secondary market research paper
TRANSCRIPT
Secondary Markets
Entrepreneurial Finance Professor Santinelli
May 4th, 2012
Prepared By: Maxwell Finn
Elizabeth Kenny Sean Prentis
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Table of Contents Introduction .............................................................................................................................. 3 Private Equity ........................................................................................................................... 6 Overview .............................................................................................................................................. 6 Measuring Returns ........................................................................................................................... 7 Current Status .................................................................................................................................... 7 Future of Private Equity Firms ..................................................................................................... 8
SecondMarket ........................................................................................................................... 9 Overview .............................................................................................................................................. 9 The Platform .................................................................................................................................... 10 Internal Liquidation Event .......................................................................................................... 12 Future Outlook ................................................................................................................................ 12 Value of Staying Private ............................................................................................................... 14
The Future of Secondary Markets ................................................................................... 14 Case Writeups ........................................................................................................................ 16 HarbourVest Case ........................................................................................................................... 16 SecondMarket Case ........................................................................................................................ 20
Interviews ............................................................................................................................... 23 Interview with Brett Gordon at HarbourVest ....................................................................... 23 Interview with Sam Ensslin at HabourVest ........................................................................... 24 Interview with Gerald Di Fiore at Reed Smith ...................................................................... 27
Exhibits .................................................................................................................................... 30 Exhibit 1 – Secondary Buyer Table ........................................................................................... 30 Exhibit 2 Employee Equity Calculation Example ................................................................ 31 Exhibit 3 Private Equity Returns Over Time ........................................................................ 32 Exhibit 4 SecondMarket History ............................................................................................... 32 Exhibit 5 SecondMarket Top 10 Most Watched Private Companies ............................. 33 Exhibit 6 SecondMarket Transactions by Industry Graph ............................................... 33 Exhibit 7 SecondMarket Transactions by Seller Types ..................................................... 34 Exhibit 8 SecondMarket Transactions by Buyer Types ..................................................... 34 Exhibit 9 SecondMarket Investor Preferences ..................................................................... 35 Exhibit 10 SecondMarket Company Page .............................................................................. 36 Exhibit 11 SecondMarket Buyer Page ..................................................................................... 37 Exhibit 12 SecondMarket Seller Page ...................................................................................... 38 Exhibit 13 SecondMarket Most Watched Non Venture-Backed Comapnies ............... 39 Exhibit 14 SecondMarket Fasting Growing Companies .................................................... 39 Exhibit 15 SecondMarket Completed Transactions by Industry ................................... 40 Exhibit 16 Secondary Market Historical Transaction Activity ....................................... 41 Exhibit 17 EB Exchange Fund ..................................................................................................... 41
Works Cited ............................................................................................................................ 42
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Introduction
The secondary market offers management and investors the ability to sell their stock prior
to the company being sold or going public. The venture industry is high risk and high
rewards, but with the emergence of secondary market entrepreneurs are able to take out
some of the risk by taking out a small portion to sell. An investor and early stage venture
capitalist can consider using the secondary market to liquidate some of their older
portfolios as they mature.
A company may look to use secondary market in order to motivate and retain employees.
This allows employees to sell a small percentage of their shares in order to incentivize
their employees to stay with the firm. The secondary market also is used to alleviate any
such financial issues an employee may be burdened with. Secondly, the market is used to
swap or remove current investor which arises when the investor’s interest does not align
with the objectives of the company. To create new value in the company the entrepreneur
will look to swap out mature investors with new. Lastly, to eliminate the need to go
public the company can offer a secondary investor a grouping of smaller current
shareholders.
This report will focus on indirect secondary funds (HarbourVest) and secondary
exchanges (SecondMarket). An extensive list of the six types of secondary buyers is
found on Exhibit 1. Indirect secondary funds consist of investors who buy limited
partnership interest in other investment fund; basically replacing the current investor in
the fund. The new investor will hold the stake in the new acquired company until the
private equity fund sells their portfolio companies and distributes the capital. What
differentiates an indirect from a direct secondary fund is that typically an indirect
secondary investor does not have any direct involvement in the management or
overseeing of the company. Secondary exchanges have gained much publicity over the
last years due to the transactions of Facebook, Zynga, LinkedIn, and Twitter. Examples
of secondary exchange markets are SecondMarket, NYPEXX, and SharesPost.
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Second market platforms tend to focus on the first tier-companies i.e. 5% of the
companies on the secondary platforms; resulting in a substantial amount of value, while
the second and third tier companies i.e. 95% of the companies on the secondary market
go unnoticed (Exhibit 5). These exchange markets are constrained by the ability to
provide information about the performance and track record of the company. If an
entrepreneur is looking for investor to participate in follow-on financing series;
secondary market platforms are not the proper fit because secondary markets offer
liquidity to investors, founders and employees as opposed to fund raising which funds the
company’s growth. Companies on secondary markets are waiting to go public. They have
the management, technology, product, revenue and profit.1 According to Accel’s Sameer
Gandhi, major venture capitalists are not really focused on such sites as SecondMarket;
because “all the-growth equity rounds are with some degree of liquidity, or a massive
amount of liquidity. They’re not all primary capital. So that earlier situation of founder
liquidity waiting for the IPO, that’s sort of a nonexistent factor for VCs.”2 Doug Leone of
Sequoia Capital found that in past, private companies all growth equity rounds were done
at a discount. In today’s market equity rounds get done above public market comparable;
“so [entrepreneurs] make [their] money on the equity side because [they] are screwed on
the public side3.” This also ties into the idea that by allowing a young CEO and
entrepreneur to take some money out of a growing business it will incentivizes the
entrepreneur and reduces the chance of the employee burning out.
On the other hand, it is important for an entrepreneur to take into account the stance that
their VC has towards an employee selling his shares. Mr. Leone’s went on to say:
Where we get offended is when a venture firm comes in to a company that
has no revenue model, no revenues, and bribes a CEO and says ‘We want
to be your series A investor.’ Imagine this. Series A, and they haven’t
1 1 http://techcrunch.com/2012/04/05/vcs-secondary-funding-markets-are-a-double-edged-sword/ 2 http://techcrunch.com/2012/04/05/vcs-secondary-funding-markets-are-a-double-edged-sword/ 3 http://techcrunch.com/2012/04/05/vcs-secondary-funding-markets-are-a-double-edged-sword/
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done anything. And $2 million goes in the founder’s pocket. That is a bad
part of the secondary market that we hate to see.4
As long as secondary liquidity is done in an organized and controlled manner the process
it can be acceptable. It is an issue when shares are given to investors you do not know,
creating much of the problems a public company must deal with, but with much less
control over the situation. Some private companies have allocated a full-time employee
whose sole responsibility is managing secondary exchanges for employees. To combat
this VCs have altered bylaws and operating agreements, in order to restrict the uses of
funds for only growth of the firm.
The price at which an entrepreneur can value their stock on a secondary market platform
is greatly dependent on the amount of information they are allowed/want to give out; the
more information released the higher the price the seller receives. The investor will
discount the price of the share if no financial information is disclosed. To alleviate the
risk of releasing too much information, one possible solution is to agree with the
interested buyer in a staged release of information. Most potential buyers will indicate an
initial interest in purchasing shares from a seller even when there is minimal information
published. As the discussion progresses and sufficient amount of interest is shown by the
buyer, the seller will have the buyer sign a confidentiality agreement; which eliminates
the possibility of information about the company being made public. Below lists key
information an entrepreneur may have to release in the selling of their shares to an
outside investor:5
• Recent Company Capitalization Table
• Corporate Documents (charter, bylaws, and investment agreements)
• Historical and Projected Financials of the Company
• Investor Presentation
• Recent Board Presentations and/or Minutes
4 http://techcrunch.com/2012/04/05/vcs-secondary-funding-markets-are-a-double-edged-sword/ 5 A Guide to Secondary Transactions: Alternatives Paths to Liquidity in Private Companies
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It is important at this point to dissolve the idea that if an entrepreneur shops around for a
deal it will result in a higher price. This is incorrect. Though there are a large number of
potential secondary transactions currently in the market, there is only a small body of
investors focused on this type of transactions; a broad auction has the disastrous potential
of resulting in an unfavorable new investors. Additionally, the entrepreneur’s 409A
valuation is not considered their selling price but rather the “fair value”. Their “best
value” can be found through: valuating the last round of financing, a recent turned down
buy offer from an outside company, calculating discounted future cash flow or the use of
a public company comparable multiple. Whatever valuation technique the entrepreneur
may decide to use will result in a price the entrepreneur is willing to sell the company
today. For a step-by-step process of calculating the employee’s equity value reference
Exhibit 2.
Private Equity
Overview
Private Equity firms in secondary markets are buying out the limited partners in Venture
Capital firms in order to invest in companies with a proven business model. Companies
on average are in the late stage. Limited partners are willing to sell their equity in the
fund because they need to become liquid. Some funds have invested in companies two-
three years longer than expected and the Limited Partner was expecting cash for their
investment.6
A Private equity firm generates negative returns in the early years because of the
management fees and underperforming companies that later becomes written down as a
result the investments are carried at cost. Over time investee companies make progress
because as other companies invest they are justifying a value of the business that is
higher than its original cost to the private equity firm. In the final years of the fund, the
6 http://www.calpers.ca.gov/index.jsp?bc=/investments/assets/equities/aim/private-equity-review/understanding.xml
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valuation is confirmed when the company is either sold or reaches an IPO as shown in
Exhibit 3.7
Measuring Returns
The Internal Rate of Return is the most widely used formula to measure performance.
The calculation takes into consideration the timing of cash contributions and distributions
to and from the partnership and the length of time an investment has been held. The
investment multiple is another widely accepted measure of performance. The multiple
measures the proceeds received from a fund plus the valuation of the remaining
investments divided by the capital contributed to the fund.8
Current Status
Sellers are now more likely to sell because they can demand a higher price therefore
increasing the number of transactions on secondary markets. Prices have risen because
firms like Coller Capital and HarbourVest have raised more money to take advantage of
the opportunity to buy; ultimately increasing the demand. In addition, big firms now can
support themselves on the management fee i.e. 2%9 annually because funds are being
raised for billion dollar funds. Neil Campbell of Tullet Prebon, an interdealer broker, says
that investors today can expect around 95 cents on the dollar compared with only 60
cents in 2009.10
Under the JOBS Act private equity firms are allowed to advertise and partake in general
solicitations as long as sales are only made to accredited investors. As a result, firms can
reach across each other for investors for money.
Some critiques of private equity argue that the industry destroys jobs and results in
bankruptcies because firms take on debt to buy companies. Firms also buy companies
that they believe they can make more efficient, profitable and cash therefore firms may
7 http://www.calpers.ca.gov/index.jsp?bc=/investments/assets/equities/aim/private-equity-review/understanding.xml 8 http://www.calpers.ca.gov/index.jsp?bc=/investments/assets/equities/aim/private-equity-review/understanding.xml 9 http://topics.nytimes.com/topics/reference/timestopics/subjects/p/private_equity/index.html 10 http://www.economist.com/node/21541430
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reorganize a company which could result in a decrease in the number of employees.
Private equity officials argue that their acquisitions drive economic growth because they
are making companies more efficient so they are becoming more profitable and cash
abundant.11
Future of Private Equity Firms
Private Equity firms are being forced to raise more money because banks are not lending
as much as they did five years ago. Banks are also going to have to follow the Volker
Rule. The Rule will prohibit banks from placing bets on their own money12 resulting in a
separation between banks and private equity firms. The rule has yet to pass congress but
is expected to go pass Congress in September 2012. As a result returns are expected to
decrease. In the past, higher debt accounted for as much as 50% of private equity’s
returns according to a 2011 study co-written by Viral Acharya of New York University’s
Stern School of Business. Returns are going to be much more mundane. As a result
private-equity firms are trying to reinvent themselves by using less debt.13
On the contrary, private equity deals have increased by 38% form quarter one of 2010 to
quarter one of 2011. Quarter one of 2010 saw 93 deals of $1.83 billion compared to
quarter one of 2011 that saw 99 deals worth of $2.59 billion.14 Mathieu Dréan of Triago
predicts $75 billion worth of private-equity transactions annually by 2015, the struggles
of private equity industry will fuel the growth because too many companies bought
companies at high prices so they need to wait until the economy improves. As a result
private-equity firms are holding onto their investments for 5 years instead of 3 years and
so firms are looking into secondary markets for returns.15
11 http://topics.nytimes.com/topics/reference/timestopics/subjects/p/private_equity/index.html 12 http://dealbook.nytimes.com/2012/05/02/progress-is-seen-in-advancing-a-final-volcker-rule/ 13 http://topics.nytimes.com/topics/reference/timestopics/subjects/p/private_equity/index.html 14 http://vccircle.com/500/news/private-equity-deal-value-up-38-touches-26b-in-q1.htm 15 http://www.economist.com/node/21541430
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SecondMarket
Overview
SecondMarket defines itself as a “marketplace for alternative investments”. Founded in
2004 by Barry Silbert, the company is a registered broker dealer that was initially
developed to provide liquidity solutions for holders of restricted securities in public
companies (Exhibit 4). The company’s core product is an electronic trading platform,
which connects buyers and sellers of five different markets: private company stock,
community banks, fixed income, bankruptcy claims and restricted public equity. This
report focused primarily on the private company stock market within the SecondMarket
trading platform. The most popular private companies trading on SecondMarket are
Facebook, Twitter, Dropbox, Foursquare, Square, Hulu, Gilt, Craigslist, Living Social
and Spotify (Exhibit 5).
During the fiscal year of 2011, SecondMarket completed $558 million in transaction
volume within their private company stock marketplace. Transaction volume was up 55%
from fiscal year 2010 at SecondMarket, which was primarily due to the increase in
popularity of social media companies like Facebook, Twitter and Groupon. Barry Silbert,
the CEO of SecondMarket, stated that in 2011 transactions of Facebook stock accounted
for 30% of his company’s revenue.16 SecondMarket went on to say that 61% of all
transaction volume in 2011 came from social media and Internet companies (Exhibit 6).17
This is an important statistic given the fact that many of the most popular social media
companies have begun to go public. Facebook’s public offering, which is set for May
18th, will adversely affect SecondMarket’s financial performance in the coming year.18
The company recognizes this threat and has already cut 10% of its workforce in
anticipation of Facebook’s public offering.19
16 http://www.betabeat.com/2012/02/03/secondmarket-facebook-ipo-barry-silbert-02032012/ 17 http://blogs.wsj.com/marketbeat/2012/01/19/secondmarket-brags-about-2011-results-but-what-happens-after-facebook-goes-public/ 18 http://www.huffingtonpost.com/2012/05/01/facebook-ipo-date-may-18_n_1469248.html 19 http://blogs.wsj.com/marketbeat/2012/03/31/secondmarket-slashes-10-of-staff-ahead-of-facebook-ipo/
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One would think that a majority of the sellers would be current employees and founders
of private companies, but this is not the case. SecondMarket states that an incredible 80%
of all sellers are ex-employees who are attempting to cash out before a public offering
(Exhibit 7). Facebook is partially responsible for the large volume of ex-employee
activity. In 2010, current Facebook employees were banned from selling their stock
because of legal concerns, which meant that the only way for Facebook employees to sell
shares was to leave the company. This rule caused Facebook to lose senior managers and
talented employees who did not want to wait for an IPO to cash out.20 Thus, only 11% of
the sellers on SecondMarket are current employees at their respective companies. The
buyers who use the SecondMarket trading platform are primarily hedge funds, family
offices and asset management firms. These three groups account for 73% of all
transaction volume on the buyer’s side of the platform (Exhibit 8).21
The Platform
In order to access the full features of the SecondMarket platform the user must first apply
and meet the accredited investor requirements. There are three requirements an individual
must meet in order to be accredited by the SEC: a net worth of greater than $1,000,000
when combined with your spouse, an individual income of greater than $200,000 for at
least the last two years and expect to make the same amount of income in the current year
and you must demonstrate knowledge and experience in the financial markets.22 After
SecondMarket confirms that you are an accredited investor you have the ability to state
investment preferences. The first step in this process is to indicate your current portfolio
allocation in terms of how much you have invested in: equities, fixed income, real estate,
alternative investments and cash and cash equivalents. Investors are also asked to state
their tolerance for risk and investment strategies as seen in Exhibit 9. SecondMarket
leverages this information to send buyers potential investment opportunities based on
their respective investment preferences.
20 http://news.cnet.com/8301-1023_3-57368449-93/three-reasons-facebook-has-to-go-public/?tag=txt;title 21 http://blogs.wsj.com/marketbeat/2012/01/19/secondmarket-brags-about-2011-results-but-what-happens-after-facebook-goes-public/ 22 http://support.secondmarket.com/entries/481382-do-i-have-to-be-an-accredited-investor-to-join-secondmarket
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Once the have met the accreditation requirements and stated investment preferences they
have the ability to either buy or sell shares in the respective private company. The
company page on SecondMarket displays specific pieces of data about the respective
business. Dropbox’s page, as seen in Exhibit 10, shows basic information like a summary
of the business and the location of their headquarters. However, the page also displays
detailed information on who has invested in the company since founding and how much
each investor contributed. As a SecondMarket member and accredited investor the user
has the ability to watch, buy or sell shares of Dropbox. If the user is looking to buy
shares, he or she must state the amount they wish to invest, the valuation range at wish
they are interested in investing in and explain to the company why he or she is a suitable
investor (Exhibit 11). If the user is an employee at a private company and wish to sell
some of their shares, SecondMarket asks for different information. When selling shares
the seller must state the quantity of shares he or she wishes to sell, the type of stock they
own, the total number of shares owned and state who can see their current holdings
(Exhibit 12).
The primary SecondMarket platform is quite different to a HarbourVest or other Private
Equity firms operating in secondary market investments. These firms buy and sell
Limited Partner interests in larger VC funds. A typical VC fund may be invested in 20-40
private companies, but SecondMarket allows the user to make an investment in one
specific company. However, if they are an accredited investor and member of
SecondMarket he or she receives an Investment Opportunity notification on their
“Activity Feed”. The most recent opportunity was to invest in SecondMarket’s Facebook
Fund. The fund required a minimum investment of $200,000 and charged a 3%
subscription fee, along with a 3% distribution fee 180 days after a liquidity event.
While the SecondMarket platform has received a significant amount of press over the last
few years, the overall transaction volume is relatively low. Since the company’s founding
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in 2004 they have completed just over 1,000 transactions, which reflects $1 billion in
transaction value.23
Internal Liquidation Event
The company uses itself as a case study for the success of its product. In 2011
SecondMarket ran its first internal liquidity program, which allowed a majority of the 100
employees to sell $13 million worth of stock at a valuation of $160 million.24 The internal
liquidation event was run in conjunction with a Series C round of Venture Capital
financing. The liquidation event was open to all SecondMarket shareholders who held
fully vested stock and allowed them to sell either 30% or $100,000 of total holdings,
depending on which amount was greater. SecondMarket also attempted to mitigate
investor risk during this event by providing investors with audited financial reports and a
list of critical risks, similar to what an investor would find in an S-1 filing. This
transaction was led by The Social + Capital Partnership, along with well-known angel
investors like Yuri Milner and Frank Lavin.25
Future Outlook While the Facebook IPO will have a significant impact on SecondMarket, the company is
still quite optimistic about its future. SecondMarket CEO, Barry Silbert, told the audience
at the Xconomy forum “We’re completely prepared to fill the hole. We’re hiring, and we
have a lot of capital.”26 The company has recently launched two new programs to
diversify their customer base and expand their revenue streams. The first of these
initiatives is called SecondMarket for Companies, which provides tools to non-venture
backed private companies like Bloomberg and Burger King (Exhibit 13). Since launching
this new product, SecondMarket has generated $6 billion in buyer interest for a select
group of non-venture backed businesses.27 The second initiative that the company has
23 https://www.secondmarket.com/discover/resource/case-study-secondmarket%E2%80%99s-own-secondary-transaction 24 https://www.secondmarket.com/discover/resource/case-‐study-‐secondmarket%E2%80%99s-‐own-‐secondary-‐transaction 25 https://www.secondmarket.com/discover/resource/case-study-secondmarket%E2%80%99s-own-secondary-transaction 26 http://www.betabeat.com/2012/02/03/secondmarket-facebook-ipo-barry-silbert-02032012/ 27 http://www.betabeat.com/2012/02/03/secondmarket-facebook-ipo-barry-silbert-02032012/
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launched is a marketplace for private community bank stocks. This platform allows
shareholders of small community banks to liquidate a portion of their total holdings.
Community banks have historically struggled to raise capital and most shareholders could
not cash out until the bank was sold entirely.28 These two initiatives have helped
SecondMarket mitigate the downside risk associated with IPOs of large customers, such
as Facebook, Yelp and Groupon.
SecondMarket has also found a new group of venture-backed, fast growing startups to
work with. The company is currently in talks with Pinterest to allow their employees to
sell shares on the SecondMarket trading platform. From Q4 of 2011 to Q1 of 2012, there
was a 667% increase in the number of SecondMarket members watching Pinterest
(Exhibit 14).29 There has also been a significant increase in level of trading activity for
private companies operating in the Software as a Service, Cloud Computing and
Enterprise markets. SecondMarket claimed that during the past quarter, software
companies surpassed social media companies in both transaction volume and community
interest (Exhibit 15).30
While a future without Facebook will be tough for SecondMarket and other secondary
market trading platforms, the recent signing of the JOBS Act will help the company
attract more private venture-backed companies. Prior to the signing of the JOBS Act,
private companies could only have 500 shareholders before having to register with the
SEC and go public. This rule played a critical role in why Facebook’s Mark Zuckerberg
was forced to make the decision to go public. The JOBS Act now allows private
companies to have up to 2,000 shareholders before having to register with the SEC,
which will increase the amount of time venture-backed companies can stay private.31
This will ultimately benefit SecondMarket, as its biggest clients will be able to stay
private and continue using their trading platform to offer liquidity to employees, founders
and early investors. 28 http://news.cnet.com/8301-1023_3-57379874-93/a-secondmarket-for-small-banks-thank-facebook/ 29 http://www.cnbc.com/id/47280435 30 http://www.cnbc.com/id/47280435 31 http://techcrunch.com/2012/04/05/with-jobs-act-becoming-law-crowdfunding-platforms-look-to-create-self-regulatory-body/
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Value of Staying Private
At a certain point in the growth of the business it is important for the entrepreneur to take
a step back and decide whether or not going public should be the next step. Deciding on
bringing the company public, the entrepreneur will have access to new, large pool of
capital. However if the company has enough liquidity, there may be no reason to go
public. With going public the company faces a whole new set of challenges. These
additional challenges include; more regulation and scrutiny from Wall Street and Security
Exchange Commission. Additionally the business’s competitors will now be able to see
how the performance of the company. This was an issue Google faced prior to going
public; they feared that by going public their main competitor, Microsoft would now
know how profitable the search engine market was. But due to the past rule of only 500
shareholders allowed to invest in a company, Google was forced to go public. Jeff
Thomas, Senior Vice President of SecondMarket stated there has been a structural change
in the process of going public; it is more complicated and harder now for companies to go
public due to Sarbanes-Oxley and the need for market capitalization to be approximately
$350-500 million.32 The complication is also due to the dot com bubble and the stricter
regulations created by the SEC. Mr. Thomas stated how it used to be one million dollars
for a company to go public, but now-a-days it is around five million dollars just to cover
additional overhead, accountants and regulatory fees per year.33 As a public company the
founders also have to potential to face a conflict when their future path of the company
does not coincide with the shareholders. For these reasons as an entrepreneur it is
important to weigh out the pros and cons of going public in comparison to receiving
liquidity from another option such as secondary market.
The Future of Secondary Markets
There are some investors that compare the secondary market to the financial catastrophe
of the credit default swap market, which may create another bubble34. In addition, Doug
32 http://vator.tv/news/2011-09-05-how-secondary-markets-created-new-financing-options 33 http://vator.tv/news/2011-09-05-how-secondary-markets-created-new-financing-options 34 Ep.61 facebook’s private fund-raising what it means for tech
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Leone of Sequoia Capital believes “the door is getting shut35” on secondary transactions
due to the Right of First Refusal for all parties. The ROFR provision gives the company
and major investors the right to match or counter any offer an outside investor submits. It
is designed to keep ownership and control within the hands of the original investors and
employees. However, the overall expectation is that second market is here to stay because
it is used as an intermediate step between start-up and IPO.
35 http://techcrunch.com/2012/04/05/vcs-secondary-funding-markets-are-a-double-edged-sword/
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Case Writeups
HarbourVest Case Private Equity Firms in Secondary Markets
Focusing on
HarbourVest is an independent investment firm that provides innovative private equity
solutions to intuitional clients worldwide. HarbourVest has three investment strategies,
Primary Partnerships which focuses on primary partnerships with fund managers;
Secondary Investments which focuses on already issued shares of companies whose
institutional investors want to become liquid and Direct Investments which focuses on
primary shares.36
HarbourVest started investing in secondary markets in 1986 when other firms didn’t
agree. Today HarbourVest has a team of 20 investment professionals focusing on
secondary opportunities, which includes 12 senior professions with an average tenure of
10 years. HarbourVest uses their extensive network of relations that help them gain early
introductions to potential buyers and sellers. Their network is also used for their due
diligence process.
In the past secondary markets provided a way to buy and sell limited partnership that
were not the high profile venture capital backed companies. Secondary Market investors
were interested in the Venture Capital firm as opposed to the company itself. The greatest
competition was in the 1990s because people didn’t want to sell their investments due to
the high valuations. HarbourVest saw $20 billion in opportunity i.e. deal flow, which
totaled 175 sellers in 2006. In 2011 HarbourVest saw $76 billion in opportunity that
totaled 550 sellers therefore the number of people coming to sell has exploded because
36 http://www.harbourvest.com/
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they held onto their investment from the Internet bubble. There has been $1.3 trillion
raised in private equity over the last 3 years (Exhibit 10).
Institutional Investors that want to become liquid seek out HarbourVest. Some of the
investors’ funds have been in the company for twelve years but when the fund was
planning they planned to be involved for 10 years so the investors want to liquidate their
investment. HarbourVest does not invest in companies whose CEO has approached them
because they want to become liquid. HarbourVest sees this as a red flag because the CEO
should not want to liquidate their shares of the company by selling them to someone else.
This could mean that the CEO does not believe the company’s share price is going to
increase over time.
HarbourVest secondary market investments are in the late stage of the business cycle.
Companies have to have a proven business model because HarbourVest prefers not to
invest more money in the company i.e. they do not want to take on the early stage risk.
HarbourVest also does not invest in research and development companies because of the
early stage risk. HarbourVest also does not invest in oil, gas, real estate, biopharm,
industrial or technology because of the high investment costs. HarbourVest is not looking
for the big home run that Venture Capital firms are looking for to even out the negative
returns. As a result, HarbourVest on average has higher returns on their secondary
investments i.e. 2x than Venture Capital firms because they are investing in companies
with proven business models (Interview 1 – Brett Gordon).
HarbourVest does a full due diligence on companies that it might invest in; they invest in
1/10 deals they receive. 1-2% of the companies they invest in are based on information
through the relationships they have created. Once HarbourVest has received notice from
the institutional investors that they would like to sell their shares, HarbourVest has two
discussions with their partners to discuss an offer. The partners will discuss a valuation of
the company based on recent financing, bottoms-up analysis, public comparables,
discounted cash flow, market valuation, cash and the current state of HarbourVest i.e.
how much HarbourVest can pay in order to get a return. HarbourVest will also look at
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management, financial statements, board presentations and customer lists. They will not
invest if the company is being restrictive with information because they feel the company
must be hiding something. HarbourVest will then meet with the company to make an
indicative offer which lets the company know how much they are willing to pay. The
company and HarbourVest then enter into exclusivity for 4-6 weeks with a binding offer.
HarbourVest then will submit a binding bid (Interview 2- Sam Ensslin).
Once HarbourVest has come to an agreement they outsource the management to
experienced Venture Capitalists who go to all the meetings so HarbourVest can focus on
financing and investing. They prefer to be hands-off. In return for HarbourVest’s
investment, they receive an average of 30% equity. They will stay as an investor in the
company until the company is bought or recapped (Interview 1- Brett Gordon).
Alternatives for Limited Partners is to sell their positions in a VC fund to a private equity
firm similar to HarbourVest consists of holding onto the equity and waiting for an M&A
or an IPO and then the Limited Partners will become liquid. The problem is that some
Limited Partners have been involved with a company for longer than expected and they
want to become liquid so they reinvest which is why they seek out companies like
HarbourVest (Interview 1- Brett Gordon).
A founding entrepreneur is not typically still involved with the company by the time
HarbourVest invests in the company. A Founding entrepreneur on average is involved in
the company for five years while HarbourVest invested between years ten-twelve. There
will still be some uncertainty in the company because HarbourVest outsources their
management to experience Venture Capitalists. The Venture Capitalist will sit on the
board because HarbourVest on average buys 30% equity. It is also important to note that
HarbourVest returns are higher than Venture Capitalists so the employees should feel
good that they are going to get a return. It also means that the employees are doing
something right because they have a proven business model and for HarbourVest to want
to invest in them means something considering HarbourVest invests in 1/10 of the deals
they receive (Interview 2- Sam Ensslin).
19
Long-Term Viability
Supply outweighs demand therefore HarbourVest picks the companies they want to
invest in. Supply outweighs demand because during the bubble companies received high
valuations which made it difficult for HarbourVest to find companies to invest in. At the
time the biggest competitor for HarbourVest was convincing the seller to actually sell.
Now that the bubble has burst and Limited Partners are still involved in companies ten
years later because they haven’t been able to become liquid they are seeking companies
like HarbourVest to purchase their equity so they can become liquid which has only
increased the supply. HarbourVest also benefits from high barriers to entry because of the
relationships that they have built. The industry is relationship based because private
equity firms have to work with companies therefore putting the company up to auction
has a high risk that the company and private equity firm will not be cohesive.
20
SecondMarket Case Internet Platform in Secondary Markets
Focusing on:
Some people look better on paper because all their wealth is tied up in equity i.e. Mark
Zuckerberg37. Internet platforms are a way for investors to access secondary markets.
Secondary markets are a tool used for people to become liquid. It is important to note that
secondary markets do not generate cash for the business itself but rather the people that
have equity in the business. For example Mark Zuckerberg is selling 30.2 million shares
for $1 billion to pay taxes38.Secondary market platforms have been limited to social
media companies because they have attracted the people that are willing to make an
investment without any information due to the fanfare.
The SEC restricts platforms that are not a broker-dealer from generating commissions
therefore making it difficult for platforms to generate revenue. In addition, platforms that
are not a registered broker-dealer i.e. SharesPost rely on a high volume transaction
because they can only generate a small transaction cost when in fact secondary platforms
will never have high volume because there is a low amount of viable information so the
number of buys and sellers is limited. Platforms choose to not be a registered broker-
dealer because it is a heavy burden on the company. It costs at least $100,000 and takes
nine months to a year to be registered (Interview 1- Brett Gordon).
There is very little due diligence done because of the lack of information available on
private companies. Before the JOBS ACT private companies with less than 500
37http://online.wsj.com/article/SB10001424052702304746604577382210530114498.html?mod=WSJ_hp_LEFTWhatsNewsCollection 38http://online.wsj.com/article/SB10001424052702304746604577382210530114498.html?mod=WSJ_hp_LEFTWhatsNewsCollection
21
accredited investors did not have to report any financials. Now private companies can
have up to 1,500 accredited investors and 500 unaccredited investors and not report any
financials. When an investor purchases stock from a private company they sign a contract
acknowledging that they, the buyer, may have an information disadvantage to the seller
and the seller signs a contract saying they may have an information disadvantage to the
buyer. The only due diligence that an investor can do is use the information that is made
available from the fan fare. For example, investors in Facebook were able to tell how
many users i.e. 800 million there were before investing because that information was
made available due to the fan fare. It is important to note that no other company has
generated the fan fare that Facebook did. People throughout the world understood
Facebook because of the amount of users therefore more information about Facebook
was available to investors than in the past (Interview 4- Gerard Di Fiore).
When a private stockholder sells their stock on secondary markets they are giving up
their equity in the company. Depending on their agreement with the company the
employee generally can only sell 10% of their equity. The buyer of the stock also needs
to follow the company’s agreement. Kevin Landis of San Jose, California bought shares
of Facebook on the secondary market for $31 to $32 a share over the past year and agreed
not to sell the shares for six months after the IPO.39 The seller will still be held up in a
lock up. The difficulty about selling stock on secondary markets is that most of the
companies who stock are being sold are only valuable to the employee at the company
because no one else understands the business due to the lack of information available
therefore there are a limited number of buyers.
Crowd funding is an alternative to secondary platforms. Crowd funding pools together
investors’ money. Before the JOBS ACT an investor had to be accredited. A private
business could only have 500 registered investors. The JOBS ACT increases the amount
of investors to 2,000 as long as no more than 500 shareholders are not accredited;
therefore 1,500 investors can be credited. The challenge with crowd funding is that a 39http://online.wsj.com/article/SB10001424052702304746604577382210530114498.html?mod=WSJ_hp_LEFTWhatsNewsCollection
22
business can only take small amounts of money per investor i.e. the non accredited
investors can only give 5% of net work or up to $10,000 of income therefore a business
can only raise $505,000. In other words, a business needs mass appeal and it is the
businesses that have mass appeal that will get money from other investors i.e. Venture
Capitalists therefore they don’t need the money from crowd funding (Interview 4- Gerard
Di Fiore).
Another alternative for entrepreneurs is the EB Exchange Funds. EB Financial Group
founded by Larry Albukerk, established the concept of private company exchange funds
as a means to attain diversification and liquidity of highly focused, illiquid private stock.
In the Founder Exchange Fund, EB Financial Group generates and manages exchange
funds for entrepreneurs holding private stocks. After the creation the entrepreneur will
have the ability to invest a small percentage of their founder’s equity (non-cash
investment) into a portfolio of other high-quality VC-backed companies.40 The website
has a calculator that determines based on the amount; type of stock, restrictions, etc. the
amount of stock at a price one entrepreneur to use to diversify their portfolio (Exhibit 11).
Employees have to be careful when selling stock on secondary markets because they are
becoming liquid before the investors so investors may think that the employees do not
believe in the company and want to get out.
Long-Term Viability
Secondary Platforms that are not a registered broker-dealer will not be able to sustain
because the SEC only allows them to generate a small transaction fee so they rely on high
volume transactions. The problem is that secondary markets themselves are not a high
volume market because it is the private companies that trade in secondary market so the
information available is limited. Platforms like SecondMarket are able to sustain because
they are a registered broker-dealer so they can charge commissions. Commissions on
Facebook were 2-3% each side, which is high for private equity as long as there is
explosive growth (Interview 4- Gerard Di Fiore).
40http://ebexchangefunds.com/press/
23
Interviews
Interview with Brett Gordon at HarbourVest Managing Director • March 13, 2012 • [email protected]
What changes have you seen in the past decade in secondary markets?
Past: • It didn’t include the high profile venture capital back companies selling their
shares • Has been a way to buy and sell limited partnership • They weren’t interested in the underlying company, interested in the VC firm
(limited partnership) • 1982- HabourVest first secondary transaction; people didn’t agree • For a decade and half there wasn’t a lot of competition; greatest competition in
the 1990s was getting someone to sell Recent (post internet bubble):
Current: • More private equity and greater need for liquidity which has caused an increase in
secondary market, which has continued to increase • 2006: HabourVest saw $20 billion in opportunity (deal flow); number of sellers:
175 • 2011: HabourVest saw $76billion in opportunity (deal flow); number of sellers
550; invest 1-2%; based on information from relationships • People coming to sell has exploded; liquidity driven, global financial crisis, asset
allocation (overall portfolio; 10% of private equity; allocation model gets out of wack; doesn’t get mark to market the same, regulatory pressures (rule; change reserves requirements); people are looking at private equity as any other asset class and should be proactive in
• $1.3 trillion in private equity over the last 3 years has been raised
What is your opinion on platforms such as SecondMarket or SharesPost? • Doesn’t think secondary markets has given greater visibility; if you are a limited
partner in a VC firm you do not own them yourself; from a fund prescriptive it hasn’t changed how a LP has thought
• Thinks they are a lot of noise • Facebook, SEC and twitter don’t want shares trading this way (secondary
markets) • A lot of volatility in the markets • Social media valuations are rich (makes it more challenging to invest) • Buying and selling shares on a daily bases is not a sustainable business for
everyone
24
• One less fund for LP to report
Investing Process:
• Invest as a primary; one of the largest LP in the world; general partner world also look at market (relationships and agents and proactive)
• Analytics (projections, models) for valuing • Investor in all of funds (go to meetings); relationships (input for analysis) • General partner don’t want things online; it was unsuccessful a decade ago • Double edge sword (some benefits giving some liquidity before at the same time
don’t want those people to become wealthy over night before value is realized); want interest align
• More supply then demand so HabourVest picks and choose • HabourVest replaces the limited partner • Organized funds (different from individual securities)- entities invest individually;
they will look to sell 50 funds at once; look for capital partner; more complex; less people doing it
Interview with Sam Ensslin at HabourVest Associate • April 10, 2012 • [email protected] • 617-348-8340
What is the process like? What are your standards? How long? Individual company; direct investment (not much different whether purchasing shares as direct or secondary investment); first step is to determine valuation- doesn’t look at the IRS; will look at a recent round of financing if done; bottoms-up analysis; public comparables; DCF; market valuation; cash based; based on the stage of the company; decide how much they can pay in order to get return. Won’t do deal if they are being restrictive; want full access to information. Management; financial statements, board presentations, customer lists. Full on diligence (varies on complexity of company; 2 discussions and then speak to company and have an indicative offer- let them know how much they can pay then enter into exclusively (4-6 weeks for binding offer); then submit a binding bid. How many new companies do you deal with within a year? Look at a lot of deals that turn them down; 1/10 invest. Is there one aspect of a company that would “break it” for HarbourVest?
25
Look for stability in business model (no burning cash which requires future investment); operate without financing; industry that they understand (no oil and gas or real estate, biopharm; industrial, technology, don’t want high transaction (they are shopping). Want infrastructure; trying to eliminate risk by purchasing later in life cycle. Target lower return VC but over time HabourVest makes a longer return (achieve 2x). Do you find that some companies are hesitant because someone else (like yourselves) will own equity in the company? (Find out about what companies think) Varies; sometimes happy because investor has been inactive; other than that it is a head ach; VC firm that fund has been around for 12 years and it was only suppose to be around for 10 years; Buying from institutional investors not CEOs (red flag). Roles and responsibilities? Don’t take on board seats as much (prefer to be hands off) buying 30% or more; outsource management to experience VC. What are you looking for? What types of companies? What stage? Not research and development want identifiable value; no early stage risk ; not burning cash. Late Stage companies with proven business models; infrastructure. Prefers not to invest more money in business; where institutional investors want out. How do you access the risk/reward? Higher returns then VCs; lower risk than VC firms. Terms: Last until liquidity by selling the company, recapping, lasts as long as it takes. Comments on platforms like SecondMarket: If a company is going to trade it should be traded publicly; too many shareholders; unregulated speculation; eventually there will be too much regulation; would make sense for small start ups for crowd funding because of the cost of bankers.
Interview with Gerald Di Fiore at Reed Smith • Partner and Chair of Securities Review Committee • April 10, 2012 • [email protected] •
26
What are some of changes you see in regards to the regulatory issues? How do you see legislation changing the way secondary markets operate? The FB IPO itself has done nothing to change the way the secondary markets operate. But the frenzy to acquire shares of FB privately prior to the filing of the FB IPO was a phenomenon of a magnitude that had never before been seen. The Congress recently passed, and the President just signed, the Jumpstart our Business Startups Act (JOBS Act). This act changes provisions of the law to make it easier for private companies to remain private longer. In essence, it allows private companies to have larger numbers of shareholders 2,000 (new) as opposed to only 500 (old) before the mandatory public reporting provisions of the securities laws come into play. This will allow companies that want to remain privately held for a longer period of time to do just that, rather than comply with onerous regulations. The JOBS Act also contains provisions regarding newly permissible ways for private companies to raise additional capital without involving a public offering (and therefore stay private longer). These new ways include (i) private offerings that can use public solicitation so long as all the investors are accredited investors and (ii) crowdfunded offerings. In the case of crowdfunded offerings, there will be a host of new rules adopted by the SEC.For smaller companies that are seeking to go public, the JOBS act creates a new class of “Emerging Growth Company”. Companies that qualify for this definition will enjoys certain advantages compared to traditional public offerings by larger companies. These advantages include a relaxing of certain accounting requirements (2 years of audited statements as opposed to 3), the 5 year post IPO phase in of more onerous requirements under SoX and Dodd Frank (404 internal control attestation, auditor rotation, executive compensation disclosure, compensation disclosure and analysis (“CD&A”) and say on pay). I can explain these things in greater detail on a call. If the professor wants me to come up to campus and give a special lecture on these topics I would love the chance to do that. How has technology impacted the secondary markets? How does the SEC plan to deal with platforms such as secondary market? The SEC is trying to regulate secondary trading platforms such as “Second Market” under the JOBS act and the rules that the SEC will have to issue under the JOBS act. These rules will basically allow electronic trading platforms for private company stock so long as the services performed by these platforms are limited [we will have to see what the rules say on this] and so long as the platforms do not charge “commissions” or transaction based fees on the activity. That is because fee structures of this type are associated with “Broker Dealer” activity in securities and that activity can only be performed by Broker Dealers that are registered with the SEC [and this registration is very expensive, difficult and time consuming]
27
What types of companies or market segments are generally being sold on secondary markets? The companies active in this segment have tended to be companies that are part of the social media phenomenon, because such companies are so easily understood by large numbers of people, and have very high overall visibility. How do you see secondary markets affecting employee-to-employee and employee-to-outsider? I am not clear what this question relates to – lets discuss Where do you see the future of second markets? Is more regulation necessary? Would the SEC make second markets illegal? The future of second market will depend on how much they are able to charge on transactions before being required to register as a Broker Dealer. The SEC will not make these transactions illegal. What they will try and do is make the market participants “accountable” as best that they can. They will also try and make the system work more like an “exchange” so that investors transacting in the secondary markets are able to get basic levels of information about a company before they buy or sell. It is the lack of any information about the [private] companies that is one of the issues of greatest concern for the SEC.
Interview with Gerald Di Fiore at Reed Smith Partner and Chair of Securities Review Committee • April 19, 2012 •
The following represent notes that we took during our phone interview with Mr. Di Fiore and is not structured like the 3 above interviews. Do not provide capital to businesses only to owner; not a direct tool to raise money Provides greater liquidity (people look better on paper) Always going to be tension between external funding vs. founders because of cash needs Trend limited to social media companies because they have attracted the people that are willing to make an investment without any information (not a characteristics of normal markets); attraction and fan fare has helped because it has allowed some information (how many users) Only time will tell; create so liquidity for top 10-20% Shareposts has low volume; not instant and it will never be a ready liquid market; it can’t be because of the viable information is limited and the number of buyers and sellers is limited.
28
Number of shares transaction is relatively insignificant; lock up is still in place There was never a company that create fan fair that facebook created; everyone knew about company before it went public, which doesn’t happen SEC created special investment vehicle to evade the requirements of section 12 g of the securities exchange act of 1934- avoid triggering the 500 record holder; if you have more than 500 registered shareholders forced (under van applicable provisions of exchange act came in the 1960) was required to become a reporting coming (filing 10-k) more than 10 million in assets with more than 500 investors has got to be big enough in the eyes of congress to be mandate to report its operations public, Facebook didn’t want to be public yet (Goldman put together to decrease the number of investors to keep under the 500 because of account rules), a single entity and that entity has lots of other shareholders as long as none of the shareholders don’t have more than 10% than the entity is created as one, the SEC viewed that as a way to evade the law, this has never been done before Jobs Act- up to 2000 shareholders before required to report so long as no more than 500 shareholders who are not accredited investors; can have 1,500 institutional investors Crowd funding- Sec is working on rules, may be successful in raising capital but is going to be challenge because you can only take small amounts of money per investor (500 non accredited; 5% of net worth/income up to 10,000) how much money can you raise, 505,000- congress way to put breaks on behavior they worry about (not accidental), need mass appeal For example, 50,00 to million, tried to raise money, crowd funding would have done money, need a lot of people to get excited about, product or service needs mass appeal Interesting things won’t get funded (gap) People who need crowd funding won’t get it; the people that attract crowd funding will VC so don’t need it (can be used as a value judgment) Not registered as a broker dealer; highly regulated activity (heavy burden, expensive; cannot afford the cost 9 months to 1 year to be one and at least $100,000) Not licenses they cannot generate a commission; generate revenue by costing small transaction fees so it has be based on volume Failed business model- secondary market trading; SEC wants it done by broker dealer, probably be forced into because they need the revenue Commissions on secondary market (2-3$ each side, massive in securities business) Buying stock with a blinder folder when knowing that you may have an information disadvantage to the seller, seller signs contact knowing that they may have an information disadvantage to buyer, both acknowledging they know nothing about the company; restrictive, cannot resale expect another private realtor or in the registered offering, will be in lock up and Facebook’s right of fight refusal, (Facebook by-laws and not that common) As long as you are an employee you can’t sell stock, motivations are different, few companies have this as a an option, average private company the stock is worthless other than employees because no one else understands the business 409a- deferred compensation of tax code, 25% equity of hardware store, if sold for 1 million, you have reportable gain of the difference between the million and what your tax bases (only a taxable to the recipient on cash on the time of sale)
29
Will be a vibrant market in social media companies, as long as there is explosive growth, those companies.
30
Exhibits
Exhibit 1 – Secondary Buyer Table
31
Exhibit 2 Employee Equity Calculation Example
1. Let's say the number is $25mm. This is an important data point for this effort. The other important data point is the number of fully diluted shares. Let's say that is 10mm shares outstanding.
2. Break up your org chart into brackets. There is no bracket for the CEO and COO. Grants for CEOs and COOs should and will be made by the Board.
a. First bracket is the senior management team; the CFO, Chief Revenue Officer/VP Sales, Chief Marketing Officer/VP Marketing, Chief Product Officer/VP Product, CTO, VP Eng, Chief People Officer/VP HR, General Counsel, and anyone else on the senior team
b. Second bracket is Director level managers and key people (engineering and design superstars for sure).
c. Third bracket are employees who are in the key functions like engineering, product, marketing, etc. And the fourth bracket is employees who are not in key functions. This could include reception, clerical employees, etc.
3. When you have the brackets set up, you put a multiplier next to them. There are no hard and fast rules on multipliers. You can also have many more brackets than four. I am sticking with four brackets to make this post simple. Here are our default brackets:
a. Senior Team: 0.5x b. Director Level: 0.25x c. Key Functions: 0.1x d. All Others: 0.05x
4. Then you multiply the employee's base salary by the multiplier to get to a dollar value of equity. Let's say your VP Product is making $175k per year. Then the dollar value of equity you offer them is 0.5 x $175k, which is equal to $87.5k. Let's say a director level product person is making $125k. Then the dollar value of equity you offer them is 0.25 x $125k which is equal to $31.25k.
5. Then you divide the dollar value of equity by the "best value" of your business and multiply the result by the number of fully diluted shares outstanding to get the grant amount. We said that the business was worth $25mm and there are 10mm shares outstanding. So the VP Product gets an equity grant of ((87.5k/25mm)* 10mm) which is 35k shares. And the the director level product person gets an equity grant of ((31.25k/25mm) *10mm) which is 12.5k shares.
• Another, possibly simpler, way to do this is to use the current share price. You get that by dividing the best value of your company ($25mm) by the fully diluted shares outstanding (10mm). In this case, it would be $2.50 per share. Then you simply divide the dollar value of equity by the current share price. You'll get the same numbers and it is easier to explain and understand.
• The key thing is to communicate the equity grant in dollar values, not in percentage of the company. Startups should be able to dramatically increase the value of their equity over the four years a stock grant vests. We expect our companies to be able to increase in value three to five times over a four year period. So a grant with a value of $125k could be worth $400k to $600k over the time period it vests. And of course,
32
there is always the possibility of a breakout that increases 10x over that time. Talking about grants in dollar values emphasizes that equity aligns interests around increasing the value of the company and makes it tangible to the employees.
• When you are doing retention grants, I like to use the same formula but divide the dollar value of the retention grant by two to reflect that they are being made every two years. That means the unvested equity at the time of the retention grant should be roughly equal to the dollar value of unvested equity at the time of the initial grant.
Exhibit 3 Private Equity Returns Over Time
Exhibit 4 SecondMarket History
33
Exhibit 5 SecondMarket Top 10 Most Watched Private Companies 41
Exhibit 6 SecondMarket Transactions by Industry Graph 41 http://www.secondmarket.com/about-us?t=hlo
34
Exhibit 7 SecondMarket Transactions by Seller Types
Exhibit 8 SecondMarket Transactions by Buyer Types
35
Exhibit 9 SecondMarket Investor Preferences 42 43
42 https://www.secondmarket.com/user/edit/investment-interests 43 https://www.secondmarket.com/user/edit/investment-interests
36
Exhibit 10 SecondMarket Company Page
37
Exhibit 11 SecondMarket Buyer Page
38
Exhibit 12 SecondMarket Seller Page
39
Exhibit 13 SecondMarket Most Watched Non Venture-Backed Comapnies
Exhibit 14 SecondMarket Fasting Growing Companies
40
Exhibit 15 SecondMarket Completed Transactions by Industry
41
Exhibit 16 Secondary Market Historical Transaction Activity
Exhibit 17 EB Exchange Fund
42
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