Cash-strapped early-stage companies have long relied on equity-based compensation to attract, motivate, and retain employees.  Employees endure long nights of software coding or other work, comforted by visions of riches when the company reaches the goal line (the initial public offering).  For a variety of reasons, the IPO is no longer the goal line for founders, many of whom are now content to remain private far longer than previously expected.  While founders may be content with their illiquid billions, most employee-shareholders want to convert at least some of their illiquid thousands to spendable cash.

A recent Wall Street Journal article described one strategy followed by companies that prefer to remain private while still providing the liquidity desired by employee-shareholders.  Successful start-up companies are increasingly using tender offers to provide liquidity to shareholders while postponing an IPO.  Under a tender offer, one or more investors create a pool of capital used to purchase shares from employees.  Such tender offers are classified as secondary market transactions because the issuing company is not a party to the transaction (other than having a large hand in designing the transaction).  Secondary market transactions often occur at the same time or shortly after primary market transactions in which the company issues new shares to investors.  The price paid to employees in the tender offer is established with reference to the issuance price in the primary market transaction.

We find an obvious analogy to the predicament facing many family business directors: while the family as a whole desires for the business to remain independent and private, at least some individual family shareholders desire access to liquidity.  The analogy is imperfect, but we think family business directors should take the opportunity to consider their shareholder liquidity strategies afresh.  In this post, we compare and contrast employee tender offers with family shareholder liquidity programs.

Source of Liquidity

For early-stage companies, the funding for employee tender offers generally comes from third-party investors.

In contrast to early-stage companies, most family businesses have no experience with, or appetite for, third-party equity investors.  We suspect this deep-seated bias is softening, with investment from deep-pocketed family offices being perceived as a more “friendly” or at least “patient” source of equity capital for family businesses.

However, if third-party equity capital is off the table, the remaining funding options are other family shareholders, the company itself, or lenders.

• For some families, other shareholders may be an underappreciated source of capital for shareholder liquidity. However, intra-family transactions can be perilous.
• Relying on the company itself may “crowd out” needed investments in other productive assets and/or dividend payments to the broader family.
• Borrowing money to fund shareholder liquidity increases the company’s financial risk for the remaining family shareholders.

Valuation for Liquidity

For early-stage companies, the pricing for employee tender offers is generally established with reference to recent or contemporaneous primary issuance of new shares to investors.  Complications may arise because of differences in economic and governance rights of preferred shares issued by the company and common shares owned by employees, but those complications are ultimately resolved by the desire of third-party investors to participate in the tender offer.

For the most part, family businesses do not enjoy the same cadence of new share issuance, which provides a market-derived valuation perspective.

• If the company elects to admit a third-party investor, the tender price will be negotiated.
• For intra-family transactions, an “open” pricing policy, under which shareholders are free to negotiate their own prices, may be simplest to administer but increases the risk that such transactions fuel family resentment and rancor.
• Without external valuation “marks,” company-funded redemptions typically rely on an independent appraisal process. The degree to which the illiquidity inherent in family business shares is reflected in the redemption price is best treated as a family policy decision rather than an appraisal matter.

Timing/Amount of Liquidity

Employee tender offers are typically restricted to one or two “windows” per year.  The aggregate pool size and employee participation rates are both generally limited and subject to caps.

Family businesses are often sensitive concerning the degree to which a shareholder liquidity program may undermine legacy discounts for lack of marketability.  Such discounts often play an important role in the orderly transfer of ownership through estate planning techniques.  This legitimate concern can often be alleviated by (1) specifying that redemptions are priced at some discount to the “as-if-freely-traded” value of the shares, (2) redemptions are limited to certain windows, which probably occur no more than annually, and (3) the size of the periodic redemption pool is limited, with a cap on individual participation.  These features are essential to demonstrating that – for estate tax planning purposes – the overall liquidity of the company’s shares remains impaired relative to a freely traded (i.e., public company) benchmark.

Family businesses that identify creative strategies for satisfying shareholder liquidity preferences are less likely to fall victim to shareholder discontent that can derail the larger family’s desire to remain independent and private.  While not providing a perfect roadmap, strategies devised by early-stage companies for satisfying the liquidity needs of their employee-shareholders may provide some timely inspiration for family business directors.  Give one of our senior family business professionals a call to discuss your situation in confidence.