The private capital markets continue to grow, both in terms of primary and also secondary transactions, including liquidity events for pre-IPO companies. How will new regulatory changes, including the JOBs Act, impact the development of the market? What online platforms are emerging that can help bring efficiency to the private placement marketplace and increase liquidity for private shares? And how does this all impact and improve equity compensation programs for private companies?
This webcast [transcript below] entitled “Private Company Trading Markets: The Latest” hosted by CorporateCounsel.net brings together industry leaders including Peter Williams, CEO of ACE Portal, Gregg Brogger, President of Nasdaq Private Markets, Annemarie Tierney General Counsel of SecondMarket and Dave Lynn, Partner of Morrison and Foerster to discuss their insights and these topics and provide their views on how the market will shape up.
Why Private Markets are so interesting today
With the continued growth of stock markets that allow for trading in pre-IPO companies, many are wondering how the federal securities laws can be complied with when trading on them. [For video interviews on aspects of compliance see here and here]. One of the most interest things going on – besides the liquidity aspect of all this and the related impact on equity compensation – is the emergence of new businesses building on top of the secondary trading markets. This is a fundamental shift in the world in which private companies operate, including their expectations of confidentiality. There are also endless technical issues beyond the obvious ones, including how these new markets affect the various definitions of “public trading market” used under tax and securities laws (280G, 409A, Reg S) and how this can impact private company valuations.
This Webinar discussion featured the following key market players:
- Peter Williams, CEO, ACE Portal
- Greg Brogger, President, NASDAQ Private Market
- Dave Lynn, Editor, TheCorporateCounsel.net and Partner, Morrison & Foerster LLP
- Annemarie Tierney, General Counsel, SecondMarket
Private Market Topics in this Webinar
- Current Private Capital Markets Environment Overview
- Legal Issues of Private Market Transactions
- Structuring Private Company Liquidity Programs
- Secondary Trading Policies for Pre-IPO Programs
- Record-Keeping Issues
- Company Policies on Secondary Trading
- Other Issues
- Securities Law Issues
- Technical Issues
- The Future of Capital Markets
Broc Romanek, Editor TheCorporateCounsel.net: Welcome to today’s program, “Private Company Trading Markets: The Latest.” It’s a bringdown of a program we did a few years ago. There have been a lot of developments in the area since then. I’m very excited about this program.
Let me go ahead and introduce our panel for this webcast. Greg Brogger is President of the Nasdaq Private Market – he’ll explain what that Market is. Dave Lynn is my co-editor of this site and a Partner of Morrison & Foerster. Annemarie Tierney was formerly with the NYSE; she’s now General Counsel at SecondMarket. And Peter Williams is the CEO of ACE Portal.
I’ll turn it over to Peter to kick us off with an overview of the current private capital markets environment.
Current State of Private Capital Markets
Peter Williams, CEO, ACE Portal: As Broc said, I wanted to give sort of a lay of the land. The private capital markets, as many people know, are actually going through a very transformative state right now, in large part due to some recent regulatory changes, primarily the JOBS Act. In particular, Title Two of the JOBS Act lifted the ban on general solicitation for private placements, and Title Five increased the maximum number of shareholders allowed in a private company fourfold, from 500 to 2,000.
The historic private company market infrastructure is not equipped to handle this market transformation. Historically, private offerings have been marketed over the telephone, typically via one or two individuals in the Capital Markets Group, and by one-to-one conversations. The number of investors in a private placement has typically been quite low.
At the same time, we’re seeing some trends in the public markets that are making it more costly and sometimes more difficult to be a public company. So companies are either electing to, or being forced to, stay private longer. As a result, this is becoming a much more important marketplace. We’re seeing a need for broader marketing campaigns, an expanding universe of market participants relative to what it’s been before, and heightened scrutiny around regulatory compliance.
I think we’ll see a lot of technology platforms being implemented. At the same time those are implemented, all participants will need to be particularly cautious around ensuring that compliance is met and regulatory oversight is maintained. I think we will see in some areas people proceeding with caution. Unfortunately, in other areas, people may be jumping the gun. We will probably see some bad actors over the next couple of years as well.
Size of the Private Capital Market
In terms of framing the size of the market, a lot of people don’t know that the U.S. private market – the new issue private market anyway – is larger than the new issue public market. We’re $900 billion per year. The secondary market is much smaller – I’ll get into that momentarily. The market is also growing at a 15% compound annual growth rate. So we see this as an increasingly important asset class relative to the public markets.
Here are some statistics. As part of the $900 billion annual market, there are over 30,000 Regulation D private offerings in the U.S. annually. About 45% of those are greater than $5 million. The average transaction size is approximately $30 million, but the median is about $1.5 million. So, there are obviously a lot of small transactions.
The secondary marketplace has been smaller as a result of limited liquidity, historically capping out in probably the $25 to $30 billion range. And a smaller portion of that would be the corporates; the larger portion is represented by the LP interests in alternative funds. If you look at the statistics, there are over 40,000 qualified institutional buyers in the U.S. and 3,000 family offices, but over 8,000,000 accredited investors.
There are currently 500,000 qualified purchasers, whom control $440 billion of alternative fund interests. When you compare that to the $25 billion in historic secondary market size, there is obviously a very large opportunity that increased as liquidity increased.
About 230,000 investors participated in Reg D offerings in 2012, but the average number of investors per transaction has been limited – about 13. There was very limited reach on marketing programs [because they were] done one-to-one. We anticipate that expanding. In terms of performance, Duke and Ohio State did a study of the performance of private investments relative to public over the period from 1984 to 2000. During that period, private investments earned 18% more than the S&P 500. There have been similar studies elsewhere.
Obviously there are tradeoffs between public and private investments. Investors need to consider whether they’re traders or investors and what their liquidity requirements are. You’ll never get the same liquidity in the private market as you will in the public markets. But if you’re looking at investing over a long horizon and liquidity isn’t critical, private investments can be an area you want to consider. Interested in allocating to alternatives? See this article and this one on allocation considerations].
Issuers considering public versus private have to consider the regulations, the cost of compliance, and the size of issuer. These are the kinds of things that go into their decisions.
Implications of the JOBS Act
We’ll get more into the JOBS Act later on. Just quickly in terms of background – as I mentioned earlier, Title Two, which lifted the ban on general solicitation, was really critical. Historically, agents or issuers were not allowed to reach out to any investors with whom they did not have a substantive preexisting relationship. So, while a lot of people refer to the term advertising or solicitation, and think that means the standard definition of advertising (billboards or letters), the traditional rule really meant that you couldn’t reach out to investors whom you didn’t know. With that ban lifted, you can still do transactions in a confidential manner, but you can avail yourselves of the safe harbor to ensure that you don’t run afoul of those rules.
The second JOBS Act issue that I mentioned was Title Five. The increase in the maximum number of private company shareholders from 500 to 2,000 is very significant. It should increase liquidity over time
Again, historically, the average number of investors in as private transaction has been 13. So a 500-shareholder maximum really wasn’t an issue for private companies unless they got larger, which we saw with Facebook and other companies. Going forward, I think you’ll see transactions being more broadly dispersed, and that increase in the shareholder limit will become important.
That was a very quick overview of the current landscape of the market, both primary and secondary.
Legal Issues of Private Market Transactions
David Lynn, Editor, TheCorporateCounsel.net and Partner, Morrison & Foerster: Great. We’ll turn it over to Annemarie to talk about some of the legal issues that come up in this space.
Annemarie Tierney, General Counsel, SecondMarket: For some background, SecondMarket has roles in both primary offerings and secondary offerings. I will talk about our role as I walk through the legal issues that we see as we do transactions in this space.
Peter is completely right – the impact of the JOBS Act cannot be underestimated. Peter noted the statistics on how many securities are offered under private placements versus the public offerings. I think that has been a historical trend that’s going to be even more pronounced as companies can choose to stay private longer.
We were pretty involved in the parts of the JOBS Act that Peter talked about – the general solicitation piece and the 2,000 shareholder piece. We were seeing private companies, including our own, being forced to consider going public because they had issued securities to a significant number of employees over time. Those employees had securities that vested, and as either RSUs or options were exercised, they became shareholders that counted towards the 500 number.
And companies are deciding to stay private longer. According to the last statistics I saw, about ten years ago a successful private company would take four to six years to go public. The numbers now are more like 10 to 12 years. So, as you are growing and hiring more employees, you start to have a significant number of shareholders who can’t get liquidity for their securities.
When we started in the secondary space in 2007, we were focused on providing liquidity for well-known tech companies. We did a big market in Facebook shares and some other well-known private companies. At that point, Facebook was not that concerned about secondary trading in their shares, because they were preparing to go public. So they weren’t really trying to limit secondary transactions. Secondary transactions are what really impact private companies.
The shareholder number that triggers registration is now 2000. And that number excludes shares that are issued to employees under exempt equity compensation plans.
Most of the companies that we deal with, at least a significant number of private companies in this space, have rights of first refusal on the securities being transferred to a third party or have some limitation of shareholders’ right to transfer. Maybe there’s a board approval requirement. All these transactions need to be taken into consideration by the company and their independent valuation entity when they do a 409A valuation, generally at the end of every year, to decide the price at which they’re going to offer equity in the following year to their employees.
Even with the private company limit now being 2,000 and excluding employees, companies are still cognizant of the impact of secondary trading. What we were seeing back in 2010 and 2011, before the JOBS Act passed, were companies actually asking us not to transact in their securities. They didn’t want the burden of the paperwork that had to be dealt with around the right of first refusal, board approvals, and their 409A valuations. So we took a step back from the secondary trading that we had been doing and started trying to figure out what companies really wanted in the space.
Secondary transactions are generally done either pursuant to Rule 144 if somebody has held the securities for 12 months – but that exemption is not available to affiliates – or under “Section 4 (1 ½)” which is not actually a codified Federal exemption but a structure or a construct that’s been developed under case law and by the securities bar. The “Section 4 (1 ½)” exemption is in-between a Section 4(a)(1) exemption and a Section 4(a)(2) exemption. A holder of securities can be deemed to have basically a good 4(a)(1) if they follow the parameters – I’ll talk about that in a minute.
It was really easy to make a market in a company like Facebook. But when we tried to create liquidity for companies that were not Facebook, or who were not other really well-known, well- followed companies, we realized that the biggest stumbling block to creating liquid secondary markets, in a traditional broker-to-broker fashion or a negotiated matching system, were the state Blue Sky laws. Since “Section 4 (1 ½)” is not an actual Federal exemption, all transactions of secondary shares have to comply with the state laws in all the states where potential buyers are located.
About two years ago, we did a really in-depth analysis of all 50 states and the exemptions that are generally available for secondary trading in each of those states. We put out a survey, which is available on our website at secondmarket.com in our legal research room. We found that, even though a majority of states had adopted similar language, many states interpreted similar language differently or imposed different limitations.
The exemptions generally relied on by sellers in the secondary sales of private company shares are we call exemptions for “isolated non-issuer transactions.” If you were a holder of shares in a private company, and you weren’t an executive or an affiliate of that company, you could sell securities in secondary transactions. But it depended on the state how many transactions you could do a year. And it depended on the state how many people you could actually sell to. So that was pretty problematic.
The other exemption that was pretty well used was the broker/dealer exemption. But in that context, the transaction has to be unsolicited. FINRA and SEC rules say that if a broker/ dealer had a substantial preexisting relationship with a client, as Peter noted earlier, in the private placement context pre-general solicitation – Rule 506(b) now – the broker could reach out to its existing client base to find out if there was interest in a private primary placement.
That’s not the case with secondary sales. You can’t reach out, as a broker/dealer, to your existing client base. That was very frustrating, because the disconnect between federal law and state law in that case didn’t make very much sense to us.
So we started working with NASAA, the North American Securities Administrators Association, about two years ago on a potential new Model Exemption that would create a new model for secondary trading. NASAA was very receptive to it.
The upside for the states is pretty significant. If employees or former employees of a private company exercise options, for example, in a state with an income tax, they pay an income tax on that exercise. And when they sell their shares, they pay a capital gains tax. So secondary trading has pretty significant tax ramifications for states. It also makes companies more attractive to employees if people know that they would be able to actually sell their shares and get liquidity pre-IPO.
So we worked with the states and, as I said, they were generally very receptive. We worked with their Board and their Corporate Finance Committee. But the states haven’t, as of right now, adopted the Model Exemption.
In the meantime, some of the members of Congress that we worked with on the JOBS Act pieces had reached out to us to ask whether there were other problems in the secondary markets. We started working with some members of Congress on the House side, Representative McHenry first and foremost, on a bill that would actually codify “Section 4 (1 ½)” at the Federal level, and make securities sold under this new exemption, which was proposed Section 4(a)(7), also exempt from state Blue Sky laws.
Happily Dave Lynn was one of the think tank people who helped us come up with the language, when we were asked by members of Congress for some input into what the draft should look like. That was pretty exciting. That bill was passed by the House Financial Services Committee back in May. We’re looking to find some bipartisan support for it and some Senate support as well to assist the Congressman who’s proposing the bill to get it into what Congress is thinking might be a JOBS Act 2.0.
So that’s what’s happening on a secondary front from a regulatory and legal point of view. More down in the weeds, what we’re seeing is that companies, although they can now have up to 2,000 shareholders excluding employees, still care about things like rights of first refusal, and tax implications. As we worked with the various law firms and companies that we have relationships with, we realized that what companies really wanted was control over all of aspects of the secondary market programs.
About three years ago, we switched our program, so that what we do now in the secondary space is really to facilitate private tender offers. Either company buy-backs or third party private tenders are done under Rule 14(e).
In the context of these programs the company gets to choose parameters – for example, existing shareholders who are employees can sell maybe 20% of their vested equity. They provide data and disclosure through a virtual data room that’s on our website. All the documentation is signed electronically to prevent the possibility of an incorrect tender. We put the whole process on our electronic platform, taking out the guesswork from share ownership and how much you’re allowed to tender.
It’s been a really popular product, and we’ve gotten a lot of positive feedback from the law firms and the companies who we’ve worked with. Just as an example, in 2014 we’ve closed about $1 billion worth of these private tender offers. About 40% were company buy-backs, and 60% were transactions where a third party, generally an institutional buyer or a group of institutional buyers, were reaching out to companies to buy either preferred or common, or whatever the classes outstanding were.
We see the secondary space heading more towards these privately negotiated transactions than historical liquidity programs, which is what we used to call the auctions that we did in private company stock. On the primary side, we’re seeing a back-and-forth between whether companies are choosing to generally solicit and whether they’re not choosing to generally solicit.
Dave will talk a little bit about the proposed Reg D changes that I think are creating an overhang on the marketplace. When the SEC finally made effective the rules that allow general solicitation last September, they also proposed rules that would impose some requirements on private companies that would create a friction in choosing to generally solicit.
We’re seeing a pickup in general solicitation. The CFTC passed some rules a week or so ago that made it clear that hedge funds had the ability to generally solicit around private transactions, which I think will mean that more issuers will choose to generally solicit if they want to.
As Peter was saying, it’s not that they’re putting up billboards or sending out letters. But under the new rules, companies are able to reach out to people who are not already clients. They’re able to have a website that’s open to the public. Many issuers are choosing to utilize electronic platforms to facilitate private placements. Some companies are choosing to disclose the fact that they’re having an offering outside an accreditation wall and some are choosing to stay inside accreditation walls, so that only accredited investors have knowledge of the offerings, which is a typical 506(b) structure.
What’s helping people get comfortable around general solicitation is that there’s an increased amount of guidance out there. The SEC set out some guidance a month or so ago around how to verify accreditation. And we put out our own FAQs.
Part of the product that we offer on the primary front is all the aspects of closing primary offerings. We don’t actually introduce capital or buyers to companies. But we do all the parts of the transaction that are closing-related.
So issuers come on our platform. We do background checks on them. We do document execution. We do accreditation verification if the company chooses to generally solicit. And then we do closing and fund settlement.
We’ve gotten a lot of experience around accreditation verification. I think that issuers are finding that investors who want to get into big transactions are generally willing to provide the documentation. It’s painful the first go-through. But once angel or other more prolific private investors are interested in other companies, they’re willing to do it again.
We’re hopeful that the SEC will continue to put out good guidance here and that more issuers will be willing to consider general solicitation. But I think a lot will depend on if and when the SEC actually adopts the proposed Reg D changes, which will have some impact on what companies have to do in the context of 506(c) offerings, what they have to provide to the SEC and some other items.
So that’s what we’re seeing in the primary tender offer space.
Structuring Private Company Liquidity Programs
Lynn: Thank you, Annemarie. Greg, maybe now you could talk a little bit about the structuring aspects of private company liquidity programs – how those come down and what they look like today.
Greg Brogger, President, NASDAQ Private Market: Sure. First of all, thank you for having me on the program. By way of slightly further introduction, I’m the President of the NASDAQ Private Market. That’s a joint venture between NASDAQ and SharePost, which is a company that I founded in 2009.
The NASDAQ Private Market is a platform for private companies to do a number of different equity-related things. Certainly the most relevant of those things for this panel conversation is the running of the liquidity programs that we’ve already been discussing. We also do things like managing capitalization table and stock plans and integrating that into liquidity programs.
The focus of my few minutes here is going to be, just as you said, Dave, on what questions or considerations companies need to think through in structuring a liquidity program. As Annemarie said, more and more companies are doing these. There are emerging best practices, or at least, we’re starting to see where most companies are going with these programs.
Naturally it starts with – why is the company doing the program in the first place? What are its objectives?
That kind of breaks down into a couple of different points, but the first and foremost is – who are you providing liquidity to? Generally it’s to employees for the purpose of enhancing the private company’s ability to recruit the best team members and to retain them. There are alternative purposes around providing angel investors liquidity, or liquidity for other players, such as strategic investors or venture capitalists. But that is the minority of these programs.
Another key objective that will have a lot of impact on how the program is structured is – who are the investors? Is it a VC that’s already invested in the company and already sits on the board? Or is the company seeking new investors? It could have a number of different reasons for that, such as bringing fresh capital or long-term deep-pocketed institutions to the company.
Then there’s a grab bag of other situational factors, things like how close the company is to an IPO, or what sensitivity the company has to financial disclosures. The last factor I’ll mention is whether the liquidity program is happening in conjunction with a primary capital raise or whether it’s a standalone program to provide selective liquidity to particular shareholders.
Because so many companies are situated differently or have different objectives along these lines, it’s hard to say that there is a single type of program that’s getting run. But I would say, as we go through these key questions, that the most popular program that we are seeing amongst our clients is one in which the objective is to recruit and retain employees and where the company already has identified particular buyers, be they existing investors or just investors that have been dialoguing with the company and that the company is now comfortable with. The capital raise portion, or the introduction to new investors, generally is already accomplished by the time the liquidity program is to be conducted. So with that as our assumption set, I’ll talk about the key terms. I’ll try and provide some concrete examples as we go.
I think the key topics the company has to decide on are the price and terms by which the shares will be repurchased, the legal structure, the amount and type of disclosure and to whom, and the parameters for the participants. Who gets to sell into the program, and what are the limits on their participation? Lastly, there are the execution details – how the program is going to be run, the timing schedule, etc.
To start at the top – price and terms. There is certainly some sensitivity here amongst companies as to how price is set and who exactly is negotiating on behalf of the sellers. I think companies see a certain amount of liability. By the way, I’d certainly like the other panelists to jump in here, because almost everything that I’m talking about has legal impacts. So, Annemarie, feel free to chime in, because I know you see a lot of these issues pop up every day.
In any case, the price and terms are usually figured out on the front end of the program, because of course, without those, the program can’t move forward. Typically, by the time a program gets to us, the buyers have been selected and the price has been set.
One of the issues that gets navigated with the buyers in conversation with the company are some of the 409A concerns. That is one of the most important issues to navigate.
There are different structures that we’re starting to see to make that an easier approach. Some companies are differentiating the common stock that’s being sold in these programs from other common stock being valued for 409A purposes, by creating some set of ancillary rights that might go to the buyers purchasing within the program. That’s I think somewhat inventive. We haven’t seen it pass scrutiny in either the case law or amongst the regulators. But we’re starting to see some experimentation there. It certainly makes some sense to us, and there is come precedent for it amongst 409A evaluation firms.
Once price and terms are set – so now we know who the buyer is, we know what the security is, and we know what rights the buyers going to take once the transactions are closed – we then move to a legal structure analysis. There you see the typical securities law analysis around what exemption is being used.
Everyone prefers of course the safe harbor of Rule 144 where it’s available. But frequently Section 4 (1 ½) is something companies get comfortable with. Law firms, of course, are involved both on the investor side (the buyer’s side), as well the company side.
Different platforms are always looking to be helpful in that securities law analysis, to make sure that everybody’s comfortable. That’s obviously a crucial part of the program.
One of the advantages I think in using the platforms – and by platforms I’m referring to SecondMarket or NASDAQ Private Market, or others that are just getting started – is that because they run these programs so frequently, their systems are hardwired, in a sense, to provide compliance. So disclosure is tracked and issuers can always after-the-fact go back and take a look at who saw what, when. And the holding periods are logged into the system. So generally companies feel more comfortable, at the end of the day, that they will have a program that meets all of the SEC’s rules and all of FINRA’s requirements, and they can sleep better at night when a large transaction gets done. So the legal structure is critical.
Moving on to the next topic, disclosure becomes an enormously sensitive issue. One of the great benefits to being a private company is that you get to be very selective as to who you share what level of financial information with.
Since the beginning of this current version of the private market, the presence or absence of financial information in the marketplace has been what has driven the secondary market for shares. Even in the company-sponsored liquidity programs that we’re been talking about, it has been the central issue – outside of companies like Facebook, because, as Annemarie said, in those companies people were willing to buy and sell without direct disclosure from the company. But by and large, in almost every other case, disclosure is a prerequisite.
That situation, at least on the buy side, is much easier if the company is dealing with an existing investor. It’s likely, if they are a preferred stock investor, that they already have information rights. So there’s no incremental information that needs to be disseminated.
Typically the companies that are conducting these programs are used to raising capital. Generally the only companies running secondary liquidity programs are ones where there is an excess amount of investment capital seeking the company’s shares. Otherwise, they’d probably just be taking what capital is available for primary purposes. So they’re typically successful companies when it comes to raising capital. And they share financial information in the traditional way with institutional investors under nondisclosure agreements and such.
When you move the capital transaction into a situation where you now have 100, 200, 500, or even 700 simultaneous sellers, almost all of whom are going to be company employees, it becomes a much trickier issue. One of the things that certainly we would encourage, and that others have encouraged, is a symmetry in disclosure, so that both the buy-side and sell-side have access to the same information at the same time, ideally at the point of, or just immediately prior to, the transaction.
One of the key questions that companies have to navigate in deciding whether or not to do these programs is how much information they are willing to share, and with whom. I think one of the advantages, again, in using a platform is that they provide some measure of control around how that information is shared – typical data room security things like watermarks or online non-disclosure agreements. They do provide some level of protection. But companies that think of liquidity as part of the price of recruiting and retaining employees need to get comfortable with some amount of disclosure.
At the NASDAQ Private Market, as you might imagine, there is a huge amount of focus on creating a fair and transparent marketplace. We have a series of requirements for minimum levels of disclosure, which companies can always exceed if they choose.
What we require are generally trailing financials. We encourage management teams of companies to provide some sort of going-forward insight into the company’s expected performance where that’s possible. But that’s more of an optional thing. Certainly that’s going to be something that gets discussed internally at a company with its board and senior team and with the platform on which it’s conducting the offering in any liquidity program.
The next key decision that a company makes in organizing a sponsored liquidity program is to decide who gets to participate – who gets to sell. In the example that we’re talking through now, we’re looking at a company whose primary purpose is to recruit and retain employees. A typical set of parameters might be that the company says this program is open to employees who have been with the company three years or more. And those eligible employees are able to sell up to 15 or 20% of their vested shares.
In that way, a company is not throwing open the doors to liquidity to people on their first day at work. It creates an incentive to stay at the company. And even when participating in the program, employees are limited in the number of shares that they can sell, so that they’re not disincented – they are not able to cash out of their position in the company. Again, that helps the company with retaining employees over time.
More and more private companies, as they get larger and larger, find themselves competing for senior executives or midlevel executives with public companies, where liquidity for equity compensation is much more reliable. Offering a program of the kind that we’re talking about on a reliable basis – maybe once a year, maybe twice a year, or something like that – gives private companies a way to offer a similar sort of benefit along with the rest of the compensation package.
The parameters for the participants of course go back to the objectives. As you can imagine, what a company is seeking to accomplish is what is going to really drive who’s eligible to participate and the limits upon their participation.
The last piece that I’ll talk about is the execution of the program. I think most people in the audience are familiar with the relatively cumbersome, expensive process for a transaction in unregistered securities – the right of first refusal, legal opinions, etc. The documentation for this type of transaction is not a simple thing.
If you imagine having 500 participants essentially closing a private company transaction all at the same time, the need for some level of automation becomes apparent. Typically, the companies that we talk to will say that at any point that they’ve tried to do one of these programs on their own for 20 or 25 employees or more, that’s the point at which it just becomes unworkable.
Typically, companies are not going to have the staff to do this – either because it’s the first time that they’ve done it, it’s not their core business, or they’re not very good at it. It becomes a more or less full time job for the CFO and/or the GC, if you’re trying to run a program with even 30 different participants at the same time. So using a platform is important for that reason, as well as some of the other reasons I’ve already talked about.
Think through what you need in a platform, meaning the scale of the platform and what sort of services it provides in addition to just the liquidity program piece. Are there escrow functions? Is it a broker/dealer? Is it an alternative trading system? Can the platform help you find investors? Is it integrated into other equity functions in a way that would be helpful to you going forward?
You can imagine, if you’re closing 500 simultaneous shareholder transactions, then having to take that information and port it over to your capitalization table system. Trying to reconcile the two can be a pretty significant headache.
There are, at this point in time, two major alternatives out there in the market. There are probably others getting started now as well. We encourage private companies contemplating these transactions to have more than one conversation.
Once you’ve picked your platform, much of the process fortunately gets taken out of the company’s hands. It’s probably more correct to say these processes can be put on something like autopilot, because the process is hardwired into the way these platforms work. So all these issues and the inputs – price, terms, legal structure, disclosure, documentation, etc. – once given to the platform, they all have a home on that platform. That can obviously make it much easier for the company to operate that program.
I don’t know if there are any questions from anyone else on the panel. But I’ll stop there.
Secondary Trading Policies for Pre-IPO Programs in Private Companies
Lynn: Great, thanks very much, Greg. I’ll just spend a couple of minutes batting cleanup on some of the legal issues. I think we’ve covered the landscape pretty well in terms of the types of things that you think about when you’re addressing these transactions.
The first thing that I think is very important to keep in mind when advising private companies today is from the get-go trying to be organized around things like record-keeping and the types of policies that you’re adopting with respect to the transferability of the company’s securities and what types of restrictions there are going to be. The right of first refusal, which we talked about, is pretty universal. But the company might also decide whether there are going to be any other transfer restrictions as part of the equity awards that are made to employees.
Lynn: Going back to record-keeping, when you think back to a world where a company could anticipate eventually going public one day, there wasn’t as much of a focus on record-keeping, because you knew you could clean up the capitalization and everything else pre-IPO. You might be inclined to keep track of things on the back of a napkin, or on an Excel spreadsheet if you were a little bit more ambitious.
What you always see when you go into these situations is – who got the options? Are there resolutions? Are there board minutes? Were the terms of the awards specified somewhere in a document. And how can you verify all that for the purpose of facilitating the secondary market type of transaction?
So my counsel to companies today is that you might want to make sure you’re thinking about the possibility of these liquidity programs down the road when you’re trying to design your internal controls around your equity compensation practices, and even your regular transactions in securities with your angel and venture capital investors and others. You should utilize the technology that’s now available to do that in a way that’s going to be much more productive if you decide one day down the road to allow people to cash out.
Company Policies on Secondary Trading
Lynn: In terms of the issues around transferability, rights of first refusal and the like, thinking back to when Annemarie and I did this webcast in 2011, we were at the tail end of a lot of focus around the possibility that companies could be subjected to these secondary market transactions when they really didn’t want to be, and what the ramifications of that would be. There had really been a lot of focus on how the company could maintain control in such a way that they weren’t going to trip the 500 holder of record registration provisions that were in existence at the time, pre-JOBS Act, and how they were going to avoid having shares get into the hands of competitors, people they didn’t like and people that were outside the control and scope of the company.
I think the world has changed a little bit. While a lot of those issues are still absolutely critical and require focus on the part of the company and their counsel when doing the initial financing rounds, today we’re in a much different environment than we were back in 2011.
Securities Law Issues
Lynn: In terms of some of the issues that come up from a securities law perspective, I think we’ve talked a lot about how people look at these exemptions. The private tender offer world, that Annemarie mentioned, is a very useful mechanism, which enables you to set up a program for a third party or for the issuer to repurchase securities.
I often run into some level of surprise that the SEC’s tender offer rules extend to companies that aren’t public companies. Regulation 14E, the anti-fraud tender offer provisions, makes no distinction between whether your company has securities registered under Section 12 or not. It’s really sort of the baseline regulation. So keep that in mind.
This is why it’s helpful, I think, to look to the platforms to try to structure these transactions. There are very specific requirements that apply in Regulation 14E tender offers. There’s a minimum time period in which the tender offer must be open. It has to be at least 20 days.
Tierney: Twenty business days.
Lynn: Exactly – 20 business days. You have limitations around situations where you are increasing or decreasing the amount of securities sought, which can result in an extension of an offer period. You have the prompt payment requirements that people are familiar with. You have notice requirements in the event of an extension.
Some of the other things that people sometimes are particularly surprised about are of the ability to make purchases outside of the tender offer under Rule 14e-5-type situations, as well as some limitations on the types of trading that might occur in connection with the tender offer under Rule 14e-3.
So it’s a very comprehensive regulatory environment. It’s certainly nothing like doing a public company tender offer. But it’s nonetheless a regulatory environment. It helps to slot yourself into a preexisting, established framework in order to accomplish it in a way that’s compliant.
Technical and Execution Issues
Lynn: Last but not least, I will pick up on one of the topics that Annemarie mentioned. One of the issues from a primary offering perspective that people have continued to focus on is that while the SEC, in accordance with the JOBS Act, did deregulate offers and permit general solicitation under the conditions established in Rule 506(c), they proposed at the same time a set of rule changes that would put people on notice as to these types of offerings. An advance Form D and then a final Form D would be required in connection with launching and closing an offering. And some additional information would be required in Form D, which would get into a lot more detail about the issuer, where they offered securities, the use of proceeds and the like, as well as the types of general solicitation used. There were also legending requirements around the types of information that might be used from a general solicitation perspective.
When these rules were proposed, they received a lot of negative commentary from certain quarters, and not as much positive commentary. I think they were designed around an investor protection theme. The SEC felt like it had to propose and suggest rules like these at the time it freed up general solicitation.
One issue that Annemarie touched on that I think is worth noting is that we don’t know whether these rules will ever see the light of day, whether they will be modified ultimately to take away some of the portions that caused people particular concern, or whether they will be adopted as purposed, which I think would have a negative impact on the market place as it develops for primary offerings under general solicitation. There really hasn’t been any indication from the staff of the SEC as to when this could happen, although they’ve continued to say that these JOBS Act implementation issues remain a priority. So even though none of these requirements are in effect, people tend to worry about them, because they are out there hanging over our heads.
Tierney: I think they also have some implications for issuers who are in a continuous capital raising mode under Rule 506, since so many startups are continuously raising capital. We’ve had questions from a lot of different constituents that if the rules came into play while they’re in the middle of a continuous offering, what would that mean and how would that implicate them?
Would they be out of compliance with, for example, a requirement to pre-file a Form D? I think that there are some real issues around continuous offerings. And some other issuers wouldn’t be interested in providing general solicitation materials to the SEC in the context of a private placement.
So I think there are some real issues for companies. And I do hope that the SEC makes a decision about how to go forward.
Something like 90% of the comment letters were negative regarding the proposed rules, but we have a Commission that is almost split 50/50 between pro-JOBS Act and pro-investor protection points of view. It will be interesting to see where the proposed rules come out.
Lynn: I agree – but hopefully they won’t come out.
Tierney: I agree.
Lynn: To wrap it up, I’ll turn it back to Peter to talk about where things go from here.
The Future of Private Capital Markets
Williams: What’s evident from this program is that the regulators will have a lot to say in terms of how this is implemented. Or at least, what the regulators come out with will change how things are happening.
But overall, very quickly, I think the markets are growing, and the regulatory environment and the market trends are all supporting that. We’ll see an increasing number of participants suddenly having the ability to look at the private markets as an investment alternative, be it through primary issuance or secondary transactions. With that, and with the increases in terms of number of shareholders and these new platforms that are coming to light, several of whom are represented on today’s panel, we’ll see increasing liquidity as well.
In the private market, the liquidity of the secondary market will always be smaller than the public markets, because that’s a highly liquid trader-centric market. But there is a very large room to grow in that space.
Companies were slow initially at adopting things like Rule 506(c). We’ve seen it actually pick up substantially over the last three to four months. The first few months after the new rule was implemented, it seemed as though everyone was sitting on the sidelines waiting for the first person to dive in. We’ve seen a substantial increase on our platform in terms of transactions that are 506(c).
In terms of secondary transactions, I think Annemarie had mentioned that things are moving more to the privately negotiated transactions. I think true secondary trading in private companies will be challenged, and the market will move more towards company-managed programs. But we are still seeing substantial increases in liquidity.
In terms of the concern about bad actors in the space, I think you’ll see a shakeout in the market in terms of the platforms and their models in terms of disintermediation – whether you will have the participation of investment banks, or whether you will be cutting the banks and the placement agent (and more importantly the regulatory oversight) out of the process and having the platforms take on that full responsibility themselves.
Either way, I think over the next few years you’ll probably see a substantial shakeout. A few platforms with the brand name and reputation will keep going and a number of the smaller upstarts will fall by the wayside. And you may see a market consolidation to a small handful of platforms.
I see a lot of upside here in the private markets driven by liquidity, technology and a favorable regulatory environment, notwithstanding some ups and downs that we will probably see over the next few years as all those regulations come to be and shake out.
So that’s my view.