Traditionally VCs and angel investors have made their over-sized returns in one of two of exits: IPO or acquisition (which includes mergers, asset sales, and the like). With the IPO market in what seems like eternal hibernation, acquisition has recently been the only likely exit strategy for private companies. Meet secondmarket.com, the angel investor’s new best friend. The site aims to provide a marketplace for sales of private securities in the secondary market. The securities regs provide an exemption for sales between accredited investors. There are a few things to be mindful of: (1) how will this affect option pricing within the context of 409A, (2) what rights of first refusal and/or co-sale need to be complied with prior to and/or in connection with such sales and (3) what does this do to a private company’s shareholder make-up (i.e. who will be buyers in this market?).
(1) Let’s say Newco raised its Series B round at $1.00 per share and the board has set the FMV of its options at $0.10 per share (valuing common stock at 10% of the most recent preferred is common practice). Now suppose shares of Newco’s Series B stock are trading at something north of $1.00 per share on SecondMarket. Does the board need to raise the FMV of future option grants? I suppose the answer is “probably” but depends largely on the volume of the transactions on SecondMarket. The stock will most likely be thinly traded and as such may not a great barometer of the market. That being said, the board might be better suited to determine the FMV based on the factors the IRS has promulgated.
(2)/(3) In most but not all venture deals, the investors subject their shares to the same right of first refusal as the common holders. I imagine this will become the de facto standard as sites like SecondMarket spring up. The company and/or the other investors will want to limit a selling shareholder from transferring its stock to a buyer outside the group. This also makes the transaction on SecondMarket more complicated. Say an investor wants to sell its shares so it puts the shares on SecondMarket and a buyer emerges. Prior to selling the shares, the seller will need to comply with the right of first refusal provisions. The buyer then has to wait for that process to end and may end up empty handed if the company and/or the other investors exercise their right of first refusal. Furthermore, if co-sale rights apply, the buyer might end up having to purchase shares from multiple investors to comply with those provisions.
In sum, it will be interesting to see how these sites end up working in practice (as well as the volume), but regardless I think it will change the way how venture deal docs are drafted to contemplate these types of transactions.
UPDATE (5/14/09)
Millennium Technology Ventures, a secondary investor, was the most active venture investor in April. Clearly there is a secondary market as more investors/founders want to take cash off the table as traditional exits look further and further away.
