A New Era for Tech Financing

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Hot tech companies with sustained profitability, robust growth projections and lots of cash in the bank are traditionally expected to go public. But for some of these companies, pursuing an IPO right away may not be right as they know they have a lot more company building to do. But how do they reward long-time employees and investors who deserve to share in the financial gains they have helped to create?

A secondary offering for a private company is a financing mechanism in which the capital raised goes directly toward buying stock from existing shareholders, be they employees or venture investors. This is in contrast to a primary fundraise (which includes the typical IPO) where the capital goes into corporate coffers to fund the company’s operations and investments. A secondary offering is probably better suited toward cash-flow-positive companies and not high-growth companies with high cash burn. In many cases, a secondary offering has a number of benefits for the company, its investors and especially its employees.

If the goal of a secondary is to provide employee liquidity, management can structure the secondary to enable employees with vested shares to sell up to a predetermined percentage of their stock to investors in the financing. This gives employees liquidity without a traditional “liquidity event,” which has typically meant either an IPO or an acquisition of the company. For employees who have been a part of building the company for years, this provides partial liquidity. From my experience, partial liquidity has tremendous value in creating real perceived value in stock options as a compensation tool.

A secondary can also be targeted toward a company’s venture investors to enable early investors with a different risk/reward profile to sell their shares. Some early venture investors may even be thinking about their own fundraising needs and pushing for liquidity in your company to enhance their fund’s return profile. Some existing investors may even choose to increase their stake in the company by buying either employee or early investor shares to further participate in the long-term investments a company is making without causing additional dilution for non-participating investors.

The company itself can benefit because it is now able to stay private longer without pressure from investors or employees for liquidity, giving it more time to invest for the long term without being subjected to unremitting Wall Street scrutiny. As every public company knows, Wall Street’s quarterly earnings cadence can put pressure to focus on short term financials at the expense of making good long-term investments. That makes projects that require several quarters of investments that won’t realize immediate returns, such as creating major new product lines, more difficult to do for publicly traded companies.

And finally, the company’s common stock can have a new, higher value set by the market to use as a currency for M&A. Typically, a private company acquiring another private company faces the challenge of either raising cash to pay for the acquisition, which is time consuming and requires simultaneously fundraising and negotiating the acquisition, or trying to convince the target company to take the buyer’s private stock as payment. Since the buyer’s stock has no liquidity, shareholders of the target company rightfully push back on accepting illiquid stock at the last round of preferred financing price.

To complicate matters even more, the acquiring company has to make a decision of either issuing preferred shares to the target’s shareholders, which adds more “liquidation preference” on top of common shareholders, or to issue common stock and try to negotiate a new price apart from the last round of preferred securities. Whew!

My company, Kabam, recently concluded a secondary financing of $38.6 million in total. New rounds of financing happen all the time. What was unique about it was what we did with the money and the structure: We used it all to enable our employees to sell their stock at a favorable gain from their stock options’ strike price. The company did not get any of the money.

Further to the uniqueness: It was all common stock, instead of the typical preferred stock that private companies sell to investors. Preferred stock has a “liquidation preference” attached to the security, such that if a company is sold beneath the financing valuation, the preferred stock holders get their money back first and at the amount they invested. All of the “downside” of the company is then absorbed by the common shareholders, who are often the employees.

With a secondary like this, employees now have a way of measuring the value of their compensation from stock options. Before such a secondary, this required faith that someday a stock option would be worth something. It better aligns employee compensation with investor interests, as investors now also own common stock and employees are now valuing their stock options the same way that investors do.

Other growing tech companies prolonging their time as private entities have started doing similar secondary financings. Twitter raised $400 million two years ago, with about half going toward a secondary. It has since launched a successful mobile video product, Vine. Last January, SurveyMonkey raised about $800 million with nearly half going to early investors and employees. In March, Automattic, which provides the popular blogging platform WordPress, raised a $50 million round that was all secondary.

It’s likely we’ll see a lot more of these types of secondary financings as companies are able to avoid being forced to go public on account of the 2012 Jumpstart Our Business Startups (JOBS) Act. The new regulation allows private companies to have as many as 2,000 shareholders — a regulatory issue that eventually forced Facebook toward its IPO after crossing the previous 500 shareholder threshold.

Rapidly growing companies have noted for many years that being a public company inflicts on them a kind of short-term thinking that makes it difficult to make the big investments that made them a great company to begin with. However, because going public had often been the only way to provide liquidity to shareholders and accomplish their M&A objectives, they were forced to take that step.

Now, though, we’re seeing a new era in tech financing. I believe this era will be characterized by many profitable growth companies staying private much longer but realizing their employee liquidity, investor liquidity and M&A needs through private market secondaries. It’s a trend that will allow ambitious and profitable startups to reinvest their profits in great new products, and eventually go public — when they’re ready.

Kevin Chou is CEO of San Francisco-based Kabam Inc.

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