A Third Path to Liquidity

When you think of a private company, you traditionally think of 2 options for liquidity: IPO or Acquisition. No longer is either one of those a short-term reality if it’s going to be a lucrative exit for startups and their investors. Shareholders hold on to their stock hoping to have a successful exit in a reasonable time frame. Employees take reduced salaries knowing that most of their compensation will come when they ring the bell on Wall Street. Finally, for public market investors, they have to figure out which companies can still squeeze out growth from their sky high valuations. Now what if there is a third path which can bridge the gap for all? Giving shareholders access to liquidity and investors the ability to participate early in a company’s life while there is still plenty of upside to be had.

Before we get into that, let’s look at the ever increasing trend creating this reality. The graph below shows some of the popular tech companies that have gone public since the 1990s.

One thing that’s immediately clear is that venture-backed startups are staying private longer than ever before.

During the period 1996–2000, the average company completing an initial public offering (IPO) was 6 years old at the time of the offering. In the early 2000s, the average age rose to 8 years. Following the financial crisis, it increased to 10 years. At the same time, the value of private companies has increased. Currently, almost 200 companies globally have a private-market valuation above $1 billion. The largest 15 of these are collectively valued at $300 billion.

This leaves shareholders in a predicament. Take the example of Jean-Pierre Bitchoka, a Customer Service Associate at CartaX since January 2017. He’s been at the company for more than 4 years and is looking to purchase his first home. Unfortunately, at this time, there’s no official discussions of the company getting acquired or going public. Luckily for Jean-Pierre, on February 3rd 2021, Carta opened up an auction for employees to sell a portion of their shares to outside investors. It completed 1,484 orders totaling $99.7M in trading volume. This is a win-win-win situation for all. Jean-Pierre gets to put a down payment on a house that he didn’t think would be possible for a number of years. Carta gets to engage in a market-driven price discovery exercise before going public and reward its employees. Investors participate earlier in the company’s life where there is still a clear growth trajectory ahead.

So why are companies staying private longer?

  • Scrutiny from public markets given the requirement to regularly disclose financials and future plans
  • 2012 JOBS Act increased the number of persons that can hold securities in a company from 500 to 2000. More importantly those who received the securities under an employee compensation plan are no longer counted
  • Unpredictable behavior of public markets
  • Ability to receive funding from private equity firms and late stage VCs
  • Going public is very expensive (accounting, underwriting, legal, time)

That being said, companies will likely have an exit because they need to allow early investors, employees, and others stakeholders to cash-in on their contributions. It just might be a while depending on when the leadership feels the need or when it is forced to. Facebook, for example, would have stayed private much longer than 8 years if it hadn’t crossed the 500 investor threshold on the cap-table which forced it to list on the exchange.

In addition to the employees and early investors who are affected by companies staying private, we also have public market investors who miss out on a lot of growth that happens Pre-IPO. By the time companies are traded on the stock exchange, their valuations are astronomical and this leaves investors having to decide whether there’s still any upside left. Not to mention the Instagram, Waze, and YouTubes of the world that get gobbled up before most investors even have a chance to participate. Imagine if you could invest even a few years before the IPO when there was still expectation of reasonable growth ahead.

The chart below shows companies that recently went public and compares their share prices/valuations from 3 years before IPO to the current day.

This data was taken off of SharesPost, a secondary marketplace that recently merged with ForgeGlobal. If you look at the change in share price of the 5 companies above and 5 others (Crowdstrike, Uber, Lyft, Pinterest, and Palantir) 3 years before IPO to after the 180 day lockup period and you get a whopping 1,552% average return.. Yes, hindsight is 2020, but we’re still talking about well established companies, not early stage startups which makes predictions easier.

So what’s the problem? The two main reasons people don’t participate in this market is because most don’t know it exists and more importantly it’s required to be an accredited investor. Roughly 10.6% of American households were accredited in 2020. That means us Robinhooders, novice stock traders will have to fight for scraps once the unicorns finally hit Wall Street. People are foaming at their mouths for the opportunity to get into these darling companies as early as possible. Look at the SPAC craze of 2020 where people were literally placing bets on blank check companies.. “A blank check company is a publicly-traded, developmental stage company that has no established business plan. It may be used to gather funds as a startup or, more likely, it has the intent to merge or acquire another business entity.” All with the hopes of that shell corporation merging with the electric-semi truck company they found out about on reddit.

You’re probably wondering if employees are even allowed to sell their vested stock in the company they work/worked for.

A study done at Stanford in 2018 found that roughly 44% of companies allow this practice.

Survey on whether companies allow secondary sale of stock

Out of the companies that allow the secondary transactions, 41% permit it during the person’s employment, 53% around the departure from the company, and 77% after the departure from the company. Keep in mind this study was done 3 years ago and companies are continuing to loosen restrictions, just take look at the NASDAQ Private Market(NPM). NPM provides transaction software to private companies and investment funds looking to do third party tender offers and share buybacks. It did a record of 90 programs in 2020 as companies needed to bring liquidity to employees during the pandemic. 33 of the tender offers were Third-Party programs which allowed employees to sell between 30% and sometimes even 100% of their equity grants to outside investors.

“If private companies could offer cash, stock, and liquidity, they would win the talent wars with public companies because they could offer the best of both worlds — private company growth curves with public-like liquidity,” Henry Ward, CEO of Carta wrote in a blog post. “That lottery ticket startup employees sacrificed for will finally turn from paper wealth to real wealth.”

Finding a way into this market as an investor may not be easy but it can be worth the effort. As of now, if you’re accredited, you can use platforms like EquityZen or ForgeGlobal. Both have minimum investment requirements and transaction fees of roughly 5% for both buyers and sellers. These platforms are still relatively new and are very illiquid compared to public markets. After all, this is just the beginning of the Decade of Secondary Markets. Look at Crypto, NFTs, and Masterworks just to name a few. This however, may be the biggest of them all.