Private Tender Offer Best Practices

Transcription

1 Private Tender Offer Best Practices How to Deliver Controlled Liquidity as a Private Company SecondMarket, Inc. 636 Avenue of the Americas New York, NY sales@secondmarket.com

2 Introduction: The Rise of Private Tender Offers It is no secret that the number of late-stage private companies has surged exponentially over the past several years. The combination of a slowdown in IPOs during the recession, the availability of private financing, and the JOBS Act amendment to the 500 shareholder limit have all contributed to entrepreneurs choosing to delay the point at which a company 1 goes public. In fact, the median age of a tech company at IPO is now 11 years. As companies stay private longer and valuations increase, the pressure to provide at least partial liquidity to shareholders has grown substantially. As a private company s valuation grows, secondary market activity is inevitable. Today s venture backed companies have realized that they need to proactively provide liquidity to their equity holders. Broad-based private tender offers have emerged as the most popular method to provide liquidity for today s private companies. Private tender offers, while common in the public market, were few and far between for private companies before Facebook completed its first tender offer with Digital Sky Technologies in In contrast, during 2014 alone, the number of private tender offers conducted by private companies 2 increased by 400%. What makes the private tender offer structure so desirable for private companies? The main appeal is control. The private tender offer rules are quite flexible, generally allowing the company to control all aspects of the transaction. The company controls who buys its shares, ensuring that new shareholders are aligned with its interests. The company controls price, which is negotiated prior to launching the tender. The company controls shareholder participation levels in the offering; for example, requiring all or nothing participation, or providing current employees the opportunity sell a portion of vested holdings. This whitepaper will guide you through best practices for considering, setting up and conducting a private tender offer. Table of Contents: I. The Profile of a Private Tender Offer What are the key variables that determine if and when a company should consider running a private tender offer? II. How to Structure a Private Tender Offer Best practices for how to structure a private tender offer to align with the goals of the company. III. Establishing Selling Rules and Restrictions How to define the appropriate rules and eligibility restrictions for a private tender offer. IV.Looking Beyond the Private Tender Offer How conducting a private tender offer impacts three different exit outcomes for a private company: going public, getting acquired or staying private. Although private tender offers are becoming increasingly commonplace in the private market, how to efficiently conduct them is still a mystery for a lot of companies. 1 Preqin SecondMarket Private Company Report

3 As private companies take full advantage of the availability of private financing and the JOBS Act amendment to the 500-shareholder limit, they are running regular private tender offers and extending their lives before going public. We field a lot of questions from companies who ask: Should I be looking at a private tender offer given my profile? What size and shape are the firms that run private tenders currently? I. Profile of a Private Tender Offer The Sweet Spot Age and size are the two key variables that determine when a company should consider running a private tender offer. Our general rule of thumb is that a private company should begin running a private tender offer on the earlier of: 1.5x the option plan vesting period (generally the 6th year of operation); or 100th equity grant (including options, restricted stock units, etc.); or Valuation exceeding $500 million The majority of our clients are venture-backed companies with a valuation between $500 million and $1 billion; but private tender offers are not just for VC-backed private companies. Over the past two years, we have worked with several companies over 10 years old that are now embracing private tender offers as a recurring feature of compensation. Source: 2014 SecondMarket Private Company Report

4 I. Profile of a Private Tender Offer Not Just a One-off Transaction Anymore Three years ago, private tender offers were used as a precursor to an IPO, a one-off transaction in which a founder or an early investor would cash out before the company went public. Today, recurring private tender offers are an integral component of private company incentive compensation. Last year (2014) 20% of the private tender offers we facilitated were from repeat customers. The reason is simple: recurring liquidity changes an employee s perception of equity compensation. Without recurring liquidity, it is difficult for an engineer or an account manager to connect the value of their equity with their day to day work. As companies stay private longer, they need new ammunition to retain talent. Recurring private tender offers that augment long term incentive programs are a major recruiting advantage. Proactive vs Reactive A lot of firms come to us after the pressure to provide liquidity has already built up. Losing control once the pressure spills over can be costly to clean up. Former employees begin finding buyers through tertiary brokers or via derivative structures that are designed to skirt company bylaws. The finance and legal team get subsumed processing ROFR notices and dealing individually with shareholder issues. In short, resources get shifted towards non-accretive activity. Being proactive about liquidity can help a private company avoid these pitfalls, while introducing the positive benefits. Private tender offers are also not only for large block transactions. In 2014, the median private tender offer we facilitated was $18 million, an order of magnitude lower than the blockbuster deals that you read about in major news outlets. Our smallest deal was $2 million, proving once again that it is not the size of the transaction, but the signal and recurrence that matter.

5 One of the most important aspects of running a private tender offer is making sure that the structure of the transaction is aligned with the goals of the company. Below we breakdown three different private tender offer structures and outline the benefits of each. II. Structuring a Private Tender Offer Option #1: Share Buyback Using Balance Sheet Cash This is the simplest structure. The company uses existing cash to purchase shares directly from its shareholders. The main benefit of this type of structure is control. Since there is no third-party involvement, the company can control all aspects of the transaction: which shareholders are eligible to participate (current employees, ex-employees, executives, investors, etc.), how many shares participants can sell, and the price per share offered. Price usually requires the most consideration since the company will not be negotiating with a third party and is left to determine the appropriate price to be offered. Option #2: Buyback Using Fundraising Proceeds Arguably the ideal private tender offer structure for a company because it combines the benefits of third party price validation, and does not diminish existing cash reserves. In this scenario, the company uses the funds from a recent primary fundraise to buy back shares directly from its existing shareholders. As a result, the company maintains full control over the transaction without using balance sheet cash. Companies that utilize this method typically incorporate the amount of capital needed to fund the tender into the total amount raised in the primary round. Option #3: Third-Party Tender Offer In a third-party tender offer, a company-approved third-party buyer tenders to purchase shares directly from a company-approved list of eligible shareholders. This is the most common structure that we see in the tender offer space; approximately 60% of secondary transactions conducted on SecondMarket last year were third-party tender offers. The main benefit of this type of arrangement for the company is that it streamlines the liquidity process. Instead of having to raise money prior to the tender, the company can rely on the buyer(s) to directly purchase shares from approved participants. The company does not have to use valuable cash to fund the transaction, or issue new dilutive securities in order to raise the cash in order to repurchase shares itself.

6 II. Structuring a Private Tender Offer Which Structure is Preferable? Choosing the right structure for a private tender offer depends on the goals of the private company. The first thing to assess is the cash available to the company. Profitable companies with consistent cash flow typically choose to utilize their own balance sheet to repurchase shares. Such companies have the luxury of being able to afford to buyback shares directly without having to spend time sourcing investors. Since most of the private companies that we work with are still raising venture capital, they are not in a position to provide their shareholders liquidity through a tender offer without bringing in outside capital. When deciding whether or not to raise the funds in a primary and then do a company buyback or have third party buyer tender for shares directly, the main considerations are preference and dilution. Historically, investors have pushed for a preferred stock primary, and subsequent buyback from the company. When a company sees high demand from investors or has investors willing to purchase common shares, they can avoid granting preferences to a new set of investors, and require that an existing investor or new third party investor tender common stock directly from existing shareholders. Given the current state of the late stage private company market, the majority of our clients choose the third party private tender offer option. While this type of transaction may involve more management time to negotiate, it has the dual benefit of preventing dilution to the cap table and not introducing new preference on top of existing investors.

7 The most attractive feature of a private tender offer is the company s ability to control the parameters of their transaction. Companies are able to establish eligibility rules and selling limitations which control the transfer of shares and ensure that the transaction aligns with the goals of the company. While eligibility rules and sale limitations differ from company to company, the considerations for determining selling restrictions are the same. Eligibility Eligibility rules vary based on the type of shareholders and type of outstanding securities. The four main types of shareholders eligible to sell shares in a private tender offer are: III. Setting Rules and Restrictions - Current non-executive employees - Founders or current executives - Early investors - Former employees Companies typically establish different sales limitations for each of these shareholder groups based on the total number of shares being purchased through the private tender offer and shareholder expectations. Available Capital: Many of our clients decide to launch private tender offers to absorb excess buy side interest. When that interest is in the $10-50mm range, companies generally favor limiting eligibility to current non-executive employees. For transactions in excess of $50mm, companies generally open the private tender offer to all shareholders, including early investors and former employees. Shareholder Liquidity Expectations: Many late stage private companies are choosing to offer shareholders liquidity through a private tender offer once every months. We view this is as a best practice. These companies typically leverage significant buy-side demand to provide liquidity to their shareholders. If the company does not have strong buy side demand, it will generally use its own balance sheet to repurchase shares or allow existing institutional investors to purchase shares through a private tender offer extended primarily to current employees.

8 Establishing Selling Restrictions: Non-Executive Employees: Where a company allows current employees to participate in a private tender offer, we typically see selling restrictions of 10-25% of vested options and common stock established. Allowing employees to sell up to 10-25% of vested equity provides meaningful liquidity without skewing the incentive structure of equity grants. III. Setting Rules and Restrictions Current employees typically receive preference over other groups of shareholders in cases where the tender offer is over-subscribed (i.e., more shares are offered than tendered for). In this scenario, current employees are able to sell all of the shares they tender, with pro-ration imposed on other shareholder groups. Founders & Executives: Contrary to popular belief, founders and executives generally sell a smaller percentage of vested equity than other shareholder groups participating in private tender offers (although absolute dollar volumes can be higher). Companies typically limit founders and executives to sales of 1-2% of total holdings. Companies often place an absolute dollar limit across tender offer participation, as well, which can further limit the amount founders sell. Enforcing limitations on founders and executives can be important way to send a positive signal to current non-executive employees. Ex-Employees and Early Investors: Former employees and early investors see the most variation when it comes to selling limitations. The majority of our clients enforce an all or nothing requirement on these groups of shareholders, allowing them to participate only if they tender 100% of their vested equity holdings. Before the JOBS Act removed the 500-shareholder limit, all or nothing tenders were used strategically to decrease the number of shareholders on a company s cap table. Despite regulatory changes, it remains a popular strategy for replacing shareholders that no longer have any vested interest in the company, and might otherwise find other ways to sell their shares.

9 For tender offers that do not impose the all or nothing sale limitation, the restrictions for former employees and early investors range from being ineligible to participate to being limited to sell 50% of vested holdings. The majority of pre-ipo companies impose a sales limit of between 25-50% of vested equity as a way to provide partial liquidity to these groups of shareholders without providing the ability to fully cash out. Venture firms that have been longtime shareholders often take particular advantage of the ability to sell a part of their holdings in these private tender offers to take money off the table. III. Setting Rules and Restrictions Establishing selling and eligibility limitations are a critical component of structuring private tender offers to ensure that the tender offer achieves the company s goals. Enforcing those limitations at scale is where SecondMarket comes in. Most companies use our platform to automate that process and provide an easy selling and closing experience for all participants. (Learn more about our tender offer solution)

10 What happens after a company conducts its private tender offer? Let s talk about the longer term benefits. The majority of our clients manage their liquidity with an eye towards the future, whether that is an IPO, acquisition or staying private forever. Below we breakdown how private tender offers impact the three exit outcomes for a private company. IV. Looking Beyond a Private Tender Offer The IPO: Running regular private tender offers provides two main benefits to private companies that eventually go public: Financial controls and preparedness: Ask most private companies that have gone public and they ll tell you that the IPO process was a nightmare. It takes months to compile all of the necessary registration documents and ensure that adequate controls and reporting lines are in place. Companies that have conducted private tender offers have already been through the process of gathering financial records and updating their cap table. Getting the finance team ready exposes weak points and gives the team time to hire new people, change software providers, and broadly test their systems on smaller scale transactions. Groomed shareholder list: Third-party private tender offers allow the company to bring in hand-picked investors onto the cap table. In 2014, over 50% of the private tender offers we facilitated involved a 3rd party buyer, and the majority of the buyers were mutual funds. Mutual funds are ideal buyers, as they will likely buy more stock during the IPO, and are generally long term shareholders. Private tender offers that are conducted right before an IPO also help private companies replace early investors who have held the stock for a long time, but are likely to sell shortly after the IPO. These types of secondaries evolve the shareholder base, paving a path to a smooth IPO.

11 Acquisition: As with IPOs, companies that have been through the motions of a private tender offer are well positioned to handle the diligence period associated with an acquisition. This cannot be understated. A short and smooth diligence process can mean the difference between a great outcome for shareholders, and the stigma of being left at the altar. IV. Looking Beyond a Private Tender Offer Staying Private While some of our clients have had some notable exits, the vast majority of them have remained private, with several expressing a desire to avoid the public markets indefinitely. For these companies, running periodic private tender offers has become a part of their company lifecycle. Of our current client base, 25% have run multiple private tender offers and many more plan to conduct them again in the future. These clients place heavy emphasis on helping their employees realize the value of their equity holdings. They are essentially offering the same incentives of public company equity, without the constant distractions of watching a stock ticker. What s Next for the Private Tender Offer Market? Staying private indefinitely has become an increasingly popular vision for private companies thanks to the flow of capital into the private markets. We are also seeing an increasingly diverse group of investors participate on the buyside. As both buyside and sellside interest grows, we believe that a continued focus on best practices, regulatory cooperation, and transparency will enable the market to grow.

12 Get in Touch With Us! At SecondMarket, we are committed to providing our clients with best in breed technology, unparalleled customer service, and industry leading experience in support of the market. If you d like to know more about private tender offers or see a demo of our tender offer solution, please reach out to us: sales@secondmarket.com And be sure to follow us on Member FINRA SIPC Registered MSRB 2015 SecondMarket Holdings, Inc.