Insights into private company direct secondary transactions, the factors behind them and their place in today's private equity landscape.

Companies such as Facebook, Groupon, Living Social and Zynga Game Network represent a new breed of Internet companies that differ dramatically from the shooting stars of the last Internet bubble.

These companies not only have revenue, but in some cases, are highly profitable.

Investors in these companies have responded to their unique characteristics and the current market dynamics by creating a new model for late stage equity financing. Widely known as "DST Deals"—named after Digital Sky Technologies, the Russian investment firm—these liquidity transactions have attracted widespread interest.

However, their exact structures and other details remain relatively unknown, principally because they involve private companies.

What Drives Them

Unlike their tech-bubble predecessors, the entrepreneurs who control these companies— rather than selling out to strategic acquirers, tapping into the public markets, or ceding control to private equity firms—have embraced the private capital markets.

In addition to the complications in the current IPO market, entrepreneurs perceive several compelling operational and legal benefits in private liquidity transactions:

  • Control over the composition of the shareholder base and managing the company's investor profile;
  • The ability to avoid an IPO at a point in the company's growth trajectory when substantial value is still being created, resulting in money being left on the table;
  • Benefits for employee recruitment and retention;
  • Additional capital for the company to facilitate growth at an attractive valuation ; and
  • Allowing companies to avoid overstepping the SEC's current cap of 500 shareholders for a private issuer, much like the "Google problem" that forced that company's IPO in 2004.

Structure

While a private liquidity transaction may appeal to this new generation of emerging tech companies, the structure of the typical private company direct secondary transaction must include a unique blend of components to meet their business goals:

  • Investors in these transactions often make a portion of their investment (10% to 33%) directly into the company in exchange for preferred stock pari passu with (or in some cases subordinate to) existing preferred stock. Investors in these new liquidity transactions are typically expected to be passive, and, in some cases, voting rights with respect to the stock the investor acquires are transferred to the dominant founder.
  • These transactions typically involve an element of liquidity for existing shareholders, the founders, senior management, and early stage institutional investors. The amount is a principal topic of negotiation. The purchase price per share in the direct secondary transaction is generally the same as that offered to employees, although the price may not be the same as the primary preferred stock investment.
  • These transactions almost always include an allocation of a portion of the overall investment to employee liquidity. This is often accomplished by having the investor conduct a third-party private tender offer for an agreed-upon portion of the vested stock of company employees.
  • Some transactions have included an assignment of the company's right of first refusal (ROFR), and the company may agree to assign its ROFR to an investor. The ability to "direct" transfers to a single investor helps keep ownership of the company in "friendly" hands and mitigates inadvertently exceeding the SEC's 500 shareholder threshold.

In addition to the attention required for already resource-challenged management, investors need to consider a host of regulatory issues, such as securities law and antitrust compliance, all of which can be addressed with proper structuring.

Whether structured as classic "DST Deals," successful private companies and their early investors will continue to seek liquidity alternatives, and will find responsive institutional investors willing to explore creative deal structures.

Goodwin Procter LLP is one of the nation's leading law firms, with a team of 700 attorneys and offices in Boston, Los Angeles, New York, San Diego, San Francisco and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.

This article, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. © 2012 Goodwin Procter LLP. All rights reserved.