Employee liquidity – good for private companies?

Opportunities to offer employees liquidity in company shares are increasing on the secondaries market, write Industry Ventures founder and chief executive officer Hans Swildens and senior associate Ira Simkhovitch. 

Startup employee stock sales were once considered “selling out” and sought only by employees who were no longer involved in the company. Today, employee liquidity is no longer taboo, and is actually embraced by some of the most innovative private companies. The real struggle chief executive officers, chief financial officers and boards of directors are having is how to deal with it.

In the past, startup companies lacking experience in secondary transactions handled these situations in a variety of ways. There were no established and reputable buyers. It was a Wild West of sorts. Some companies allowed a seller to transact with any buyer. Other companies only allowed sales to certain trusted third parties, such as secondary funds and hedge funds. More conservative companies blocked all such transactions, or even opted to buy employee shares themselves using the company balance sheet. Venture capital firms were also unsure of how to deal with the secondary market and viewed secondary sales as misaligning the interests of investors and company management. If founders and employees sold their shares, would they still be motivated to drive the business to a successful M&A or IPO exit?

There are now many companies confirming that, if handled correctly with employees continuing to hold a meaningful quantity of stock and options, secondary sales can be a powerful tool for talent recruitment and retention. With the mean time from funding to exit for a startup increasing from two to five years in the early 2000s to an average of six to 10 years today, an employee may hold illiquid stock for quite some time while undergoing major life events such as marriage, birth of a child, home purchase, or graduate education. Employee liquidity is a tool to help employees manage through these events and turn paper gains into real money when needed. Phil Lubin, CEO of Evernote, said “Why would anyone want to put pressure on the founders of a company to potentially sell [their business] prematurely? Yeah, they are kind of successful, but can’t put their kids through college.”

Fearing the potential misalignment that secondary sales could cause, some companies reacted with tight restrictions on share sales. Rather than retaining control, the “grey market” for employee liquidity that emerged resulted in some companies actually having less control of their cap table. Brokers and secondary exchanges engineered structures including share loan transactions designed to provide liquidity by circumventing restrictions. Lenders have sold these to shareholders touting tax benefits and upside sharing agreements. Companies have struggled to understand these complicated agreements that use share pledges and escrow provisions. Management and boards are often unaware when key employees have pledged the majority of their shares in a loan agreement.

We believe the most innovative startup companies have instead embraced employee liquidity as a standard employee benefit. First pioneered in the mid-2000s and now used by leading private companies such as AirBnB and Dropbox, liquidity programs can allow employees to balance short-term and long-term rewards on an individual basis which ultimately improves recruitment, retention and motivation.

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An original version of this story appeared on Industry Ventures’ website.