The private markets had a record year in 2021. U.S. venture capitalists raised approximately $110 billion in new funding—adding to the billions of dollars VCs already held in dry powder, or undeployed investment capital.
The availability of venture capital has encouraged tech companies to stay private for longer when compared with their counterparts of two decades ago. Founders can now nurture their companies through multiple growth stages before going public. They now require secondary transactions as a way to provide liquidity for employees and early investors while retaining control of their cap tables.
These two trends have sparked increased activity in the market for secondary liquidity. “We’re seeing not only more companies doing these types of transactions—but also more companies doing these transactions more often,” said Jamin Agosti, associate at Cooley, LLP. Carta saw unprecedented growth in secondary liquidity transactions in 2021. The trend will likely continue into 2022.
Founders and leadership teams at startups of all growth stages can benefit from understanding how secondary liquidity can help them accomplish their goals. In December 2021, Alex Farman-Farmaian, head of corporate coverage at CartaX, hosted a panel of industry thought leaders to discuss the growing trend of secondary liquidity offerings and what it means for venture-backed companies. Joining him were:
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Alyssa Filter, chief financial officer at Clari
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Mike Pestana, partner-elect at Wilson Sonsini Goodrich & Rosati
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Matt Heiman, partner at Vetamer Capital Management
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Jamin Agosti, associate at Cooley LLP
In the webinar, the panelists discussed the difference between primary and secondary liquidity events, how secondary transactions can help founders shape their shareholder base and satisfy their employees, and common roadblocks founders should look out for before structuring a secondary transaction.
*This transcript has been edited and condensed for length and clarity.*
__Alex Farman-Farmaian:__ I’m Alex Farman-Farmaian, the host of today’s panel on private liquidity. Before we jump into introductions, a quick word from our lawyers:
*This communication is on behalf of eShares, Inc. d/b/a Carta, Inc. This communication is not to be construed as legal, financial, or tax advice, and is for informational purposes only. This communication is not intended as a recommendation, offer, or solicitation for the purchase or sale of any security. Although this presentation may provide information concerning potential legal issues, it is not a substitute for legal advice and any opinions or conclusions provided in this presentation shall not be ascribed to Carta. Carta does not assume any liability for reliance on the information provided herein.*
Now that we have that behind us, let’s go through introductions. Again, I’m Alex Farman-Farmaian. I lead corporate coverage at CartaX. CartaX is Carta’s liquidity platform to help facilitate a variety of secondary transaction types, including private company tender offers, bespoke auction-based transactions, and other advisory services.
Alyssa Filter: I’m Alyssa Filter. I’m the CFO at Clari. Clari is a revenue operations platform that drives efficiency, predictability, and growth in the revenue process. I’ve participated or facilitated, on the company side, several secondary transactions throughout my career, so I’m looking forward to sharing with you all and learning from the other panelists.
Mike Pestana: My name is Mike Pestana. I’m an attorney at Wilson Sonsini. I handle startups, private companies, and do a number of secondary transactions. I’m looking forward to the conversation today.
Matt Heiman: I’m Matt Heiman. I’m one of the partners at Vetamer Capital. We’re a new investment firm that my co-founders and I started last year. We are what people call a crossover firm: We invest in both public market companies, as well as companies in the private market, and we do that at the intersection of financial services and technology. And we do that globally. We primarily do primary-round investments, but sometimes do secondary investments in partnership with our companies. We’ve invested in ten companies in the private market since we launched. One of those companies is Carta: We are both an investor in one of their primary rounds, as well as in a secondary round via being a beta customer on CartaX.
Jamin Agosti: My name is Jamin Agosti. I’m an associate at Cooley, in our San Francisco office. I help founders and companies do secondary transactions all the time. It’s honestly one of my favorite parts of my job, because it means getting value back to the people actually doing the work at the companies. It’s really cool to see. And it’s something that’s happening more and more often now, that we’ll talk about it in this presentation. But it’s cool to see it outside of the M&A and IPO scenario—it’s an exciting part of my job.
The rapid growth of the secondary market
Alex: Thank you all for being here with us today. We’re really looking forward to discussing the evolving private market landscape with you. As we’ve been witnessing over the last few years, there’s an unprecedented amount of capital flowing into private markets. As we dug into Carta’s Q3 State of Private Markets report, we found that a lot of the capital has actually been flowing into late-stage companies, as well.
Following that trend, we’ve also seen a massive growth in the number of liquidity programs executed on CartaX, and the dollars transacted. Almost as many programs were run on Carta in calendar Q3 of 2021 as in all of 2020. We believe this is indicative of both a growing need for liquidity programs in the private markets, and also indicative of the benefits of an integrated technology platform that reduces a lot of the burden on the company, participants, and investors who get those deals done.
In running so many of these programs, we wanted to highlight some of the themes that we’re hearing. These programs matter for companies as they try to retain top talent through compensation packages, and also as an opportunity to reprice the business to create value for existing shareholders. They also can be used as a way to diversify the investor pool as the company matures on that path towards being public. For investors, buying secondaries can help expand the universe of potential alpha-generating investment opportunities. The broad-based programs that we see help to aggregate supply, and also help investors strategically increase ownership of those portfolio companies and discover new opportunities to do more investments in the private market.
Now, that’s just what we’ve been hearing on the Carta side. We’re really lucky to have all our panelists here to share more about their experiences—that’s really the focus of what we’re here to talk about today. So let’s jump over to the panelists.
As we just talked about, 2021 has been a crazy year for private markets and secondaries, with unprecedented deal flow and incoming capital. I want to start with Mike, since you have so much visibility into a lot of different deals and can see both sides of the table. Can you talk a little bit about how you’re advising clients that are starting to think about private secondaries and liquidity? What are the main things that they need to think about?
Lessons from a year of surging liquidity
Mike: I agree that the market trend has been for increased secondary offerings for a variety of reasons. When clients come to us, it’s not always for the same purpose. Usually, the way we start is to understand why a company wants to have a secondary tender offer or liquidity event. It can be for a number of reasons: It can be to provide liquidity to all the stockholders, or it can be to provide liquidity to a subset of stockholders, which may result in two very different approaches to the transaction. We may be trying to get investors more ownership in connection with the financing—i.e., selling preferred stock—and not have enough in that round, so you want to sell some existing common shares to increase ownership. You could be potentially trying to remove people from the cap table who no longer want to be involved with the company, or who are involved in the general corporate restructuring. All these different reasons to approach a liquidity event will change the form of the transaction, how long it will take, and the tax and other procedural considerations that firms like ours really specialize in. We definitely see the increase in traditional tender offers—all stockholders getting a chance to get liquidity. But we also see an increase in these other sorts of restructuring-type transactions, too, as companies stay private for longer.
Alex: Super interesting perspective. Alyssa, pivoting over to you. You heard a lot about what Mike had to say about the different reasons that companies are putting these transactions together, or even just one-off investors. Can you share a little bit more about your experience with broad-based secondaries and how those came together.
Alyssa: Sure. There are a couple of different experiences that I’ve had in terms of how they’ve come together, based on different needs from employees or founders, as well as investor interest. Given all of the funding in the market, I would say a lot of rounds now are oversubscribed—so you’re getting a lot of investor interest in the company, but not always the ability to fulfill that with a primary round. One thing I’ve seen a lot with my peers and experienced personally is interest from current investors who have appetite for more capital in the company. But also, as you’re putting together primary rounds, there may be investors who want to be involved in the company but don’t have that opportunity. Those are different ways that I’ve seen investor participation come together.
As a CFO, I would say one challenge that I faced in one of the secondaries I was helping facilitate was allocations. I’ve had this come together a couple of different ways: once with just one secondary investor and one that had multiple investors who were involved in the secondary. In the latter scenario, it became a lot more complex than thinking about allocations, and really starting to think about the supply and demand elements. Investors may want a dedicated amount of capital that you really have to balance the supply on the sell side. Thinking a lot about that as you’re starting to put the entirety of the deal together can be a challenge for a CFO, and for managing all the different players. I would say it starts to get complex during the documentation process, as well, the more investors that you have participating.
And there’s one other element—just to share with the group from a CFO perspective—that can get complex during a transaction. Mike mentioned the tax implications, and that’s a topic that comes up a lot among myself and my peers. It’s really thinking through the tax implications for the employees. And not just the employees, but how that trickles out to the company, as well. You’ve got your lawyers. You’ve got your auditors. You’ve got your tax firms, and maybe some consultants. So really starting those conversations as early as possible, to get ahead of any potential tax implications before you get too far down the cycle of pulling the secondary together—I learned that was really helpful, as well.
Alex: Yeah, the piece on the tax is something I hear a lot in working with the companies doing these with Carta—finding that balance between making sure that the programs are there for the employees, first and foremost, for those transactions where the goal is employee-oriented. And also, ensuring that the whole transaction doesn’t look like a compensation event. Can you actually elaborate a little bit more on those tradeoffs that you considered, and anything for the audience that might be able to speak to the two outcomes for employees?
Alyssa: Maybe I need my legal disclosure, as well. I’m definitely not a tax advisor. We worked really closely with our legal team, and we had a great advisor on the tax side. As you mentioned, really thinking through what the triggers might be for the transaction to be compensatory to employees. One thing we were talking about as a group earlier was QSBS. That’s one big advantage to founders and early employees, and you can inadvertently blow QSBS for those employees and have an unintended negative outcome. It’s not always easy at the company to interpret the tax code and understand what the implications might be. But there’s a host of criteria that could potentially lead the transaction to be deemed compensatory for the employees. And then, if it’s compensatory for the employees, the company would owe employer tax on that, as well. So it has a substantial impact on the company.
So I would say, understand what all those levers are, and how to think about them, by partnering very closely with your legal team and getting in front of it with a tax advisor—because it’s not black and white, it’s not a yes-or-no checkmark on whether it’s compensatory. Really work with your advisors and service providers to get ahead of that early, so you don’t have an unintended tax consequence to your employees and founders.
Why companies are pursuing secondary liquidity
Alex: Thank you for all that color. Again, it’s something that we hear a lot and talk through a lot. But at the end of the day, just to summarize what you said, it’s really important to work with your tax advisors, your lawyers, and everyone involved in the deal—because there’s so many levers and no real answer there.
Switching gears over to the investor side of the house: Matt, can you share a little bit more about how you’re partnering with companies to do secondaries, and some of the objectives that you’re working with your portfolio companies on?
Matt: What’s important and what’s kind of consistent across all of our investments is that we’re always working with the the founders, the management team, and the company, to help them accomplish their goal and their business objective. Sometimes, and probably the preponderance of times, that goal is primary capital for growth for marketing spend or employee cash compensation—things like that. But other times it’s secondary capital, which is essentially to reward and continue motivating the employees. Increasingly, we’re finding that rounds and transactions involve a combination of both. So usually, when we invest in secondary, it’s in conjunction with investing in primary.
And we think it’s great. That chart, Alex, that you showed, showing the increased liquidity programs this year—it’s good for the ecosystem. Why should it be the case that for the first five or even ten years of a company’s life there’s no liquidity at all for anyone? And then all of a sudden the company goes public, and there’s infinite liquidity. Why should the state of the world be so binary? We think liquidity programs are generally good for the ecosystem: They’re good for the employees, to be able to fund their lives and continue to go along with the company; and good for investors, because there’s more supply of stock, which can allow one to increase ownership of the company. Of course, when there’s more supply of stock, that also serves as somewhat of a throttle on valuation. Then for the company, we think it’s good as well, because they get to continue to shape their shareholder base and motivate their employees.
Alex: Really good comment there on the employee side, as well. Like Alyssa mentioned, she’s been a part of putting together many of these over the last few years. Being at Carta for the last few years, I’ve seen the impact on Carta’s employee base and morale there. But I want to ask a follow-up question. As you’ve been doing these investments in secondaries and primaries, can you talk a little bit more about how technology has evolved to help execute these deals for you?
Matt: Overall, “not much” is the punchline. Certainly, there’s 10 or more technology/data/workflow software around our research process, but relatively little around the operational process of finding these opportunities and closing these opportunities. Neither has it evolved much for primary investments in that regard—which is why I think we were excited to be a part of CartaX. In particular, the experience of transacting and closing in a single instant was quite powerful. It avoided a lot of the back and forth, the legal costs and complexity that might be involved on the investor side—for either primary or secondary transactions, for that matter. My understanding is that even on other kinds of secondary platforms that exist, that kind of closing process still exists—so Carta and CartaX are pretty unique in that regard, because they are essentially the source of truth, the record keeper for the stock. They’re able to do that, which was a very nice and efficient experience for us.
Balancing employee supply and shareholder demand
Alex: Back to Alyssa on the company side. As you went through your transactions, you mentioned that part of it was around the employees and the shareholders, and part of it was around kind of balancing that investor (demand). Can you talk a little bit more about how the transactions you’ve done have resonated with the employees and shareholders, and how you thought through participation and that balance there?
Alyssa: Yeah, absolutely. I’ve done this a couple of different ways in different transactions. I would say one typical structure that I’ve seen is having some sort of tenure requirement for employees. I’ve found it fairly common that you would require a certain number of years of service for employees to be eligible to participate. That helps a little bit with managing that allocation process that I was describing earlier. I think that can be very successful. But what I would say is most recently, we thought about this quite differently. We most recently opened up the secondary to the entire company, and that was really successful for us. Number one, just from an employee morale and excitement perspective, it means being able to tell employees that we were opening this up to everyone, and not just a benefit based on tenure. The tenure piece sorts itself out, because it’s typically based on a percentage of vested shares. You can still get some of your early employees some liquidity engagement around the process, and the company is not only allowing the transaction to happen, but helping to facilitate the transaction. Personally, and at the company, I’ve found that to be pretty successful. It’s potentially a little bit harder to manage on the allocation side, but worth it. Especially as the company gets a lot bigger, it’s a lot harder to manage only a subset of the company being allowed to participate. And trying to message just a subset of people with, “Hey, you’re allowed” or, “You’re eligible to do this thing, but there’s this other group that isn’t.” I think platforms like CartaX help the facilitation across the board. If you can manage on the allocation side to open it up to the entire company, we felt like that was a great opportunity for the whole company. It also gave us the ability to do employee education on options, liquidity, etc. across the board, across the company, and to talk about it in a more holistic way. I think that was a big benefit of having the program company-wide.
Just one quick thing to add on to Matt’s comments about Carta facilitating on the investor side: We leveraged Carta on the company side for our transactions, and it was a really seamless process given that our cap table is already set up in Carta. I would say from an employee experience and a company administrator experience and perspective, it’s really great across the board. That was helpful as we rolled this out company-wide, as well: to have the platform support all of that.
Alex: Thanks for sharing that, Alyssa. We’ve loved partnering with you and a lot of companies on these transactions. Like Jamin mentioned earlier, it’s a really exciting time to see this value created for the people who are building the company and really doing the work. Jamin, seeing so many deals as you do, especially over the last few years, have you seen a shift in the secondary markets, in primary vs. secondary, from the pre-pandemic days to now?
Jamin: Yeah, absolutely. I think it’s just a reflection of the froth in the startup and VC market. You’re seeing a ton of demand. VCs out there are getting very competitive. You’re seeing a lot of founder-friendly terms. And as there’s more demand to invest in the startups, you’re seeing people get creative in how to do that. When you’re oversubscribed in a round and there’s not enough room to sell preferred, you’re going to go and look at how you can create that supply on the secondary side. We’ve seen these transactions ramp up in volume and in size since the pandemic times, especially with the froth in the market. So it’s really cool to see some of that value going to employees, as well.
There’s also a lot of things founders can do now to prepare themselves for when they’re in the situation where they’re looking at a primary financing and they’re looking at getting value to their employees from simple things—like not setting up roadblocks in your way to enable these transactions.
I don’t know, Alyssa, if this is something that you’ve experienced: Which investors do you need to consent? Do you have any debt facilities where you might have to go to a lender to get consent to do a transaction like this? If you’re early stage, not putting these roadblocks in your way—and if you’re later stage, starting to think about these and how you’re going to work with your existing stakeholders to make it easier for you to execute some of these transactions.
How liquidity objectives drive transaction structure
Alex: Jamin, in those deals that you’ve been working on, we talked a lot about the balance between the excess capital and also the employee incentive. When companies come to you and you’re advising them, have you seen any themes around that? Is one reason more common than the other? Or is it more the combination of all these factors driving the transaction structure?
Jamin: It’s definitely a combination. I think this is the future of where the industry is going: People are going to be looking at using these features as employee incentives. We’re seeing not only more companies do these types of transactions, but more companies do these transactions more often. Whereas a company might only do one of these in their lifetime pre-IPO, you’re seeing more companies do them two or three times pre-IPO. I think that’s a function of valuation; it’s a function of the money in the VC industry; and it’s a function of companies staying private longer.
Alex: I’ve got a question for everyone here that I think will really help the audience. We can start with Matt. The question is, after going through the first secondary transaction you’ve done or some of the earlier transactions that you led, what surprised you about the process? What did you learn?
Matt: I might just say that not all secondaries are created equal. When we talk about secondaries or the market for secondaries, we’re describing a lot of different sub-markets and types of transactions, ranging from brokers on one end to anonymous forward contracts and things of that nature, with individual employees around the company, to a fully-sanctioned company secondary that’s closely tied to a primary transaction and helps the business accomplish one of its goals, which is kind of where we participate. So I would just say, as you think about the market for secondaries, realize that there are really several different markets that operate in very different ways.
Alex: Jamin, what about you?
Jamin: First off, these are complex transactions. As Alyssa mentioned, these are complex transactions for both legal and tax, and for companies to implement. So there is always friction. There’s always the transaction costs, the legal fees, the platform fees—all the things that go into making this happen. One of the coolest things that I’ve noticed recently is that these transaction costs are absolutely decreasing. As there’s more repetitive tenders, companies, both on the HR and tax side and the legal side—are getting faster and quicker in doing these transactions in a way that’s more efficient for the company and for the employees. And the technology providers, whether it’s CartaX or others, are able to do this quicker and to do this for less cost.
For companies that are looking to implement these transactions, I would say the most interesting thing in the last year is that it’s getting easier and quicker to do, with the caveat that it’s still a complex transaction. There’s still a lot to do on the HR and tax side, but a secondary tender offer now, compared to two years ago, might be executed in half the time for half the legal costs.
Alex: Alyssa, any commentary or any learnings from your first transaction?
Alyssa: I think I can probably take up the entire hour on learnings that I took from the first transaction. I think we hit on several of them, but there’s a couple additional things I would add. I talked about the tax implications on employees and then potentially on the payroll tax side for the company. Another thing to think about is you’ll likely have audit implications with your auditors, and that may be totally different than the outcome or the conclusion that you came to on the individual tax side. That’s something to consider.
I think someone said these are becoming more frequent for companies. Think about talking to your valuation firm and your auditors to understand what the implications on your 409A might be. If you’re still quite a ways from IPO and you’re getting into a more regular cadence on doing these sorts of transactions, it could have a very material impact on your 409A. So understanding what those triggers are and planning ahead—really thinking about what your cadence and what your frequency might look like on these sorts of transactions and being really strategic about when you do them and why.
And then there’s things as simple as understanding the timing and the mechanics. The first time I was involved in this process, we were doing it over the month of December. There happened to be too many holidays in the month of December, and we couldn’t meet the 20 business day requirement. Just really dig deep with your legal team and your tax team ahead of trying to kick this off and understand things, so you can set expectations with your investors, with your internal management team, etc. As others have mentioned, it’s very complex, and they’re all very different. Getting as much advice as early as possible from the experts that you’re engaged with, I think, is just super critical. There are blind spots and lots of complexity on this topic, even after you’ve done it multiple times.
Alex: Mike?
Mike: We’ve talked mostly about traditional secondary events so far. I think one thing that has evolved and continues to evolve is the use of debt to solve a lot of these tax problems. You’re seeing multiple funds and platforms using debt and loans to stockholders to extend holding periods, to defer tax gains, to sort of bring the value forward for a lot of these transactions. I think it’s good to think about this early on, because as everyone’s mentioning, the tax considerations are just huge in these transactions. If you’re selling preferred stock and using that to fund the repurchase of common stock, you may be looking at a compensatory event for certain employees who are holding that stock. On the flip side, if you’re using direct purchases of common stock and then flipping into preferred stock, it’s a whole different set of tax considerations. It is important early on to understand the approach you’re going to take on the tax side and whether it makes sense to do a traditional tender offer, whether this is going to be a small-scale repurchase of stock by the company, or whether maybe a third-party firm is going to be involved, offering debt to stockholders in exchange for the pledge of shares. There’s a lot of different ways to set this up. And from what I’ve seen from my first transaction to now, the complexity of the use of debt has really accelerated. I think that’s going to continue in the future.
Alex: That’s a really good comment on the debt. We’ve also been seeing a lot of that, especially around using debt, either recourse or non-recourse, to facilitate the exercise of those options for employees, and cover a lot of tax costs for those who may have a high tax burden with that exercise.
That kind of leads me into a question from the audience: Have you seen any other secondary liquidity deal structures for early employees who are looking to plan ahead around the taxes for an exit that’s two to three years away? Is it primarily those stock-based loans for exercise or are there other things you all have seen?
Mike: Certainly for me at least, stock-based loans are the most common mechanism used to extend your holding period for QSBS and for long-term capital gains purposes. There are other ways to set things up. I think it was mentioned earlier about setting up your corporate structure to allow for these types of transactions. There’s kind of two sides to that. One, maybe you want to facilitate these transactions and make them much easier in the future. On the other hand, whether you want to control these transactions and leave them up either to board control or stockholder vote. So thinking about it early on is good, because you could be inadvertently creating a private market for your shares when you didn’t intend for that to happen. If you do intend for that to happen, I think it’s good to consider it up front, too. A lot of this stuff is really buried in the bylaws and the charters of companies. So getting attorneys and tax counsel involved early on is helpful.
Educating employees about equity
Alex: Going to another question from the audience—and I think this one’s probably going to be more geared towards Alyssa. We talked about education earlier. What are you seeing in terms of education programs for employees? How are you running those for them, or partnering to run them?
Alyssa: I had done it a couple of different ways. First, without having internal counsel, we leveraged external counsel to come in and do an education session, not just on the transaction itself, but much more holistically around understanding options, understanding liquidity, understanding some of the longer term implications, etc.
I think, number one, outside of a transaction, doing that ongoing education on a regular basis and setting a foundation for your employees is really important. And then typically—again, this totally depends on the structure of the transaction—but typically the window that these are open is around four weeks. So what we thought was successful was letting the eligible folks pore through the documents, explore what was provided to them, and then setting up an education session a week and a half into the process. People had a chance to digest a little bit before that education session. And then having external counsel—or if you have it, internal counsel—in partnership with the finance team, come in and do an education session for the employees. And then obviously, encouraging people consistently to talk to their personal tax advisors—that’s always key. You’re not giving folks tax advice since it is so nuanced. I would say, a combination of internal teams, if you have them, or leveraging support from external counsel to do those education sessions throughout the process. And then having an open forum or an open line for your employees to ask questions either to your attorneys or, in some cases, you may have tax advisory. So providing just as much education as possible, and giving resources to your employees—but also making sure that they understand that their situation is unique, and they need to speak to their own personal advisors, as well.
Alex: That piece about general education vs. personal is a really common theme that I’ve seen in doing a lot of these. As a part of that, we’ve been seeing more and more companies—and a lot of it through partnership with Carta, as we’ve seen this need develop, either through partnership or directly—provide a one-to-one resource for a lot of employees via financial wellness programs, to talk to a CFP or CPA, and map out their individual situation, whether it be more complex tax issues like QSBS, AMT, and all these things that you can’t really solve for at a general level. They’re partnering to provide that one-to-one resource. I’m seeing that it’s more common this last year, than it was two or three years ago.
Jamin: I think what Alyssa is talking about is absolutely one of the biggest hidden benefits of running a program like this. This kind of educational opportunity for employees is huge. Learning about this at a time when it actually matters personally to them, not just in a vacuum like, “Go Google ISO/NSO”—that kind of thing. It’s a huge benefit, both for the instant transaction and for employees in the startup ecosystem as they switch from company to company, or as they stay with your company, looking at different types of equity and what the tax consequences are in different types of transactions. Huge benefit. And absolutely, your outside counsel who’s helping you with the transaction should be able to come in, likely with one of their compensation and benefits experts, to give a presentation on what this transaction looks like, and then just generally how different types of equity are treated. There’s also the option to bring in someone to give generalized tax advice, like a banker or tax advisor, to do the same thing. Personally, I think it’s one of the biggest benefits for the employees, as well.
When should companies pursue secondary liquidity?
Alex: Another question from the audience here. When does it make sense to do these transactions? Is it Series B? Is it Series E? Is it a year before IPO? When are you seeing companies doing this, and what are some of the tradeoffs as to why companies don’t do it earlier or don’t do it later?
Jamin: I think we’re going to see more companies doing this earlier, as valuations increase faster in earlier rounds. I think I saw a stat that said in 2017, the average valuation for a company doing a tender was about $1.4 billion. I think we’re going to see that number go down as these transactions continue to get more common and happen more often.
I think it’s just going to become part of the ecosystem in the same way that companies are looking at ways to provide more employee benefits, like looking at extending post-termination exercise periods—or other equity perks to employees as a retention and incentive. I think we’re going to see more companies do these earlier. Again, it’s also a function of demand. And as Matt will tell you, it depends on who’s looking to come onto your cap table. Third-party, company-sponsored tender offers are almost always done in connection with a financing where there’s an oversubscribed round and investors are looking for more supply.
Alyssa: I would say, though, for companies that are earlier stage that are thinking about doing this: Really think about the longer term, and understand what your rough timeline to an exit would be. Because again, there are pretty big implications on your 409A valuation that could have an impact on the strike price for which you’re issuing options, and that could potentially be less incentivizing for your new employees. I think there’s a big balance that you have to think about: What’s your longer-term liquidity strategy for employees? Make sure that you can balance all of that.
I think—and I’ll let some of the legal folks correct me on this one—but what I’ve heard is basically a three strikes rule. You’ve kind of got three shots at a secondary before it really impacts your 409A valuation. So if you start doing these at Series B and you intend to stay private for a long period of time, you may get in a situation where it impacts your strike price and the way that you’re incentivizing are compensating employees as they come on board. And then you may get in a situation where you have to think about RSUs earlier than you’ve anticipated, and that sort of thing. Really, you have to think about the entire comprehensive program and strategy over the longer term.
Recent trends in secondary transactions
Alex: That 409A topic continues to come up. Frequency is a big driver, and how that’s weighted in the analysis along with other pieces in the full fact pattern of the deal and with primary, without. But yeah, rule of thumb: The more of these you do, it can really drive that compression from the difference in the 409A and what the preferred was.
Matt, we have a question from the audience for you. I’m wondering if you can speak about any trends in the size of secondary, and why investors start to blink, so to speak.
Matt: What do you mean by blink?
Alex: I’m interpreting this as, is there a certain size that just feels like too much to do in secondary that’s not primary? If you start to see secondaries, is it $100 million? Is it $50 million? Is it $200 million?
Matt: It depends on the context of the company. There are certain companies at a given valuation and transaction size for which $100 million would be very, very large. But there’s also companies for which it wouldn’t, where it represents a really small portion. You can imagine if Stripe organized a secondary today and sold $100 million, I don’t think folks would bat an eye at that. I think it really depends on how much secondary there is in relation to the total ownership of the sellers. You probably don’t want to see senior employees cashing out the majority of their ownership, but short of that we understand. We don’t really worry too much about some secondary on the way. In some cases, there are companies for which this is rare, but there are companies for which they’re actually very profitable already. As a result, they really don’t have any need for primary capital, and so they do secondary both as kind of a midway point to give employees some liquidity, and also as the only way to bring in new investors, because they just don’t have appetite to take more primary capital when they don’t need it at all, and don’t want that to bring that dilution on all the existing shareholders.
Alex: On that topic of signaling with founders or executives, sharing a big piece—this is really for anyone here—in board conversations around doing the secondary, is there anything that as a company, or while advising a company, that folks should be aware of when talking about doing a secondary with their board?
Mike: If you have a secondary where, for example, you have just the CEO have his shares repurchased or something, it’s very limited. And that CEO is also on the board, so you’re going to have a conflicted or interested party transaction. There’s a number of ways to solve for that. It depends on how you structure your board and how the parties are related. Essentially, what you’re trying to get to is a disinterested vote, and you may even in some scenarios, think about creating a committee of the board to discuss this. You may already have one: You may already have a compensation committee of the board that’s going to discuss executive comp, and it’s in their purview. So I think what you’re trying to get to is a disinterested vote of the board. If you can’t get that, you may even be thinking about putting it to your stockholders, which may be required by your charter. If you have outside VC, ordinary kind of investors, there’s probably a provision in your charter that says you need to get a stockholder vote if you do this kind of redemption—if it’s a company-led redemption as opposed to a third-party purchase of the CEO stock. Even in the case of a third-party CEO purchase of stock, you maybe have a right of first refusal—the stock needs to be waived by the company. But to the exact question: you know, with the sole executive scenario, who is also on the board, you will be worried about getting the right disinterested vote to approve it from a fiduciary duty perspective. When you expand beyond that to a general tender offer to all the stockholders, depending on what your stockholders look like, you may be far less worried about an executive participating if they just so happened to be a common stockholder among a hundred other stockholders.
Jamin: To add to that—because it touches on what Matt talked about, as well—is looking at eligibility criteria. Who’s eligible, and how much they can sell? On the demand side, investors aren’t going to want to see everyone eligible selling 80% of their vested equity. They’re going to want to see some incentive retained. Generally what I’ve seen—and Mike, please let me know if you’ve seen different—is somewhere between 15% – 25% of vested equity is what eligible holders are allowed to sell. Sometimes you’ll see smaller percentages for founders and for folks who hold a lot of equity. As Alyssa mentioned right at the top, coming in and thinking about what’s supply, what’s the demand, how are you managing the groups of people that are eligible, and then the quantum that they’re eligible to sell—it’s super important.
Understand your company’s bylaws
Alex: Do you see a lot of consideration around priority of who can sell? Once you get past the balancing on tax, who’s getting that liquidity first? Is it the founders and employees? Or some early investors? Or does it depend on the company and their objectives? And can any of you comment on how you’ve seen that done?
Alyssa: I’ll just speak from my personal experience. I haven’t seen this where early investor liquidity was a driver. In my experience, it’s all been around prioritization of founders and employees. And there are nuances to allowing participation of early investors—again, based on that supply and demand—but the experience that I’ve personally had has not been focused on earlier investor liquidity.
Alex: If the early investor needs liquidity or is looking for it, are they typically going to participate alongside employees? Or from the company’s perspective, are you going to allow them to go out and do a one-to-one outside of the company’s visibility?
Mike: I’ve seen this come up in a number of scenarios. You have the early stage angel investor who’s not in it for the long haul, for whatever reason. They want out earlier, even if it’s a third-party transaction, I think the company’s probably still going to be involved, to some extent. To your point, they probably, in most cases, don’t have a right of first refusal to block the sale—meaning the company would purchase the stock instead of a third party. They may, though. This is another reason to check your bylaws. You may have a block on transfers of all stock, and not just common stock, in your bylaws, which would include your investors and require a director approval for that sale. It splits in a lot of different ways. If a small investor wants out, a company has cash on hand, everyone agrees that a repurchase makes sense, and you have the cash to do it, then the company will often complete that transaction. If there is a heavy demand for the stock in the market, and they have a buyer—assuming the buyer is accessible to the company and someone they don’t object to having on their cap table—I’ve seen that go through, as well. To counter that point, most kinds of startup investors, early stage investors, are looking to stay in it for the long haul. So it’s not a transaction you see a lot of.
Alyssa: I think it’s been brought up a couple of times now—really understanding transfer restrictions in your bylaws. On the company side, it’s just really important to work with your legal teams to understand what’s allowed under your bylaws. As you get later stage, as the valuation of the company increases, there’s more noise around people trying to go sell in one-off situations. So understanding what’s allowed in your bylaws and having a comprehensive plan on hand of how you’re going to treat those one-off requests as they come in outside of a structured secondary like this—it’s really important for the company to understand. I know it’s a little bit of a separate topic, but I think it’s great that it’s been brought up. As you do these sorts of transactions, it sets a signal for a value for those shares and spins up a little bit of noise for folks who are looking to get additional liquidity outside of these transactions.
Alex: So, looking at the clock, we’ve got about five minutes left. So as closing words, are there any last comments from each of you—words of wisdom, so to speak—or any final comments you want to share with the folks in attendance? Maybe we can start with Mike.
Mike: Sure. I think the most important thing is talking to your tax advisors. That’s going to drive so much of your decisions around secondaries. So get them involved early. If you need an individual tax advisor outside of the company’s tax advisor, get one. It is definitely worth the money.
Alex: Alyssa?
Alyssa: I’ll just echo that. I think I’ve driven up all the legal teams and tax advisor fees during this call, but I can’t stress enough that you’re overcommunicating with all of your advisors, whether it be legal, whether it be tax, your valuation firm, your auditors, etc—just making sure that you have clarity and understanding of the implications all across different functions for the company and for your employees.
Alex: Jamin?
Jamin: I completely agree with what’s been said so far. There’s a lot of factors that are going to be driving eligibility: who’s eligible to participate, the types of equity you have, geography, tax, and being able to square that with your employees—like having a really good internal communications plan for how you’re going out to your employees describing who’s eligible and describing the program—it’s super important. This is a huge employee incentive, and you don’t want this to come off as a negative thing if there are folks who aren’t eligible to participate for some reason. Making sure that your eligibility criteria aligns with your internal communications plan is super important.
Matt: I have nothing to add, really. I’ve learned a lot on this call about the legal and company side of the transaction. I might just say for companies out there, if you’re in the fortunate enough position to have a lot of parties that want to invest in your company, consider secondaries organized through CartaX or another platform as another tool in your toolkit, as way to do that while also accomplishing your goals for your employees.
Alex: Based on what I’ve heard here and a lot of the transactions that I’ve personally worked on, I think a really important thing is getting started early. We’ve talked about how complicated these transactions can be from tax to eligibility. It’s important to start those conversations earlier with all the partners involved: your tax advisors, your attorneys and, of course, Carta as a platform, since we see so many of these and want to make sure we’re talking through a lot of those considerations and planning appropriately.
To close, I just want to thank all of you for participating and sharing your wisdom and experience with the audience. I also want to thank everyone who took time out of a busy end-of-year schedule to come and learn about secondaries.
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