UK: Finding Liquidity In Late Stage Private Markets

Last Updated: 7 September 2016
Article by Simon Toms and Michael Bloch

The environment for growth companies is changing. For a start, 2016 has seen a marked slowdown in the number of IPOs that have come to the market globally.

Conditions including the European referendum, U.S. presidential elections and uncertainty over interest rate rises have all played their part, but founder/management team sentiment towards public listings has also shifted.

While IPOs provide a "badge" of maturity and market recognition (alongside the obvious injection of capital), the preparation for them is also an enormous distraction for management teams of growing companies. Furthermore, public companies have to adjust to the punishing half-yearly or even quarterly schedule of hitting targets and reporting which can encourage strategic short-termism rather than a focus on "good growth". For companies with a good business model, happy customers and economic sustainability, pushing out the IPO window may be a viable option.

The issue of economic sustainability brings us to the question of funding. A rising number of private companies (and particularly "unicorns" – those with valuations of over USD 1 billion) have successfully completed either more private funding rounds or larger private funding rounds (or both). This enables them to fund direct growth rather than capital investment from injections of cash from private investors. (Platform-based, capital-light companies in industries such as Fintech have a clear advantage here in terms of capital requirements).

The group of investors participating in these rounds has also expanded, opening up a wider pool of funds to successful private companies. This area is no longer solely the preserve of traditional venture capitalists; we are seeing sovereign wealth funds, asset managers and hedge funds, as well as corporate venturing, participating in this section of the market. These investors are joining the market for reasons that range from straightforward portfolio diversification through to opportunities to spot and nurture emerging talent and innovation to build research pipelines (often a driver when corporates set up investment vehicles).

Not all these investors have the same timeline in mind for realising their investments and, without the aligned expectation of the traditional VC five-to-seven year window until a trade sale or IPO, a number of pressures build in the market.

One is the liquidity expectation of earlier stage investors, and this has implications for the broader start-up ecosystem not just in terms of liquidity. Early stage investors are the life blood of the start-up community. They are frequently successful entrepreneurs themselves who are committed to investing in and, equally importantly, mentoring the new kids on the block. Without the release (and hopefully increase) of their investment capital, they are not able to reinvest either funds or expertise into emerging companies – and this is potentially a problem in terms of supporting the pipeline of new talent.

Another pressure comes from employees. Frequently incentivised by their start-up employers through options and share schemes, employees need a liquidity event to realise these benefits, and they need to be managed in terms of how they capitalise often large shareholdings without the company losing talent or investor confidence.

So how can we bring liquidity into the late stage growth company market?

One option is to explore the opportunity for private secondary share sales – a device frequently used in U.S. markets but much less common in Europe. In this scenario, investors wanting to realise their investments or employees wanting to sell their shares would be able to do so.

The problem is that secondary sales don't always get good press. Pre-IPO, Facebook was a notable example of the poor investor sentiment that can be generated by staff selling off shares privately.

But it would be possible to build a healthy infrastructure around secondary sales in Europe. Companies could use the mechanism as part of their structures to invest in and retain talent, and investors could exit their transactions in a timely way without the market automatically reading this to be an expression of negative investor sentiment. Various models could deliver these goals. For example, in the U.S., certain advisory firms specialise in block sales of private companies' shares in the secondary market, either on an ad hoc basis or within pre-defined windows. Key to the success of these transactions is the release of appropriate financial and operating data about the performance of the company. The success of crowdfunding in recent years points the way to another possibility for secondary sales, with platform-based services connecting buyers with sellers and controlling the release of financial information on behalf of sellers. A platform-type solution would likely bring broader access to the market; a broker approach could be more associated with a smaller qualified group of market participants and the support available on issues like due diligence and pricing.

There are, none the less, a number of questions to be answered about the design of such a market, and indeed regulatory and other barriers to be overcome, before we can expect to see secondary share trading becoming more common on this side of the pond. These include:

  • Cultural and reputational issues. There may be an unwarranted perception that secondary trading of shares by early investors and employees suggests that the company is performing badly and that investors or staff "want out". Equally in an environment where there are no barriers to "cashing out" large incentive holdings, high-talent individuals would potentially be free to leave and set up competing businesses or invest in other opportunities. While clearly this benefits the ecosystem as a whole, it potentially removes some of the levers available to encourage valued members of staff to stay with the organisations and keep working to scale it.
  • Complexity of shareholding structures. Even smaller private companies may have several different classes of share with different rights attached, and a company's articles of association may impose specific restrictions on the sale or even gifting of shares (particularly if such a transfer means the shares will go outside the company).
  • Challenges concerning pricing and information. There is a huge question around how to price equities and, related to this, how to ensure accurate and appropriate information flow to possible investors. Information for prospective buyers needs to be provided within the confines of existing regulation and in a way that ensures that pricing bubbles are not created through opportunities to acquire shares in secondary sales being infrequent or supply being artificially restricted. Furthermore the process of providing information to potential investors needs to be manageable and realistic for the company.
  • Tax. The UK Enterprise Investment Scheme (EIS) is an important incentive for investors in early stage companies, providing tax breaks on qualifying investments. However, as currently structured, this relief is not available on secondary sales and it is only available to investors who hold their shares for three years or more.

This leaves us in something of a "chicken and egg" situation. With sufficient demand in the secondary market, precedents could likely be established to deal with all of the above issues, but without solutions to these issues, demand is unlikely to build. The tipping point in demand might just come from other pressures in the market to stay private longer, which in turn will force us to think harder about how we create liquidity both for existing and new investors.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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