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 reward employees and feeding the avarice of both sellers and buyers of private stock. This is partly for reasons of SecondMarket’s own making. For the first couple of years after it started facilitating private trades in 2008, it worked directly with shareholders—mainly ex-Facebookers at first, then others—without necessarily getting approval from the companies that issued the shares. The idea of losing control over who owns their shares doesn’t sit well with most startups, so some companies, such as Zynga, began blocking sales on SecondMarket. (Most options grants give the issuer the right of first refusal or ROFR when an employee wants to sell shares; companies can also deter sales by imposing big fees.)

But lately, SecondMarket has changed its approach. Despite increasing demand from both sellers and buyers—the company completed $100 million in private company stock transactions in 2009 and $400 million in 2010—SecondMarket now says it thinks of stock issuers, the startups themselves, as its core clients. It says it wants to help them set up systems that let employees cash in pre-IPO shares in an orderly way. It calls these systems “controlled liquidity programs.”

“If there is one thing that people don’t understand about SecondMarket, it’s this transition from working on behalf of shareholders to working on behalf of companies,” says Jeff Thomas, a senior vice president who leads business development for SecondMarket’s Private Company Market division in San Francisco. “It’s a strategic decision we’ve made, that for our long-term business model to work we need to work with the issuers to solve a couple of different problems.”

To understand those problems and the solutions SecondMarket is offering, it helps to look first at the history of the company, which started out under the name Restricted Stock Partners. Barry Silbert founded the firm in 2004 after working in the restructuring practice at investment bank Houlihan Lokey, where he had helped to sell off the assets of bankrupt or distressed companies like Enron and US Airways. “Through that experience he decided he wanted to create an online exchange for all of the world’s illiquid assets—anything that wasn’t already traded on an exchange,” says Thomas. “The concept was to match buyers and sellers by running auctions, setting a price, and handling settlements, but in an automated and scalable way.”

The company started off selling restricted stock in public companies (hence its name) and did well enough to attract venture funding from firms like New York’s FirstMark Capital. But its first big break came during the financial downturn in 2008. The company realized it could use its technology to facilitate trades of collateralized debt obligations, or CDOs—the notorious asset class, made of rolled-up mortgages, student loans, and other fixed-income instruments, whose collapse fueled much of the banking crisis. Little information was available about exactly which assets were rolled into most CDOs, so owners were having trouble unloading them. “We stepped into the market to match buyers and sellers,” says Thomas. “A lot of the assets were high quality, but the owners needed liquidity, so they were willing to take a discount. We got a ton of press for that in 2008 and 2009. We were the only financial services company growing through the downturn. That success really allowed us to launch all of our other markets.” The company, which changed its name to SecondMarket in 2008, now trades nine different asset classes including bankruptcy claims, limited-partner interest in private equity funds, and private company stock.

But it wasn’t SecondMarket’s idea to start trading in private company stock. That chain of events started in 2007, when Microsoft invested $240 million in Facebook in a deal that valued the social networking company at $7.5 billion. The deal got some ex-Facebookers thinking more concretely about the value of their own stock, and some of them approached Silbert’s firm. “They said, ‘We see you make a market in restricted stock in public companies. We hold some restricted stock in a private company. Can you help?’” says Thomas. “That motivated us to go out and talk to clients on the buy side, and we found that there was demand.” In 2008, SecondMarket got about $20 million in such deals done. The company profits by taking a commission of up to 5 percent, split between buyer and seller. (See this excellent article by Bloomberg BusinessWeek writer Brad Stone for more background on the company.)

Thomas says that when SecondMarket researchers stepped back to try to understand the supply-and-demand equation for private company stock, they found a world that had changed drastically since the go-go 1990s, when the mean time between a startup’s first venture financing and its public offering was three to four years. It’s not just the economic downturn that has put a damper on IPOs. There have also been important structural changes in the public markets, from the decimalization of trading prices on the major exchanges (all but eliminating the bid-ask spreads that once made it so profitable for investment banks to sponsor public offerings) to the post-Enron Sarbanes-Oxley legislation, which made financial reporting more complicated and costly for public companies. “The net effect of all of these changes is that fewer companies are able to go public, and fewer want to go public,” says Thomas. “That is what motivated us to get into this market. There are literally thousands of venture-backed startups with no good alternative to provide liquidity to their shareholders besides an IPO, which can take a decade, or a sale.”

At the same time, there are plenty of buyers, from private individuals to big investment banks like Goldman Sachs and JPMorgan, who’d love to own shares in hot pre-IPO companies like Facebook and Twitter. At SecondMarket’s site, members can express an interest in buying or selling such shares, even if SecondMarket isn’t yet handling trades in the company’s stock. By gathering information in this way, says Thomas, “We were able to validate that for the top couple of dozen technology companies, there was an active market of buyers and sellers looking to transact. And even outside those top couple dozen, there’s a huge universe of companies where shareholders are looking for liquidity.” The 10 “most-watched” companies on SecondMarket in the second quarter of this year were Facebook, Twitter, Groupon, Zynga, Foursquare, Skype, Yelp, Dropbox, Gilt Groupe, and LivingSocial.

In the second quarter of this year, the company handled $112 million in private company stock trades. That was a drop compared to the $156 million in trades in the first quarter, thanks largely to SecondMarket’s move toward courting issuers rather than shareholders. But it’s still a big increase over the $51 million figure for the same quarter a year ago.

A Question of Control

Silicon Valley CEOs say privately that the emergence of secondary markets for employee shares is a growing and largely unwelcome distraction. Companies like Facebook and Groupon have taken some of the pressure off by arranging for outside investors to buy common stock from employees. In a deal sanctioned by Facebook, Digital Sky Technologies (DST), founded by Russian investor Yuri Milner, snapped up $100 million in employee shares in 2009. Groupon did something similar—a good portion of the $135 million it raised in 2010 from DST and Battery Ventures went straight into the pockets of founders, employees, and early investors. But not every company has one or two deep-pocketed backers willing to provide all the liquidity employees want.

David Sacks, the founder and CEO of three-year-old enterprise social networking startup Yammer and the former COO of PayPal, is one of the few Silicon Valley executives who will speak on the record about the issue of pre-IPO liquidity for employees. “I think there are circumstances under which it does make sense to let employees cash out,” Sacks says. “One instance where it make a lot of sense is when you have a choice between going for the home run, the IPO, or taking an acquisition offer. The VCs always want to go for the home run, but the employees tend to be more conservative because they have all their eggs in one basket. So allowing a partial cash-out is a mechanism to align incentives.”

But even in these cases, finding a single outside investor like DST is a better solution than letting employees trade at will, Sacks says. “Our view is that we want would to keep control over that process,” he says. “A company has to be very careful about how many shareholders it has and who they are. We don’t want random people becoming shareholders. Also, if you had a situation where employees are cashing out 100 percent of their stake, or even the majority of their stake, it would be very problematic. It would destroy incentives. So there are good arguments for allowing some of this type of stuff, but I do think it has to be reasonable.”

Interestingly, that’s the key point SecondMarket is trying to make these days—that it’s a reasonable partner. The company says it’s working with issuers to address their biggest concerns and to bring more order to the process of private stock sales.

For one thing, there’s the issue of disclosure and what Thomas calls “information asymmetry.” Private stock transactions obviously aren’t regulated in the same way as those on the public markets; pre-IPO companies don’t have to file 10-Ks or any of the other SEC paperwork that makes going public such a hassle. But individuals must be “accredited” to take part in secondary trading—meaning they must have a net worth above $1 million and an income above $200,000 a year—and the assumption is that these buyers are sophisticated enough to know what risks they’re taking. Still, the more light companies can shed on their financial prospects, the better decisions potential investors can make. To help with that, Thomas says SecondMarket can set up private online “data rooms” where companies can share selected information. For example, they might share overall financials, but not detailed breakdowns of revenue streams.

Along with these data rooms, SecondMarket says it can regulate access to the online marketplaces for each company’s shares, allowing issuers to control who sees their data and who might end up owning shares. “There is a commonly held misperception that if you allow trades in the secondary markets, all your private financial data will be broadcast to everybody,” says Thomas. “But by controlling who is let in on the buy side you are controlling who has the ability to see that information.”

The company can also work with issuers to meter private trades by setting up liquidity schedules similar to vesting schedules—for example, employees might be told that they can sell up to 25 percent of their stock each year. Finally, SecondMarket says it can work with issuers to set up temporary “market windows” so that secondary trading happens only during a defined time every quarter or every year. “Companies aren’t looking for a 24/7 or even a 9:30 to 4:00 market experience,” Thomas says. “By centralizing to market windows, it’s much easier for them to deal with the question of information disclosure.”

Thomas says that SecondMarket is so committed to building a system that makes secondary trading less threatening for issuers that it’s willing to scale back its whole private market operation until it can get more companies on board. “We are walking away from a short-term revenue opportunity around a handful of companies that would be very actively traded if we hadn’t made the transition,” he says. “But what we are trying to do is develop a new market structure that works for private companies.”

Privately, however, CEOs still say they’re worried that secondary trading is causing problems for which SecondMarket doesn’t yet have workarounds. One is that private trading can push actively traded startups closer to the so-called 500 shareholder limit. Under SEC rules, companies with more than 500 shareholders must report their financial data as if they were public; avoiding that burden is one of the reasons companies like Facebook are so desperate to 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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