PrivateCompanyLiquidity:FuelingAmericanEntrepreneurshipBoBrustkernIntroductionForhighgrowthcompanies,oneofthemostefficientandeffectivewaystoaligninterestsamongstakeholders,andtoallocatewealthamongthosewhohelptocreateit,isthroughtheissuanceofstock,stockoptionsandrestrictedstockunits.Thisholdstrueforcompaniesattheveryearlieststagesofformationallthewaytolarge,publiclytradedentitieswhoseprospectsforgrowthcontinue.Stockoptionsaremostvaluablewhentheunderlyingstockcanbereadilyexchangedinawellfunctioning,liquidmarketplace.Stockoptionsforpublicmarketcompaniesarethepremiereexampleofthis.Forexample,thoseemployeeswhoreceivedstockoptionsofpubliclytradedApple,Inc.in2003atastrikepriceof$9.00pershare,andwhoseawardsvestedduringthefollowingyears,haveenjoyedspectacularreturnsontheirinvestmentoftimeastheyhavecollectivelybuiltAAPLtoapproximately$400pershareasofthiswriting.Thisrepresentsa$350billionmarketcap,makingAAPLamongthemostvaluablecompaniesontheplanet.1Forthehypotheticalemployee,thisrepresentsaninstantaneousgainof$391pershare,or43.5timesthestrikepriceofthestockinonlyeightyears.Growthofthismagnitudeinanemployeesnetworthcanonlyreasonablybeachievedthroughequitycompensation.Itisnowonderthatstockoptionprogramsaresuchanimportantcomponentofcompensationpackagestoemployeesofhighgrowthcompanies.Itisalsonowonderthatcompaniesandboardsarewillingtofootthebillfor409Acompliance,includingappraisalsconductedbybusinessvaluationfirms.2

1IuseexamplessuchasApplebecausepubliclytradedcompaniesontheNasdaqGlobalMarketandtheNewYorkStockExchangearerichindatatransparencyandvaluationsaretrustworthyduetorobustmarketdynamics.However,thispaperwillbefocusedonprivatecompanies,wherevaluationisuncertainintheabsenceofapublicmarket.2TheauthorisaffiliatedwithArcstoneValuation,anationallyrecognizedbusinessvaluationfirm,andArcstoneEquityResearch,anindependentinvestmentresearchfirm.

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Itiseasytoseewhystockoptionsareanimportantcompensationcurrencyamongresourceconstrainedtechnologycompaniesthatpromisehighgrowth.Ascompaniesprogressfromearlystagestartupstowelldevelopedstandaloneenterprises,milestonesareachieved,revenueiscreated,earningsaregenerated,andrisksaremitigated.Asearningsgoup,valuegoesup.Asrisksarereduced,valuegoesup.Itisasimpletheorybut,aseveryentrepreneurknows,itsanincrediblechallengetostartacompany,allthemoresotobuildone,andinfinitelymoresotobuildasustainablehighgrowthenterprise.Whenacompanysequityvalueexpandsrapidly,sodoesthenetworthofemployeeswhoholdstockoptions.Thisisthemagicofthesystemofequitycompensation:manyshareintherewardsbecausemanycontributetotheeffort.Forallofthistowork,however,equitymustbeconvertedtocashatsomepoint.Foremployeesoflargepubliclytradedcompanies,suchconversionisnotaproblemasthereisareadymarketinwhichindividualsmayreceiveliquidity.Butforprivatecompanieswithnoreadymarketfortheirstock,whencanvaluecreationlikethisbemonetized?

NextExit100Miles?Untilveryrecently,theanswertothisquestionwasadisappointment:nosingleemployeeorinvestorcouldexpecttoconverthisorherstockholdingstocashuntilthecompanyasawholeexperiencedaliquidityevent,suchasaninitialpublicoffering(IPO)ormergerwithoracquisitionbyanotherentity(M&A).Classicalventurecapitalmarketpractices,asperformedthroughtheearly2000s,wouldhaveallprivatecompanystockremaininthehandsoftheoriginalstockholdersuntiltotalliquidationofallsharesofthecompanyinacoordinated,boardcontrolledevent.Theserestrictionsincludefoundersstock,earlyemployeestockoptions,commonstocksoldtoangelinvestorsatthecompanysveryearlieststages,preferredstocksoldtoventurecapitalistsorotherprofessionalinvestorsduringsuccessiveroundsoffunding,andallemployeesalongthewaywhoarecompensatedwithstockoptionsat(presumably)everincreasingstockoptionstrikeprices.Allthesesharesarelockedupuntilabigevent(IPOorM&Aexit).Tomakemattersworse,inanIPOscenario,employeesareoftenlockedupuntilsixmonthsaftertheIPO,inanattempttoprevent(oratleastdelay)amassivedumpingofsharesfromemployeestakeholderstoarmslengthstakeholders.Comparethistothepubliccompanycounterpart.Anemployeeofapubliccompanymayundernormalcircumstancesfindareadyliquidmarketwillingtotradecashforhisorherstock.Butforprivatecompanyemployeesthereisnoreadymarketfortheirstock.Thisisespeciallyburdensometothoseearlyemployeeswhoholdarelativelylargeproportionofshares,andforwhomthosesharesrepresentalargemajorityoftheirownnetworth.FromthefirstfinancingtoIPO,thewaitforliquiditynowstretchestoanearhistorichighofover9yearsonaverage.

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Bydefinition,earlyemployeesplayakeyroleinthedevelopmentofyoungcompanies.Andyettheirtenuretendstolastmateriallylessthanthattheaverage9yearsfromfoundingtoexit.Theseearlyemployeesmaynotmakeittothebigexitthatsuccessfulcompaniesenjoy,andyettheymayhavebuilttremendousvaluefortheirrespectivecompaniesintheiryearsofservice.Forexample,letssayastartupmarketingspecialist,Jane,joinsacompanysixmonthsafterthecompanysfounding,andshortlyafterreceivingitsroundofangelfinancing.Janeisinstrumentalinbuildingawarenessofthecompanysproductsandservicesinitstargetmarket,andcreatestremendousvalueforthecompanyduringherfiveyearstintthere,duringwhichtimethecompanygrowsfromzerotoover$5millioninannualrevenue,withforecastsforfuturerevenuegrowthexceeding100%yearoveryeargrowth.ButJaneisastartupspecialist,andthiscompanyisnowinanewphaseofprofessionalizationorinstitutionalization.Herteamhasgrownmanyfold,andJanesdailyactivitiescallonhertobeamiddlemanagermorethantheroleofmarketingninjashefancies.Herskillsarelessvaluedbythecompanyinthisstageofgrowth,andfranklysheslessenthusiasticaboutherdaytodayimpactonthecompany.Sosheleavestostartwithanewventurethathasjustrecentlybeenformedandwhichhasreceiveditsfirstroundofangelfinancing.Countlessresearchhasconcludedthatthepeople,processes,andpracticesthatmakeacompanysuccessfulfromitsearlieststagesofformationmustbereplacedorretooledinordertomakeitthroughprofessionalization,institutionalizationandlaterstagesofmaturity.3

Janehaseveryrighttoleaveherfirmtojoinanewone.Sinceshehasfiveyearsoftenure,allofheroriginallyissuedoptionsarenowfullyvested.Whenshejoined,shewasgrantedoptionsatastrikepriceof$0.10fromhercompanysboardofdirectors.Whensheleftthecompany,thefairmarketvalueofthecompanysstockwasshowntobeover$1.60pershare.4Whatsmore,asanearlyemployee,she

3Worksinthisarenaofmanagementsciencearevoluminous.GrowingPainsbyFlammholzandCrossingtheChasmbyChristiansenaretwowellknownstandards.4Wewontgointothespecificsof409Avaluationsinthispaper,butwillassumeallentryandexitpricesaremadeatfairmarketvalue,inaccordancewithInternalRevenueCodeSection409A.

Earlyemployee&angelliquidity

Midstageliquidity

ExitZone

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wasgrantedtheequivalentofroughly1%ofthecompanysoutstandingstock,or1,000,000shares.Withtheexpansionofvalueofthecompany,Janehasapaperfortuneof$1.5million.

Butthatsjustit:itsallpaper,itsallinprivatecompanystock.Withanyluckthecompanywillhaveabigliquidityeventinanadditionalfiveyears.Thatsfiveyearsofprivatecompanystockvolatility,whichJaneisnothappytobear.ToquantifyJanesdiscomfort,wecanrunasimplecalculationusingtime(fiveyears)andvolatility(letsassume70%)asinputs.Usingaprotectiveputmethodology,todaysvalueofa$1.60stockwithafiveyearlockupis$0.74,a54%discounttoitscurrentfairmarketvalue.5Naturally,Janewouldprefertoconvertthe$1.5millionofilliquidvalueintocash,andmovethecashintoabasketofdiversifiedinvestments,includingrealestate(read:paydownmortgage)andeducation(read:schoolingforthekids).PossiblyIwouldarguelikelyaportionofthiscapitalwouldbeinvestedinnewentrepreneurialstartups;perhapsherownnewcompany.WithoutearlyliquidityforearlyinvestorsofhumancapitallikeJane,allofthisvalueisunnecessarilylockedupintheilliquidequityoftheprivatecompany.Thiscycleofentrepreneurshipiswellrecognizedintheworldoftechstartups.Itsonereasonthat,aftersomanyupsanddownsintheprivatecompanymarket,privatecompanystockoptionscametobeconsideredessentiallyvaluelessforemployees,exceptinthemostexceptionalcases.TroubledAngelsThesameistruewithinvestorsoffinancialcapital.Itturnsoutthatsomeinvestorsareverygoodatpickingwinnersattheirearlieststagesofdevelopment.Manyinvestorsarenotcomfortablewiththatlevelofrisk,andprefertoinvestlaterinacompanysmaturation.Stillmoreinvestorswaituntilacompanyhasachievedgreaterscaleanditsriskprofileisfurtherreduced.Thedeepestpoolsofcapital,includingmutualfundsandhedgefunds,playinthepublicmarketswheremidcapcompaniesofgreaterthan$10billionequityvalueandlargecapcompaniesofgreaterthan$30billioninequityvalueattractamassiveportionoftheworldsinvestmentdollars.Butforthoseearlystageinvestment5Theprotectiveputmethodologycalculatesthecostofaputoptiontoprotectthevalueofastockpositionforagivenperiodoftimeundergivenvolatilityassumptions.Inthiscase,purchasingaputtoprotectthe$1.60valueforfiveyearswouldcost$0.86.Purchasingsuchaputwouldwipeoutmorethanhalfofthestocksvalue.

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specialists,theyhavetoridealongwiththecompanymuchlikeJanethemarketingninjafromanequityvalueapproximatingzerotoanequityvalueapproaching$100million(inthecaseofM&Aexits)or$1billion(forIPOs)beforetheycanexpecttoexittheirinvestment.Isthisefficient?WhyhaveAngelo,anearlystageinvestmentspecialist,lockuphiscapitalfortenyearswaitingfora40xreturnonanIPO(afortybaggerinthejargon)whenhemightexitwithahighlyrespectable5xreturnoninvestmentinfiveyears?Considerthetablesbelow:

Theoretically,Angeloshouldbeindifferentbetweenthesetwoscenarios,ashisInternalRateofReturn6(IRR)isroughlyequivalentbetweenthe10yearfortybaggerandthe5yearfivebagger.Butwhatismoreefficientforanearlystagespecialist?Why,returnhismoneyquicklysohecangoinvestitagain,ofcourse.Buthow?WithoutawellfunctioningmarketplaceforAngelosstock,heslikelytobestuckforfivemoreyears.WhatifAngelocouldsellhisstockatthefiveyearmark?Isthisnotjustswappingoutoneinvestorforanotherwiththesameexpectationsofthe$4millionexit?No.RecallthatAngeloinvestedinthecompanyasanangel,priortoitsfirstinstitutionalroundofventurecapital.Assumethecompanywasjustanalphastageproductbuiltoutofadormroomorinsomeonesgarage.Fortheriskhetook,6InternalRateofReturnisdefinedastheannualizedeffectivecompoundedreturnratethatmakesthenetpresentvalueofallcashflowsfromaparticularinvestmentequaltozero.FollowthemathasillustratedintheaboveexampletounderstandthemechanicsoftheIRR.Thediscountfactor(itemdabove)growsexponentiallyinrelationtothediscountrateandpassageoftime.BecauseIRRsaresubjecttocompounding,a50%IRRincreasesreturnrequirementsmassively,asillustratedinthisexample.

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Angelorequireda50%IRRonhisinvestment(orlikelygreater).Butthatwasfiveyearsago,andthatwasexpensivecapital.WhatifAngelocouldsellhisstakeatthefiveyearmarktoanewinvestor?Thenewinvestor,inalllikelihood,wouldrequireamateriallylowerIRRfortheinvestmenttoday.Twentyfivepercentmightsuffice.Afterall,thecompanyhassignificantrevenues,wellfunctioningoperationaldepartments,andisonitswaytoabigexit.Whatdoesthis25%returnrequirementdototheexpectationsofcurrentinvestors?Bythemagicofcompoundinginterest,itreducestheneedforamegaexittoamoderateone.Hereswhy:ifAngelosexpensivecapitalweretocontinuetheridefromyear5toyear10,his50%IRRrequirementwouldcompoundsoaggressivelythatthe$500,000valuetodaywouldhavetogrowbyapproximately8xoverthenextfiveyears(to$4million)tomeethisexpectedreturn.A25%IRRthreshold,ontheotherhand,onlyrequiresa2.5xreturnoverthesameperiodoftime,to$1.250million,asillustratedbelow.

Ifthecompanyweretoswapoutallofitsearlystageinvestorsformezzanineinvestorsatthefiveyearmark,theywouldcollectivelyrequireonlya$1,250,000exitforeach$500,000theyinvested.Thatsnearly70%lessthanthe$4,000,000Angelorequiredforhisownhotstuffcapital.Thus,notonlyisitmoreefficienttogetAngeloinvestingagain,itsstrategicallyimportantforcompaniestoreplaceearlystagecapitalintheirequitystructurewithmezzanineinvestorsattheappropriatestagesofdevelopment,soastoreducepressureonmanagementtokeepswingingforthefences,whenmoremoderatestrategiesmaybeappropriateforthecompanyssustainedgrowthandsuccess.

HowDoesItWork?Wecouldhavediscussionsaboutthesecuritieslawsthatallowprivatestocktransactionsbetweenprivateindividuals.WecouldalsotalkabouttheexecutionissuessurroundingtheT+45closing

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processesthatoftencharacterizetheprivatecompanymarketplace.7Butwellleavethesediscussionstotheattorneysandstockadministrators.Therearemanygoodmindsatworktryingtosimplifyandspeeduptheprocess.Sufficeittosaythatprivatecompanystock,atthesimplestlevel,isthepropertyofitsindividualowner.Oneofthefundamentalcharacteristicsofpropertyisthatiscanbetradedfromonepartytoanother.Thusestablished,thequestionswithwhichwearewrestlinginthispaperpertaintovaluationandeconomics.Whatisacompanysvalueatinception,atearlystagesofgrowth,atmezzanine,andproximatetoexit?Howarevaluesallocatedacrosstheclassesofsecurities(debt,preferredequity,andcommonstock)thatmakeupthecompany?Whatexitpointsarelogicalforearlyinvestors?WhatdoesitmeanforentrepreneurshipintheUnitedStatestohaveawellfunctioningmarketplaceforprivatecompanystock?CompanyValuationsthroughTimeWhatisacompanysvalue?Askanyprofessionalbusinessappraiserthisquestionandthelikelyresponsewillbeitdepends.Onwhatdoesitdepend?Simplyput,thecompanysvaluedependsonthepresentvalueofitsexpectedfuturestreamofcashflows.Inotherwords,ahypotheticalbuyerwillwillinglyexchangecashtodayforexpectedfuturecashflows,discountedfortheriskthatfuturecashflowsmaydifferfromwhatisforecasttoday.Valuationanalystsandmoreimportantly,buyersuseawellestablished,timetestedmethodologytomathematicallycalculatethevalueofsomethingtodaygiventheinherentriskinessofitscashflows.Thisisreferredtoasthediscountedcashflowmethod(DCF),anditunderpinseverythinginbusinessvaluation;thatis,allothervaluationapproachesandmethodologiescanbereconciledbacktowhatbuyersarewillingtopayforastreamofuncertainfuturecashflows.TheDCFiselegantinitssimplicity,withonlytwovariableelementsintheclassicalapproach:

1) forecastcashflows,and2) theriskassociatedwiththoseforecasts,expressedintermsofadiscountrate

Discountrate,compoundannualrateofreturn,andInternalRateofReturnallrefertothesamemeasure.Inthispaper,Iusethetermsinterchangeably,accordingtothepointofviewofthesubject.Forexample,AngelorequiresanIRRof50%forhis$100,000investmentbecausethediscountrateassociatedwiththisparticularinvestmentis50%andthecompanyexpectstogrowitsequityvalueatacompoundannualrateof50%.Belowisamuchsimplifiedtablethatcomparesstageofcompanywithtypicalratesofreturnrequiredbyinvestorsateachstage:

7IndustrystandardsandregulationsrequireInvestorstocompleteor"settle"theirsecuritytransactionswithinasetnumberofbusinessdays.Thissettlementcycleisknownas"T+x,"shorthandfor"tradedateplusxdays."T+3meansthatwhenyoubuyasecurity,yourpaymentmustbereceivedbyyourbrokeragefirmnolaterthanthreebusinessdaysafterthetradeisexecuted.Whenyousellasecurity,youmustdelivertoyourbrokeragefirmyoursecuritiescertificatenolaterthanthreebusinessdaysafterthesale.Fortransactionsinvolvingsecondarysalesofprivatecompanystock,T+30settlementtimesaremorecommon.

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Inception EarlyStage Mezzanine PublicMarket Mature USGovtMilestone: Concept RevenueGrowth

ProfitGrowth

LongTermCompetitiveness

LongTermSustainability RiskFree

CostofCapital: >50% 30%50%

ToexplaintheconceptoftheDCFfurther,andthetimesensitivityofreturnsoninvestment,welltakethesameexamplebutrequirethattheinvestorponiesupforthefullinvestmentonDay1ofYear1.Thesamecompanywillrenderjustshyofa30%return:

Nowthatwehaveanappreciationfordiscountrates,letsconsiderwhathappenswhenaninvestormakesaninvestmentinanentrepreneurialventure.Evenattheearlieststageofcompanydevelopment,investedcapitaldoesnotcomprise100%ofthevalueofthecompany.Toillustratethis,wewillassumethatanangelinvestoriswillingtoinvest$500,000upfrontinanentrepreneurialventureinexchangefor50%equityinthecompany.Aftersettingasidesharesforanoptionpool,thecompanycapitalizationtable(captable)lookslikethis:

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Angelopurchasedthesesharesat$0.05pershare.Thecommonstockisthensaidtobeworth$0.05pershare,andthepostmoneyvaluationissaidtobe$1million.AtthebeginningofYear2ofthisventure,thesamecompanyattractsanadditional$2millionofventurecapitalfinancing.Thisinstitutionalcapitalismadeasapreferredequityfinancing,withcontrolandpreferencefeaturesattachedthatgivetheVCsenhancedreturns,controlanddownsideprotection.ThisisthecompanysPreferredAfinancinground,andinexchangeforthe$2.5millioninvestmentthecompanytradesaway10,000,000sharesofPreferredAstockpricedat$0.25pershare.Nowthecaptablelookslikethis:

Notethatthepostmoneyvaluation,whichisequaltothepricepersharepaidinthelastroundoffinancingmultipliedbythetotalnumberofshares,isnow$7.5million.Thatssignificantappreciationfortheentrepreneurialteamsefforts.Thecompanysprospectshavechangedconsiderably,andalongwithheightenedforecastsoffutureperformance,thecompanyalsorequiresmorecapital.

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Twoyearslater,thecompanyclosesonitsPreferredBfinancingof$7.5millionat$0.50pershare,anuproundwith100%appreciationinstockprice.Nowthecaptablelookslikethis:

Wearenowthreefullyearsintotheventure.Aftertwomoreyears,andwithamezzanineroundofgrowthcapitalonthehorizon,itcouldbesaidthatAngeloisfeelingfatigued;soaretheearlyemployees.Recallourpriordiscussionregardingearlystagespecialistsfounder,investors,andmarketingninjasalikearebeginningtotireofthisadventure.Inordertoconsiderthepossibilityofcashingoutearlyinvestors,wemustconsiderthevalueoftheirequity.ValueIsAllocatedAccordingtotheCapitalStructureEquityparticipantsaredividedamonggroupsofinvestorsaccordingtotheirseniority.Muchlikedebtcanbelayeredinsenior,subordinateandunsecuredclasses,equityvalueisallocatedaccordingtodifferentsecurityclasses.Becausethepreferredstockgetspreferentialpayoutsuponliquidation(andinthiswaysomewhatfunctionslikedebt),liquidationtablesmustbecreatedtodescribehowinvestorswillbepaidoutgivencertainliquidationscenarios.Thisexerciseiscalledtheallocationofequityvalue.Inthisexample,wellassumethefirst$10millionisallocatedparipassubetweentheSeriesAandSeriesBpreferredstock:

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Thenext$5millionisallocatedtothecommonstock:

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Thenext$7.5million,whichtakestheequityvalueto$0.50pershare(thesamepriceasthelastroundoffinancing)issplitbetweenthecommonandSeriesApreferredstock:

AndeverydollarthereafterissplitparipassubetweentheSeriesA,SeriesBandcommonstock:

Thus,ifthecompanystotalequityvalueisdeemedtobe$10million,thepreferredAissaidtobeworth$0.25pershare,thepreferredBworth$0.50pershare,andthecommonstockzero.Thepreferredstockata$0.25valuepershareactsmorelikedebtthanequity,sincetheytakeallthevalueandthecommonstockgetsnone.However,atatotalequityvalueof$30million,thecommonstockhascaughtuptothepreferredstockonapersharebasis,andisnowworth$0.67pershare.

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Agraphicaldisplayoftheabovemaylooklikethefollowing:

ExitStageLeftWhichbringsusbacktothecornerstonequestion:atwhatpointwillearlyemployeesandinvestorscraveliquidity?Recallthebelowtable,wheretimeisrepresentedontheXaxisandexitvaluationsarerepresentedontheYaxis.Whenoneviewsthebelowtableinthecontextofadiscountedcashflowmodel,andthetimevalueofmoney,60quartersoftimestartstolooklikeaneternityforsomeoneexpectinga50%IRR.

Earlyemployee&angelliquidity

Midstageliquidity

ExitZone

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Inthisillustration,earlyemployeesandangelsseekliquidityasthecompanyliftsofffromavaluationofnearzerotoapproximately$30million,afterabout20quarters(fiveyears)ofinvestment.Letsexaminethisdesireforliquidityinthecontextofthecapitalstructurefromabove.Inthisexample,commonstockcomprises20,000,000sharesofatotalof45,000,000sharesoutstanding.Ata$30,000,000valuation,thecompanysfullydilutedvalueisequalto$0.67pershare(identifiedbythedottedgreenlinebelow).Nowanewinvestormakesanoffertoangelsandearlyemployeesat$0.60pershare(identifiedbythedottedblacklinebelow).

Forfounderswhostartedwithnothing,andforAngelowhopurchasedsharesat$0.05pershare,a$0.60pershareofferrepresentsanIRRofover64%.

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Whomightacceptsuchanoffer?Eachpotentialsellerorfundwillhavetheirowndecisioncriteria,butasimplifiedviewmightyieldtheconclusionthatthefoundersandangelswouldbemotivatedtosellsomeoralloftheirholdingsatthe$0.60pershareoffer.Inthissimpleexample,thenewinvestorsoffering$0.60persharearemotivatedtobuyintothecompanyatanattractiveprice(~10%discounttothefairmarketvalueofthestock).ThesellersaremotivatedtosellbasedontheattractiveIRR,andrealdollars,representedbytheoffer.

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Meanwhile,theboardofdirectors,representingallstakeholders,maywishtoswapouttheangelinvestorswithnew,longterminvestorseagertoparticipateinthecompanysforecastgrowth.Intheend,atransactionofthiskinddoesverylittletoimpacttheownershipstructureofthecompany:

Atransactionofthistypeimpactsthestructureanddynamicsofthecompanyinthefollowingways:

Foundersandmanagementarepartiallyrewardedfortheirefforts.o Vestedstockoptionsmaybesold.Bydefinition,thisisonlyasmallportion(ornoneat

all)ofrecentlyhiredemployees,andpossiblyagreaterportion(upto100%)offoundersstock.Thepressuretoexitisthusreducedmaterially,whichisoftenviewedpositivelyinthesamewaythatpatientinvestorsareviewed.

o Earlystagespecialistsaregiventheeconomicfreedomtoinvesttheirtimeandcapitalintheirnextventures.

Angelsarepartiallyorwhollyrewardedfortheriskstheytookattheformationofthecompany,andthiscapitalisredeployedintotheentrepreneuriallandscape.

NewinvestorsareallowedexposuretoprivatecompaniesatattractivepreIPOvaluations.Thisisanexcitingareaofinvestmentformanyinvestors,whereriskadjustedreturnscanbehigh.

Companieshavetheopportunitytoremovefatiguedinvestorsandemployees(knownasdeadcap)fromthecaptableinexchangefornew,longterminvestorseagertoparticipateinthecompanysforecastgrowth.

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o Asdiscussedbefore,newinvestorsatthisstageofinvestmentrequireareducedIRRduetothereducedrisksassociatedwiththecompany.Inourexample,anIRRof25%isameaningfuldifferencefromtheexpensivecapitalthecompanyacquiredatitsfounding.

o Replacingdeadcapwithpatientcapitalisnearlyalwaysviewedinapositivelight. Theboardofdirectorsremainsunchanged.Controlstillrestswiththepreferredstockinvestors.

OtherExitsNotAvailable8DavidWeildandEdwardKim,twosenioradvisorsatGrantThorntonCapitalMarketsandformerNASDAQexecutives,haveanalyzedthecausesofthecurrentIPOcrisisintwosubsequentwhitepapers.Intheirpapers,WhyareIPOsintheICU?andMarketStructureisCausingtheIPOCrisis,WeildandKimidentifyregulatoryandtechnologicalshiftsthathaveirreversiblyalteredthemarketforIPOs,includingtheneardisappearanceofVCbackedIPOsafterthedotcombustof2000andthetelecombustof2001.ThedisappearanceofsmallerIPOshasdirectlyledtolongertimestoexit,termedtheIPOGap:

Onlinebrokerages,decreasesinbrokersspreads,anddecimalizationreducedtheprofitabilityofprovidinginvestmentresearchandliquidityforsmallerstockstwocriticalelementsforsmallcap,recentlypublicfirms.ThesestructuralchangesprovidedanantagonisticenvironmenttosmallerIPOsand,byextension,toagreatmanyventurebackedIPOs.

TheRoleofPrivateCompanyLiquidityintheUSEconomyAstheIPOwindowforcompanieswithequityvaluesbetween$100millionand$1billionhasbeeneffectivelyshut,andasM&Aactivityhasnotprovidedanequivalentvolumeofexitoptions,thereareanincreasingnumberofattractivecompaniesgrowingthroughthesmallcapvaluationrangeasprivatecompanies.Withoutaviablesecondarymarketforprivatecompanystock,thesecompaniesareholdinghostagecountlessfatiguedearlystagespecialists,investorsandemployeesalike.8DreanandHege,TheSecondaryPrivateMarketsNewPlayersintheVentureCapitalEcosystem,coledesHautestudesCommercialesdeParis,2011.

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WhileIPOandM&Aexitsarestillavailabletoprivatecompanies,theyhavebeencomplementedandinsomecasespossiblysupplantedbythisnewlyrecognizedformofliquiditycalledthesecondarytradingofprivatecompanystock.AhealthyprivatecompanyliquidityenvironmentintheUS,whereinvestors,employees,directors,regulators,andlawmakersunderstandthebenefitsandrisksassociatedwithprivatecompanyliquidity,wouldbeofimmensevaluetotheUSeconomy.Thelegalexchangeofprivatesharesofstockhasbroughtnewefficiencytotheprivatecapitalmarketsbyallowingearlyemployees,foundersandearlystageinvestorstoexitalloraportionoftheirholdings.Thebenefitsofallowinganexitatearlierstagesinacompanyslife,andatvarioustimesingraduatedfashion,arenumerous:

Earlystageinvestmentspecialistsareempoweredbyallowingthemtorecycletheircapitalintothenextgenerationofpromisingstartups.

Earlystagestaffareempoweredbyallowingthemtoleaveacompanytheyvehelpedbuildandputtheirenergyintonewearlystageventures.

Entrepreneursandfoundersareempoweredbyallowingthemtoreceiverepaymentforwhatareoftenlargepersonalinvestments,thusmakingiteasierforthemtogiveupthereinsofcontroltoexecutivesmoresuitedtomanagementofmidandlaterstagestartups.

Thecompanyisnotpressuredtopushforexaggeratedgrowthatthecostofsustainablebusinesspractices.

ConclusionStockoptionprogramsareanimportantcomponentofcompensationpackagestoemployeesofhighgrowthcompaniesbecausetheyaresoefficientandeffectiveinaligninginterestsamongstakeholdersandallocatingwealthamongthosewhohelptocreateit.Forstockcompensationtowork,however,equitymustbeconvertedtocash.Foremployeesoflargepubliclytradedcompanies,suchconversionisnotaproblemasthereisaliquidmarketinwhichindividualsmayselltheirstock.Thispaperillustratestheincreasinglywellacceptedmethodsthatallowprivatecompanyshareholderstoaccessareadymarketinwhichindividualsmayaccessliquidity.Thereasonsthatprivatecompanyemployeeliquidityprogramsaretakingholdarenumerous,includingthelongtimehorizonsthroughwhichearlyemployeesandangelshavetowaituntiltheircompaniesexperienceanexitthroughM&AorIPO.Thenegotiationofpriceandterms,structuring,andthemaththatunderliesprivatestocktransactionsarecharacteristicofthecomplexitiesoftheprivatemarketsthemselves.Butintheend,itsallmath;specifically,itstheapplicationofadiscountedcashflowmodeltoexpectedfuturereturnsatanappropriatediscountrate.Atleast,itsallmathasfarasthetransactionisconcerned.Thetruevalueofaninvestmentcanneverbeforetold;itisalwaysultimatelyuptomanagementtomakeorbreakanyopportunity;tomakeorbreakanycompany.Increasedacceptanceandprevalenceofprivatecompanyliquidityprogramsshouldbeembracedasahighlypositivedevelopmentforallmarketparticipantsincludingcompanymanagement,shareholders,boardsofdirectors,andnewandoldinvestorsalike.TheUSeconomyasawholewillenjoysome

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measureofliquidityagaininthemarketforcompaniesthatareworthlessthan$1billioninequityvalue,therebyrewardingearlystagespecialistsandliquefyingcurrentlyfrozencapital.BoBrustkernisFounderandManagingDirectorofArcstonePartners,anindustryleadingbusinessvaluationandinvestmentresearchboutique,wherehedirectsstrategyanddevelopmentforthefirm.Mr.BrustkernhasleddirectandsecondaryinvestmentsinprivatecompaniesthroughhisprincipalrolesatBACEIndustriesandRusticCanyonPartners.HehasperformedinvestmentresearchleadingtosuccessfulinvestmentsinsecondarytransactionsthroughArcstoneEquityResearchandHighStepCapital.Formerly,Mr.BrustkernwasaninvestmentprofessionalatventurecapitalfirmRusticCanyonPartnersandmiddlemarketprivateequityfirmBACEIndustries.Priortohiscareerasaprivateequityinvestor,Mr.BrustkernwasasenioranalystatWellsfordResidentialPropertyTrust(NYSE:WRP),wherehefocusedonacquisitionsanddevelopmentforthefifthlargestresidentialREITinthecountry.BoholdsanMBAwithdistinctionfromTheAndersonSchoolatUCLAandaBAfromDartmouthCollege.

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