July 19, 2023
Traditionally, private company shares have been a highly-illiquid asset, meaning they’re not easily convertible into cash (unlike public company stock for example, which is extremely liquid and trades on public stock markets). This is starting to change with the advent of transparent and centralized marketplaces for private stock trading like Hiive, which lower barriers to liquidity and help create a robust market for private stock. But despite these advancements, one obstacle remains: the private companies themselves (we refer to them in the industry as the “issuers” because they issue the private securities to employees and investors).
While most issuers today permit their current and former employees to sell in the secondary market, the management and boards of directors of some unicorns believe they get no benefit from an active secondary market for their stock or view secondary trading with suspicion. These issuers typically exercise their power to veto stock transfers, denying liquidity to employees and investors alike.
These restrictive issuers should evaluate the many potential benefits of a healthy secondary market for their stock. Here are just a few of the many reasons why private companies should care about the liquidity of their shares.
Issuers should care because investors care! Investors increasingly consider the liquidity of a private stock as a risk factor when investing. Less liquidity means higher risk, as the investor must now incorporate the risk that they won’t be able to get capital out when they need it. Higher risk means a higher implied cost of capital when valuing the investment, resulting in a lower valuation.
Conversely, consider a private company that enables trading of its shares on the secondary market. This company has potentially reduced their risk profile by increasing the avenues for liquidity, ultimately lowering the return on capital that investors need to expect. This may allow companies to achieve higher valuations in private funding rounds and better outcomes at IPO.
Issuers may be concerned that by permitting investors to trade on the secondary market, they will cannibalize the demand for primary investment rounds. In fact, it could have the opposite effect: some investors may not want to invest, on a primary basis, if they have no assurance that they can sell, on a secondary basis, when they need to.
But secondaries can have other benefits for primary fundraising too: secondary market transactions may introduce the company to new investors, who are keen on the company, and who might invest in primary rounds in the future. This may be particularly important as companies mature, and it becomes more difficult for them to secure primary capital from their early investors.
Companies that allow employees to sell their shares in the secondary market can use it to attract and retain top talent and reward high performers for their contributions. Even more importantly, with the IPO market frozen for the foreseeable future, a secondary sale might be the only option for a current or former employee looking to generate some cash.
Hiive regularly talks to employee-shareholders who need liquidity for important life events, such as buying a first house, paying off student debt, or funding medical treatments for cancer or other serious illnesses. When these employees are denied the opportunity to sell their shares, or a proposed secondary transaction is blocked by their current or former employer, the frustration (even desperation) is palpable.
Issuers should view employees, both current and former, similarly to investors in this context. If employees are aware that their equity will be non-transferrable, they will naturally prioritize other companies (often competitors) in their job search, just as investors will consider other companies when they look to put their dry powder to use.
Finally, a restrictive secondary strategy dismantles one of the primary reasons that stock is awarded in the first place — loyalty and incentives. If issuers give stock to employees to align their incentives with those of the company, that incentive is virtually worthless if the actual liquidity event is too far in the future. Employee turnover may increase if they don’t view their stock as valuable and liquid.
Employees often accept lower salaries and bonuses in exchange for stock options, joining risky, early-stage companies on the promise of participating in the company's growth potential. But what is the value in owning vested stock options that cannot be exercised and then sold? Those who stuck it out during the vesting period and then find out they are not allowed to sell the stock they have earned may feel like their loyalty is being punished rather than rewarded.
Some issuers worry that a “free-for-all” secondary market for their stock would cause them to lose all control over who is invested in their business. But this is not a reason to restrict trading altogether.
Just because an issuer permits an active secondary market for its stock does not mean that the issuer loses all control over their cap table. By maintaining approval rights (versus blanket restrictions), issuers can restrict trading to existing investors and to new investors that the issuer has reviewed or vetted. This has the extra benefit of “cleaning up” the company’s cap table, by consolidating small employee lots into the hands of fewer, larger investors.
While blanket restrictions against secondary trading may give issuers the feeling of full control, this can be a mere illusion. In these cases, the nearly-inevitable result is a grey market for the company’s stock. Using indirect methods such as special purpose vehicles and forward contracts, investors and employees will still find a way to trade shares. However, the issuer has zero control over these transactions, and their proliferation can cause complexity, negative publicity, and lawsuits as a liquidity event eventually approaches. As well, these indirect arrangements result in lower prices for sellers due to the higher risk involved for buyers. These arrangements are in no party’s interest, but they will continue to take place as long as some issuers continue to block direct stock transfers.
Enabling open trading of a private company's shares on the secondary market provides greater liquidity for employees and other shareholders. This liquidity is also in the company’s best interest, as it will result in potentially higher valuations, more motivated employees, and more transparency for all stakeholders involved.
To learn more about buying and selling shares of pre-IPO companies, join over 3,000 accredited and institutional investors by signing up to Hiive, the most active true marketplace for private stock.
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