SecondMarket Attempts to Sell Startups on the Value of Letting Employees Trade Their Stock

8/18/11Follow @wroush

Startups usually relish disruption. For a Silicon Valley entrepreneur, there’s no brighter badge of honor than being able to say that your company reinvented a product category, sweeping away older competitors’ business models in the process.

But these days, many of the disruptors are being disrupted, as the traditional system of incentive-based stock options for startup employees comes under strain. Part of the turmoil is coming from within, in the form of employees and former employees who own options or stock and are itching to see some financial rewards, even if their companies haven’t yet achieved a traditional “exit” in the form of an acquisition or public offering. And part is coming from outside, in the form of businesses building new marketplaces where employees can turn their shares into cash.

The emergence of a so-called secondary market for employee shares is an increasingly vexing issue for many startup CEOs, who say it’s interfering with their ability to attract and retain talent. But by the time this is all over, these executives and their boards may well be forced to rethink the way they keep employees loyal, the way they govern stock ownership, or both. Today we’ll take a close look at one of the companies behind this change, New York-based broker-dealer SecondMarket.

The story starts with options, which are traditionally doled out to employees of early-stage companies as a form of deferred compensation. These options, which typically vest over the course of four years, are supposed to incentivize employees to stick around and work harder by dangling the prospect of a big payoff if the company eventually gets acquired or goes public. When options vest, it means employees have the right to buy a specified amount of stock, typically at a low price called the exercise price. The presumption is that they can make money once a company is sold or goes public by buying shares at the exercise price and immediately selling them at a higher market price. Employees who leave a company typically must exercise their vested options within 90 days or lose them.

Plenty of Microsofties, Googlers, Yahoos, and alums of other public technology companies have grown rich on their options—and the investments they pour back into the startup ecosystem are part of what makes Silicon Valley go around. But for companies that are still privately held, there’s a growing flaw in the system. Back in the 1990s, when incentive-based stock option packages became common, it was reasonable to expect that a company would achieve some kind of an exit—either an acquisition or IPO—within the four-year time frame, making the notional value of employees’ options very real. But over the last decade, that timeline has been stretched out dramatically, thanks to a myriad of factors that make going public far less attractive. So employees and alums of even extremely successful pre-IPO companies like Facebook, Twitter, Zynga, and Yelp are being asked to sit on their stock for much longer.

In classic entrepreneurial style, a few financial firms are now trying to relieve some of the pressure by connecting startup employees and alums with outsiders who’d like to buy their shares. Secondary markets are hardly a new invention: firms like San Francisco-based Industry Ventures have spent at least a decade in the business, typically offering limited partners in venture capital funds a way to cash out before the funds mature. But the idea that startup employees should also be able to sell their shares on the secondary markets is entirely a product of the Facebook era—and the two companies pushing the concept hardest are SecondMarket and its main competitor, San Bruno, CA-based SharesPost.

I’ve spent some time recently speaking with executives at SecondMarket and learning how their business works. There’s been a lot of fuss around the company in the tech and business media; it’s often been cast as a bull in a china shop, upsetting the mechanisms startups use to … Next Page »

Wade Roush is a contributing editor at Xconomy. Follow @wroush

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