At our second CFO summit in NYC, we held a panel to discuss the intricacies of secondary markets. John Buttrick, a partner at USV gave insights from the investor side. Josh Auerbach from Digg was our resident CEO and our Head of Capital Markets, Stefan Fischer gave a finance perspective.
For more from the summit watch an address by Jack Sinclair of Stack Overflow and a speech by Kevin Weinman of Mohawk Group.
Lesson 1) It is often better as a company to support secondaries and disclose what information you can to potential new buyers as they are future owners in the company.
Lesson 2) Both LLCs and corporations that develop multiple share classes can become incredibly convoluted. It’s hard to understand waterfall scenarios and who gets paid when and therefore how to value each share. Try to avoid share class complexity whenever possible.
Lesson 3) Companies should always get involved in secondaries even when they don’t want to. It’s important for them to share information so new investors understand the value of the stocks they are buying. Also, in situations where options are being purchased, employees will have to purchase those options to then sell shares, which causes money to go in and out of the company. Sometimes a better solution can be found using promisary notes (this is an interesting situation in general).
Lesson 4) More and more companies are going beyond ROFR’s and giving themselves veto powers on any secondaries. In order to satisfy employee demand for liquidity in these situations they run regular secondaries on their own.
When should my company do a tender offer?
Tom Matta: At what point during the company’s lifecycle should management start considering secondary transactions?
John Buttrick: Companies are going public much later. Some companies aren’t going to go public, period, because they don’t need to because they’re profitable. They want to control their own destiny. They can get liquidity in the private markets. It just feels to me like, where they’ll always be periods where there’s more interest rather than less interests. Even now, while some of the big firms have pulled back a little bit, they haven’t stopped. I just think we’ve crossed a threshold where private liquidity and secondary is here to stay.
There’s still a little bit of an issue. The largest, what’s really ironic, is the largest private company today, Uber, has been the least interested in secondary markets. Which makes absolutely no sense to me. There are a lot of people that invest in Uber for a long time, working at Uber for a long time. There was a lot of pushback from employees in the last 18 months. There is now some liquidity but Travis’ original view was all money had to go into the company. There’s always that tension which I mentioned at the beginning. I think that’s the exception, not the rule.
In our experience, I’d say, almost of our companies, Series D and later is probably, without exception, I mean, I have to actually go thought the list, probably without exception, if there is an exception it would be certainly less than 10%, have done some kind of secondary liquidity. For employees who are certainly fully vested, often you have an arrangement, secondary liquidity when employees are leaving, as part of the exit package and also for early investors. Sometimes that’s driven by the old investors, sometimes it’s driven by the new investors.
The company doesn’t want to take too much dilution. They only want to issue primary for 20% max. We generally don’t recommend around that as more than 20% dilution, except in special circumstances. Secondary’s also give companies that want more ownership, because a lot of companies want ownership targets in the 15 to 20% range. They can often use secondary markets, either to early shareholders or employees who want to sell, either options or shares, that is a way to increase their ownership percentage.
Maybe I’ll talk for two seconds about an example of that. One of our companies, one of the companies we did the Series A in was Etsy. We invested in 2006 or something like that and there was a series … we lead the A and Accel lead the C round I forget who lead the B, but Accel lead a big, big C round. They bought secondary as part of that C-round because they wanted more ownership. They actually ended up having more ownership than USV at the end of the day.
Then in 2011, I think it was, Tiger Global was the big, big private equity/hedge fund wanted to invest Etsy and they could only work out a deal for Tiger, I think it was around 10% of the company. Tiger had an appetite for much more. Tiger basically functioned as, what I would call a mop-up buyer for the next three year. Every time an employee wanted to sell, they did a bunch of organized tender offers, then they did some more informal repurchases. Tiger, who had all the disclosure, they knew exactly what was going on in the company, we’ll talk about that issue, maybe in a bit, would just be available if they had million of dollars that they were interested in spending, in buying up secondary. That’s one of the models for secondary is to find an institution who has more appetite to own the company and is just willing to acquire more shares that become available.
Company Buy back or sell to an Investor?
Tom Matta: Stefan, how do you evaluate whether you want to have a company buy back a stock versus selling to new or existing customers?
Stefan Fischer: Yeah, I think John touched on it a little bit. I think ultimately it’s a strategic decision to a certain extent. Company buy backs, let’s start with that, maybe. I think, the company buying back stock that means the balance sheet that the company’s used to buy those stocks and that should really only happen if company has excess cash that they don’t know how to use or the company believes that they’re going to do a primary or just did a primary and just don’t want to involve the investors in a secondary. It really shouldn’t be done or only be done for smaller transactions for venture-backed companies is generally the rule there.
Let’s say employees leave and they do not want those employees who left have shares in the company so when the company can just do a buy back for all transaction and claim the cap table. As John said, the company’s really in charge of the cap table, which is one of the huge advantages of staying private because once you become public you give that control up, who your masters are because anyone can buy your shares. That’s a huge benefit of staying private, you can choose who you’re going to work with. You should not let go of that control and we can talk about later how that sometimes happens in private companies where you lose that control because the black market is basically taking over.
To come back to your question, whether to use or new existing investor, that’s really up to the company. As John mentioned, it’s a huge opportunity a lot of times to using a secondary to basically be able to bring in a strategic investor that otherwise wouldn’t be accommodated because you don’t necessarily want to dilute further when using a secondary transaction you’re bringing in your strategic and at the same time providing liquidity to employees and older investors who may no longer be the appropriate investor in the stage where the companies at now. So between new and existing it’s really the decision of the company.
One thing also to imagine that if you use an investor who is used to doing secondaries, there’s a lot of complexity that are involved in secondaries so there’s also a benefit of using a Tiger Global or someone else who done various secondary transactions before and is used to buying common stock or previously stock that is lower in there graph stack. and understands how to price that and understands how to deal with that transaction.
One thing that is important to know is, I know we have a lot of CFOs here … I actually am kind of curious, whose already done a secondary transaction in their current firm or a prior firm. Okay, relatively few.
Who’s thinking actively about doing a secondary transaction? Okay, great.
One thing, for those who are thinking about a secondary transaction, whether you do a company buy back or you use new or existing investors, to do that secondary transaction, you as a company will be involved in that transaction. That’s really important to know. You’re either going to set the price or the terms or you’re going to negotiate the terms on behalf of employees.
How do you find the Price?
Tom Matta: Can you comment a little bit about how to find market price and who’s involved in that process.
Josh Auerbach: Yeah, we’ve seen that a bunch of different ways, at different times, so I’ll give a few examples. Probably the easiest to start with are the few deals that I’ve seen where the market price was wrong but everyone was fine with it. Which is to say that, in a couple of the Betaworks companies and at the Betaworks studio level, we have bought back common from employees at the time that there was a new preferred financing round at the parent company and paid for common the same price that we were selling preferred for. It clearly was an off market transaction.
The company was buying back common or, in one instance, the new investor was buying common directly but we all agreed to ignore the difference between preferred and common. Obviously it works better if there’s not a huge preference stack on the company. Those deals have been fine. Obviously, the employees who are associated can feel good about that because they know that they are selling a share that’s clearly worth less than that price. The investors, as long as they are comfortable with the company, that works fine.
When it’s the investors bought it directly, in a couple of instances, the company bought common back and just issued a little bit more preferred but everyone was comfortable with the overall size of the round relative to the cap table of the company. That’s the easy case where everyone’s happy with the price that’s wrong.
The harder cases are where there’s a secondary transaction and the parties have to figure out, usually with very little information, what the fair price is. We certainly have this at Betaworks I’ve seen this personally. Probably the best example was in ’08, I think actually right after the USV round. Betaworks bought some Twitter common from a departed employee and that was a complicated transaction to negotiate. Betaworks sold some stake in Twitter, as did I, in the 2011-2012 time frame. You know, Twitter went public in November of 2013, so this was a couple years before it went public and the price discovery and price negotiation process around that was incredibly awkward because usually the buyers and some of us didn’t have much data and there was a lot of asking around Twitter, why does someone not want to be involved in the front part of that transaction, which was wise of them.
But it was mostly calling around and saying how I heard so and so was blamed to offer 15 dollars a share. Oh well that’s interesting I heard so and so was offering 19 dollars a share. And through that very oddly telephone process we got the prices that everyone felt good about. That price was steadily rising over 2010/2011/2012 year range for Twitter and I think everyone felt fine with it but it was messy and confusing.
Wisdom from a Finance Pro, Stefan Fischer
In terms of, you know, what excites me in the secondary market, it’s very clear to me that the public market is no longer a solution for liquidity. Generally, looking for investments for big pools of capitals and we’ve seen that over the last few years, shifting dramatically. Just looking at the number of companies that are public. I think if you take the last 20 years, it’s almost half now, in terms of numbers of companies that are public in the U.S. versus 20 years ago, that just shows you trend. I think there’s a huge opportunity to create new solution networks for private companies to address this problem of providing liquidity and providing access to attractive investments for private investors.
Also, a lot of employees have not exercised their options a lot of times so there are ISOs and there are also different types of options as well when you’re a CFO or not aware of this. So how do you treat that or how do you look for a solution? A lot of times you don’t want the employees to have to exercise their options and you have cash going into the company and then cash going back to the employee so you would want to do this cash-less. Which means in certain types of options you want to do an exchange first into a promissory note, which means you’re selling or exchanging the security to non sophisticated retail investor. But the complexity just goes on and on and I think if you’re not involved in this and you let a third party deal with all this, then it can create a real mess.
If you as a company start providing regular equity rather than regular secondary events then you can just tell the former employee “Look, we’re going to have an event coming up (whatever it is) I’m not dealing with any new transactions” and you can restrict the employee to not selling those shares and can have them wait until you do this company wide, which gives you control of bigger transactions. I think this is where market is moving or at least I see where this is moving where you have regular equity events where you can control who can have liquidity and see that the investors are buying those and then they can buy enough shares that is irrelevant for them.
Audience 1: I guess do you have any perspective on, maybe it’s not an employee, but its actual patterns to the company and, at what point is that actually appropriate, Because a lot of these companies might not. They probably have, but they have huge quantities of investors throwing money at them and they don’t know what to do with it. And they ask or they made a comment about it when there is excess money. Maybe it’s appropriate, but do you guys have any perspective on what is appropriate, what is not appropriate?
Josh Auerbach: So, my attitude on that is that, as an investor and as a co-founder in some instances, I always feel like, if employees are able to take a million dollars or two million dollars off the table in a Series B, I’m always very supportive of that if the company’s value has gone up a lot. Because, you’ve got people paying themselves 30,000 dollars a year for the last five years and they really want to buy an apartment or something like that. And, it is, I think, entirely appropriate for them to be able to take some money out of the rounds as long as they’re maintaining a pretty heavy stake in the company and as long as there’s room, I would be very supportive of that.
I would like to see it happen very early on before the company’s dead of demonstrative value, but there’s a time when it makes a lot of sense. And, you’ll find that I think you can keep a founder excited about the company and the founder’s family excited about the company for a longer period of time if they have enough money to buy an apartment or whatever it is, pay off their student loans, that kind of thing.
John Buttrick: Yeah, we’re generally supportive in these situations. I think the biggest issue is if the founder is able to sell some then what’s the opportunity for other employees to sell some. And, that’s a political issue and if it’s how much money is available, how it gets all split out, those are sort of questions. You know, I think it’s definitely happening more.
Stefan Fischer: And for a good reason. By the way, you don’t need to treat all employees equally. You can totally discriminate by employment tenure, you can say people working at the firm for five years, or certain seniority levels, or active employees versus former employees. So, there’s a lot of ways of actually granting liquidity, but not to everyone. Obviously you want … I mean, that’s an imbalancer and, as the CEO or founder, what I want is alignment. I want … the reason I’m giving them options and the reason founders have common stock is because we want alignment from an investment perspective. So, as long as that alignment is still there, hold that transaction, I think most people are really open-minded about it.
Audience 2: Quick question a tender or secondary offer for primary the employee shares. Any guide post on what the typical discount is for the last price round? I know you mentioned, your price is right at the last preferred round and everyone seems happy, but does it tend to 60 percent discount or 10 percent discount?
John Buttrick: Let’s ask Stefan, he’s more of the banker among us. I have a view but once you start
Stefan Fischer: This is an incredibly complex question because it really depends on how acquitted your cap structure is in place for that particular company. If you look at market prices today, it ranges from 40 to 50 percent discount at high end to no discount at low end. I think what’s really important to me is that there’s a mechanism to find that price. And what is really important there is from a regulatory stand point, so that you’re not running risks … because you’re negotiating on behalf of your employees usually management is involved in that negotiation and secondary transactions happen in conjunction with the primary transaction.
I loved buying common shares, because I felt like the graph structure was always overvalued. Because a lot of those companies, either they’re zeros or their successful, and a lot of them have debt on the balance sheet anyway. So, if something goes wrong, the graph structure’s usually not worth the discount that I get buying common shares.
John Buttrick: One rule of thumb, I would say, is that the discount declines as the valuation increases. Okay, so if you’re at a valuation of a hundred million dollars, you know, 20 to 30% is a pretty common, maybe even more, but something in that range. And if you’re at a billion or more, then it’s starts to get very close to zero at the end of the day. And, there are a couple ways to solve it and I’ll go back to Etsy for a second.
So, when Accel invested first, they bought primary because they couldn’t come to an agreement on the discount. The company wanted to do some secondary, and Accel and the company couldn’t agree with the employees on the discount. So, what happened is Accel. Let’s say, I forget exactly the number, but let’s say they invested fifty million dollars and forty of that was for operating and ten million of that was designated for an Etsy led secondary. Okay, so Accel got the benefit of the preference and, I don’t know what the share price was, but the secondary wasn’t the same price as the preferred, but it was done by the company. So, Accel did buy common so they didn’t have to say what the discount was.
When Tiger came in, it was at a much higher valuation. It was closer to a billion. And so, Tiger was very happy, basically, to have the same price as the preferred on a first share basis as the common. Because at that point, the preference stacked was, you know, less than 15 or 20% of the overall market cap of the company.
So, there are two very different ways to structure it. We did one, for example, we were investors in a company called Indeed, and it never really needed to raise money. It was profitable very quickly on an operating basis. We couldn’t agree so that then, there … They wanted to sell some secondary in the company and we couldn’t agree with them on a discount, so we just bought primary preferred. It was fifteen million dollars or something like that, and then the company ran a secondary at the same price.
We didn’t care what the price was, really, at that point, because we had our preference. It was sort of in a two-hundred million, two-hundred-fifty million valuation range. So, does that answer your question?
Audience 3: When your employees invested on exercise options, what do you guys find is the cleanest way to offer liquidity to those employees?
Stefan Fischer: So, usually the cleanest way to do it is what we call a cash-less exemption. So, you basically don’t have cash going back and forth. For that, it really depends on how the options are structured. And, generally with ISO options you usually need to do an exchange first, but it really depends on the fine print there. But it usually is possible to do in a way where you have basically employees receiving cash at the end of the day minus the exercise price. And, you as a company, may have to withhold taxes as well or, should withhold taxes that are adequate for that transaction.
One of the things that we basically have not talked about secondaries and why companies should actually be in favor of more secondaries as well, is precisely this. A lot more employees will exercise their stock if they know there is a way for them to actually get liquidity. The exercise price is a way for the company to get non- diluted financing, right, because that money goes straight to the company balance sheet. And so, in many ways, this is actually a way for raising money, non-dilutive money, because they’re providing leverage to the employees through the options. That’s one of the points that a lot of people forget. So, the company, at the end of the day, is walking away with more money after secondary transactions. Even just existing shares have traded.
Audience 4: Hi. What advice do you have on working with employees who are selling through online market places rather than company buybacks.
Stefan Fischer: I’ll let John answer that.
John Buttrick: Avoid it. Yeah, I mean, I think we’ve talked about that. I think that there’s a lot of appetite out there for sophisticated institutions to … for secondary, there are funds that are set up to do nothing, but this, and I think all of ECs, have done secondaries at this point. So, you know, the issue I have with most of these markets is the lack of transparency and the lack of information and so, I’m not a big fan of them, generally speaking. It’s much better to do it … have company control it at the end of the day. From my point of view, for lots of different reasons that I think we’ve discussed, but I’m happy to repeat if you want.