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

8/18/11Follow @wroush

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keep their shareholder count under the threshold. SecondMarket says it’s working with members of Congress to introduce a bill that would rewrite SEC rules by raising the shareholder limit from 500 to 1,000, while at the same time exempting employees and accredited investors from the count. SecondMarket founder Barry Silbert has testified in Congress on the proposal, which the company portrays as a way for companies themselves to access additional capital without having to go to the public markets.

Then there’s the “409A” problem. That’s the section of the IRS tax code that deals with deferred compensation, including stock options. Among other things, section 409A requires startups to set an exercise price for stock options that’s no lower than the fair market value of the company’s underlying common stock at the time of the option grant. Companies often determine fair market value by hiring outside appraisers—and as secondary trading becomes more common and more efficient, it’s likely that appraisers will consider the prices that shares are fetching on secondary markets as one guidepost to the fair market value.

Here’s the real hitch: if shares are trading at a premium on SecondMarket or SharesPost—because of high demand from buyers, say—it could push up the perceived fair market value of a company’s common stock. The higher exercise prices go, the smaller the likely spread between the exercise price and the market price when employees finally cash in their options—and the less a company’s options are worth as an incentive. So in a perverse way, efforts by SecondMarket and SharesPost to give some employees more liquidity could actually end up reducing the overall value of options programs.

It’s just one more of the issues that SecondMarket will have to address if it hopes to bring more companies into its ecosystem. But that’s often the position that disruptors find themselves in: having to explain to potential customers that disruption is inevitable, and that it won’t be so bad if they just buy in. “We are helping these private companies control a phenomenon that is occurring anyway, and that is ultimately what we think our biggest value proposition is—we are helping to facilitate it in a much more orderly way,” Thomas says. “The simple fact of the matter is that companies need some solution to keep their employees engaged, or they are going to go off to greener pastures.”

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

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