s legal team considers the key legal, regulatory, and corporate factors associated with liquidity. The finance team calculates the impact secondary transactions may have on the company’s valuation, the tax implications of the transaction for the company and selling shareholders, and the accounting implications of the transaction. These considerations inform the transaction design for each company’s liquidity program. In addition to the CartaX team, Carta’s ecosystem of law firms, 409A valuations analysts, wealth management partners, and audit firms provide a support system for companies preparing to offer liquidity on CartaX.
In order to foster fair, orderly, and compliant secondary trading, companies can securely share the relevant disclosure materials only with the eligible buyers and sellers. Investors often need more information about the company than just their disclosures; they also look for the company’s equity story and seek one-on-one engagement with the company’s leadership team. The CartaX Equity Capital Markets team helps facilitate these relationships, providing guidance every step of the way.
With CartaX, private companies can design their own liquidity programs and organize transactions that satisfy the interests of sellers. Doing so discourages outside transactions by offering shareholders a better option. Both the platform and the buyer network are approved by the company, with lower fees and the benefit of comprehensive education and information for all parties involved in the transaction.
CartaX also simplifies administration by tightly integrating the marketplace with equity data that resides in Carta. CartaX streamlines market configuration by leveraging up-to-date cap table information. Additionally, any transactions that occur on the market seamlessly update the company’s cap table through the direct integration of CartaX with the ownership data of Carta. This saves legal and financial resources and allows companies to focus on building their business.
Liquidity solutions are crucial for private companies—whether they’re looking to raise capital, attract and retain top talent, or build deeper relationships with new investors without dilution. As the CartaX team continues to research and design new customized transaction types, our focus is to give companies the ability to easily access liquidity—while keeping control of its impact on their valuation, tax withholding, accounting requirements, cap table, and admin team.
1 Block trades available Q1 2022, subject to regulatory approval.
©eShares, Inc. DBA Carta, Inc. ("Carta") and Carta Capital Markets, LLC (“CCMX”) (collectively "Author") | All Rights Reserved | Carta is a transfer agent registered with the SEC | Descriptions of brokerage products and services offered by CCMX | CCMX is a broker-dealer and FINRA/SIPC member | Author undertakes no obligation to update content herein | No business, investment, tax or legal advice is provided by author | Potential investors are advised to conduct their own due diligence and consult with their tax, legal, and financial advisors with respect to any investment | All securities involve risk and may result in partial or total loss | Investments in private securities are speculative, illiquid, and involve a high degree of risk, including the possible loss of your entire investment | There is no guarantee that a private company will conduct an IPO or provide an alternative exit strategy for your invested capital | Same day settlement only applicable to certain transaction-types | Testimonials may not be representative of the experience of all customers and are not a guarantee of future performance or success.
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The Carta liquidity report: Q2 2022The volume of secondary transactions on Carta remained robust, reflecting momentum from a record-breaking 2021 for venture capital.
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Experts share tips on how to structure a tender offerOn the surface, a tender offer is simple. Beneath the surface, a number of complex considerations are necessary to align the transaction structure with your company’s objectives.