PrivateCompanyLiquidity:

FuelingAmericanEntrepreneurship
BoBrustkern
Introduction
Forhighgrowthcompanies,oneofthemostefficientandeffectivewaystoaligninterestsamong
stakeholders,andtoallocatewealthamongthosewhohelptocreateit,isthroughtheissuanceofstock,
stockoptionsandrestrictedstockunits.Thisholdstrueforcompaniesattheveryearlieststagesof
formationallthewaytolarge,publiclytradedentitieswhoseprospectsforgrowthcontinue.
Stockoptionsaremostvaluablewhentheunderlyingstockcanbereadilyexchangedinawell
functioning,liquidmarketplace.Stockoptionsforpublicmarketcompaniesarethepremiereexampleof
this.Forexample,thoseemployeeswhoreceivedstockoptionsofpubliclytradedApple,Inc.in2003at
astrikepriceof$9.00pershare,andwhoseawardsvestedduringthefollowingyears,haveenjoyed
spectacularreturnsontheirinvestmentoftimeastheyhavecollectivelybuiltAAPLtoapproximately
$400pershareasofthiswriting.Thisrepresentsa$350billionmarketcap,makingAAPLamongthe
mostvaluablecompaniesontheplanet.1Forthehypotheticalemployee,thisrepresentsan
instantaneousgainof$391pershare,or43.5timesthestrikepriceofthestockinonlyeightyears.
Growthofthismagnitudeinanemployeesnetworthcanonlyreasonablybeachievedthroughequity
compensation.Itisnowonderthatstockoptionprogramsaresuchanimportantcomponentof
compensationpackagestoemployeesofhighgrowthcompanies.Itisalsonowonderthatcompanies
andboardsarewillingtofootthebillfor409Acompliance,includingappraisalsconductedbybusiness
valuationfirms.2

IuseexamplessuchasApplebecausepubliclytradedcompaniesontheNasdaqGlobalMarketandtheNewYork
StockExchangearerichindatatransparencyandvaluationsaretrustworthyduetorobustmarketdynamics.
However,thispaperwillbefocusedonprivatecompanies,wherevaluationisuncertainintheabsenceofapublic
market.
2
TheauthorisaffiliatedwithArcstoneValuation,anationallyrecognizedbusinessvaluationfirm,andArcstone
EquityResearch,anindependentinvestmentresearchfirm.

Itiseasytoseewhystockoptionsareanimportantcompensationcurrencyamongresource
constrainedtechnologycompaniesthatpromisehighgrowth.Ascompaniesprogressfromearlystage
startupstowelldevelopedstandaloneenterprises,milestonesareachieved,revenueiscreated,
earningsaregenerated,andrisksaremitigated.Asearningsgoup,valuegoesup.Asrisksarereduced,
valuegoesup.Itisasimpletheorybut,aseveryentrepreneurknows,itsanincrediblechallengetostart
acompany,allthemoresotobuildone,andinfinitelymoresotobuildasustainablehighgrowth
enterprise.
Whenacompanysequityvalueexpandsrapidly,sodoesthenetworthofemployeeswhoholdstock
options.Thisisthemagicofthesystemofequitycompensation:manyshareintherewardsbecause
manycontributetotheeffort.Forallofthistowork,however,equitymustbeconvertedtocashat
somepoint.Foremployeesoflargepubliclytradedcompanies,suchconversionisnotaproblemas
thereisareadymarketinwhichindividualsmayreceiveliquidity.Butforprivatecompanieswithno
readymarketfortheirstock,whencanvaluecreationlikethisbemonetized?
NextExit100Miles?
Untilveryrecently,theanswertothisquestionwasadisappointment:nosingleemployeeorinvestor
couldexpecttoconverthisorherstockholdingstocashuntilthecompanyasawholeexperienceda
liquidityevent,suchasaninitialpublicoffering(IPO)ormergerwithoracquisitionbyanotherentity
(M&A).Classicalventurecapitalmarketpractices,asperformedthroughtheearly2000s,wouldhaveall
privatecompanystockremaininthehandsoftheoriginalstockholdersuntiltotalliquidationofall
sharesofthecompanyinacoordinated,boardcontrolledevent.Theserestrictionsincludefounders
stock,earlyemployeestockoptions,commonstocksoldtoangelinvestorsatthecompanysvery
earlieststages,preferredstocksoldtoventurecapitalistsorotherprofessionalinvestorsduring
successiveroundsoffunding,andallemployeesalongthewaywhoarecompensatedwithstockoptions
at(presumably)everincreasingstockoptionstrikeprices.Allthesesharesarelockedupuntilabig
event(IPOorM&Aexit).Tomakemattersworse,inanIPOscenario,employeesareoftenlockedup
untilsixmonthsaftertheIPO,inanattempttoprevent(oratleastdelay)amassivedumpingofshares
fromemployeestakeholderstoarmslengthstakeholders.
Comparethistothepubliccompanycounterpart.Anemployeeofapubliccompanymayundernormal
circumstancesfindareadyliquidmarketwillingtotradecashforhisorherstock.Butforprivate
companyemployeesthereisnoreadymarketfortheirstock.Thisisespeciallyburdensometothose
earlyemployeeswhoholdarelativelylargeproportionofshares,andforwhomthosesharesrepresent
alargemajorityoftheirownnetworth.FromthefirstfinancingtoIPO,thewaitforliquiditynow
stretchestoanearhistorichighofover9yearsonaverage.

Bydefinition,earlyemployeesplayakeyroleinthedevelopmentofyoungcompanies.Andyettheir
tenuretendstolastmateriallylessthanthattheaverage9yearsfromfoundingtoexit.Theseearly
employeesmaynotmakeittothebigexitthatsuccessfulcompaniesenjoy,andyettheymayhavebuilt
tremendousvaluefortheirrespectivecompaniesintheiryearsofservice.Forexample,letssaya
startupmarketingspecialist,Jane,joinsacompanysixmonthsafterthecompanysfounding,andshortly
afterreceivingitsroundofangelfinancing.Janeisinstrumentalinbuildingawarenessofthecompanys
productsandservicesinitstargetmarket,andcreatestremendousvalueforthecompanyduringher
fiveyearstintthere,duringwhichtimethecompanygrowsfromzerotoover$5millioninannual
revenue,withforecastsforfuturerevenuegrowthexceeding100%yearoveryeargrowth.ButJaneisa
startupspecialist,andthiscompanyisnowinanewphaseofprofessionalizationorinstitutionalization.
Herteamhasgrownmanyfold,andJanesdailyactivitiescallonhertobeamiddlemanagermorethan
theroleofmarketingninjashefancies.Herskillsarelessvaluedbythecompanyinthisstageofgrowth,
andfranklysheslessenthusiasticaboutherdaytodayimpactonthecompany.Sosheleavestostart
withanewventurethathasjustrecentlybeenformedandwhichhasreceiveditsfirstroundofangel
financing.
Countlessresearchhasconcludedthatthepeople,processes,andpracticesthatmakeacompany
successfulfromitsearlieststagesofformationmustbereplacedorretooledinordertomakeitthrough
professionalization,institutionalizationandlaterstagesofmaturity.3

Earlyemployee
&angelliquidity

Midstage
liquidity

ExitZone

Janehaseveryrighttoleaveherfirmtojoinanewone.Sinceshehasfiveyearsoftenure,allofher
originallyissuedoptionsarenowfullyvested.Whenshejoined,shewasgrantedoptionsatastrikeprice
of$0.10fromhercompanysboardofdirectors.Whensheleftthecompany,thefairmarketvalueof
thecompanysstockwasshowntobeover$1.60pershare.4Whatsmore,asanearlyemployee,she

Worksinthisarenaofmanagementsciencearevoluminous.GrowingPainsbyFlammholzandCrossingthe
ChasmbyChristiansenaretwowellknownstandards.
4
Wewontgointothespecificsof409Avaluationsinthispaper,butwillassumeallentryandexitpricesaremade
atfairmarketvalue,inaccordancewithInternalRevenueCodeSection409A.

wasgrantedtheequivalentofroughly1%ofthecompanysoutstandingstock,or1,000,000shares.With
theexpansionofvalueofthecompany,Janehasapaperfortuneof$1.5million.

Butthatsjustit:itsallpaper,itsallinprivatecompanystock.Withanyluckthecompanywillhavea
bigliquidityeventinanadditionalfiveyears.Thatsfiveyearsofprivatecompanystockvolatility,which
Janeisnothappytobear.ToquantifyJanesdiscomfort,wecanrunasimplecalculationusingtime(five
years)andvolatility(letsassume70%)asinputs.Usingaprotectiveputmethodology,todaysvalueofa
$1.60stockwithafiveyearlockupis$0.74,a54%discounttoitscurrentfairmarketvalue.5
Naturally,Janewouldprefertoconvertthe$1.5millionofilliquidvalueintocash,andmovethecash
intoabasketofdiversifiedinvestments,includingrealestate(read:paydownmortgage)andeducation
(read:schoolingforthekids).PossiblyIwouldarguelikelyaportionofthiscapitalwouldbeinvested
innewentrepreneurialstartups;perhapsherownnewcompany.Withoutearlyliquidityforearly
investorsofhumancapitallikeJane,allofthisvalueisunnecessarilylockedupintheilliquidequityof
theprivatecompany.
Thiscycleofentrepreneurshipiswellrecognizedintheworldoftechstartups.Itsonereasonthat,after
somanyupsanddownsintheprivatecompanymarket,privatecompanystockoptionscametobe
consideredessentiallyvaluelessforemployees,exceptinthemostexceptionalcases.
TroubledAngels
Thesameistruewithinvestorsoffinancialcapital.Itturnsoutthatsomeinvestorsareverygoodat
pickingwinnersattheirearlieststagesofdevelopment.Manyinvestorsarenotcomfortablewiththat
levelofrisk,andprefertoinvestlaterinacompanysmaturation.Stillmoreinvestorswaituntila
companyhasachievedgreaterscaleanditsriskprofileisfurtherreduced.Thedeepestpoolsofcapital,
includingmutualfundsandhedgefunds,playinthepublicmarketswheremidcapcompaniesof
greaterthan$10billionequityvalueandlargecapcompaniesofgreaterthan$30billioninequity
valueattractamassiveportionoftheworldsinvestmentdollars.Butforthoseearlystageinvestment

Theprotectiveputmethodologycalculatesthecostofaputoptiontoprotectthevalueofastockpositionfora
givenperiodoftimeundergivenvolatilityassumptions.Inthiscase,purchasingaputtoprotectthe$1.60valuefor
fiveyearswouldcost$0.86.Purchasingsuchaputwouldwipeoutmorethanhalfofthestocksvalue.

specialists,theyhavetoridealongwiththecompanymuchlikeJanethemarketingninjafroman
equityvalueapproximatingzerotoanequityvalueapproaching$100million(inthecaseofM&Aexits)
or$1billion(forIPOs)beforetheycanexpecttoexittheirinvestment.Isthisefficient?Whyhave
Angelo,anearlystageinvestmentspecialist,lockuphiscapitalfortenyearswaitingfora40xreturnon
anIPO(afortybaggerinthejargon)whenhemightexitwithahighlyrespectable5xreturnon
investmentinfiveyears?Considerthetablesbelow:

Theoretically,Angeloshouldbeindifferentbetweenthesetwoscenarios,ashisInternalRateofReturn6
(IRR)isroughlyequivalentbetweenthe10yearfortybaggerandthe5yearfivebagger.Butwhatis
moreefficientforanearlystagespecialist?Why,returnhismoneyquicklysohecangoinvestitagain,of
course.Buthow?WithoutawellfunctioningmarketplaceforAngelosstock,heslikelytobestuckfor
fivemoreyears.
WhatifAngelocouldsellhisstockatthefiveyearmark?Isthisnotjustswappingoutoneinvestorfor
anotherwiththesameexpectationsofthe$4millionexit?No.RecallthatAngeloinvestedinthe
companyasanangel,priortoitsfirstinstitutionalroundofventurecapital.Assumethecompanywas
justanalphastageproductbuiltoutofadormroomorinsomeonesgarage.Fortheriskhetook,

InternalRateofReturnisdefinedastheannualizedeffectivecompoundedreturnratethatmakesthenetpresent
valueofallcashflowsfromaparticularinvestmentequaltozero.Followthemathasillustratedintheabove
exampletounderstandthemechanicsoftheIRR.Thediscountfactor(itemdabove)growsexponentiallyin
relationtothediscountrateandpassageoftime.BecauseIRRsaresubjecttocompounding,a50%IRRincreases
returnrequirementsmassively,asillustratedinthisexample.

Angelorequireda50%IRRonhisinvestment(orlikelygreater).Butthatwasfiveyearsago,andthat
wasexpensivecapital.WhatifAngelocouldsellhisstakeatthefiveyearmarktoanewinvestor?The
newinvestor,inalllikelihood,wouldrequireamateriallylowerIRRfortheinvestmenttoday.Twenty
fivepercentmightsuffice.
Afterall,thecompanyhassignificantrevenues,wellfunctioningoperationaldepartments,andisonits
waytoabigexit.Whatdoesthis25%returnrequirementdototheexpectationsofcurrentinvestors?
Bythemagicofcompoundinginterest,itreducestheneedforamegaexittoamoderateone.Heres
why:ifAngelosexpensivecapitalweretocontinuetheridefromyear5toyear10,his50%IRR
requirementwouldcompoundsoaggressivelythatthe$500,000valuetodaywouldhavetogrowby
approximately8xoverthenextfiveyears(to$4million)tomeethisexpectedreturn.A25%IRR
threshold,ontheotherhand,onlyrequiresa2.5xreturnoverthesameperiodoftime,to$1.250
million,asillustratedbelow.

Ifthecompanyweretoswapoutallofitsearlystageinvestorsformezzanineinvestorsatthefiveyear
mark,theywouldcollectivelyrequireonlya$1,250,000exitforeach$500,000theyinvested.Thats
nearly70%lessthanthe$4,000,000Angelorequiredforhisownhotstuffcapital.Thus,notonlyisit
moreefficienttogetAngeloinvestingagain,itsstrategicallyimportantforcompaniestoreplaceearly
stagecapitalintheirequitystructurewithmezzanineinvestorsattheappropriatestagesof
development,soastoreducepressureonmanagementtokeepswingingforthefences,whenmore
moderatestrategiesmaybeappropriateforthecompanyssustainedgrowthandsuccess.
HowDoesItWork?
Wecouldhavediscussionsaboutthesecuritieslawsthatallowprivatestocktransactionsbetween
privateindividuals.WecouldalsotalkabouttheexecutionissuessurroundingtheT+45closing

processesthatoftencharacterizetheprivatecompanymarketplace.7Butwellleavethesediscussionsto
theattorneysandstockadministrators.Therearemanygoodmindsatworktryingtosimplifyandspeed
uptheprocess.Sufficeittosaythatprivatecompanystock,atthesimplestlevel,isthepropertyofits
individualowner.Oneofthefundamentalcharacteristicsofpropertyisthatiscanbetradedfromone
partytoanother.
Thusestablished,thequestionswithwhichwearewrestlinginthispaperpertaintovaluationand
economics.Whatisacompanysvalueatinception,atearlystagesofgrowth,atmezzanine,and
proximatetoexit?Howarevaluesallocatedacrosstheclassesofsecurities(debt,preferredequity,and
commonstock)thatmakeupthecompany?Whatexitpointsarelogicalforearlyinvestors?Whatdoes
itmeanforentrepreneurshipintheUnitedStatestohaveawellfunctioningmarketplaceforprivate
companystock?
CompanyValuationsthroughTime
Whatisacompanysvalue?Askanyprofessionalbusinessappraiserthisquestionandthelikely
responsewillbeitdepends.Onwhatdoesitdepend?Simplyput,thecompanysvaluedependson
thepresentvalueofitsexpectedfuturestreamofcashflows.Inotherwords,ahypotheticalbuyerwill
willinglyexchangecashtodayforexpectedfuturecashflows,discountedfortheriskthatfuturecash
flowsmaydifferfromwhatisforecasttoday.Valuationanalystsandmoreimportantly,buyersusea
wellestablished,timetestedmethodologytomathematicallycalculatethevalueofsomethingtoday
giventheinherentriskinessofitscashflows.Thisisreferredtoasthediscountedcashflowmethod
(DCF),anditunderpinseverythinginbusinessvaluation;thatis,allothervaluationapproachesand
methodologiescanbereconciledbacktowhatbuyersarewillingtopayforastreamofuncertainfuture
cashflows.TheDCFiselegantinitssimplicity,withonlytwovariableelementsintheclassicalapproach:
1) forecastcashflows,and
2) theriskassociatedwiththoseforecasts,expressedintermsofadiscountrate
Discountrate,compoundannualrateofreturn,andInternalRateofReturnallrefertothesame
measure.Inthispaper,Iusethetermsinterchangeably,accordingtothepointofviewofthesubject.
Forexample,AngelorequiresanIRRof50%forhis$100,000investmentbecausethediscountrate
associatedwiththisparticularinvestmentis50%andthecompanyexpectstogrowitsequityvalueata
compoundannualrateof50%.
Belowisamuchsimplifiedtablethatcomparesstageofcompanywithtypicalratesofreturnrequired
byinvestorsateachstage:

IndustrystandardsandregulationsrequireInvestorstocompleteor"settle"theirsecuritytransactionswithina
setnumberofbusinessdays.Thissettlementcycleisknownas"T+x,"shorthandfor"tradedateplusxdays."T+3
meansthatwhenyoubuyasecurity,yourpaymentmustbereceivedbyyourbrokeragefirmnolaterthanthree
businessdaysafterthetradeisexecuted.Whenyousellasecurity,youmustdelivertoyourbrokeragefirmyour
securitiescertificatenolaterthanthreebusinessdaysafterthesale.Fortransactionsinvolvingsecondarysalesof
privatecompanystock,T+30settlementtimesaremorecommon.

Inception Early Stage Mezzanine

Revenue
Profit
Milestone:
Concept
Growth
Growth
Cost of Capital: >50% 30% 50%
<30%

Public Market
LongTerm
Competitiveness
~10%

Mature
LongTerm
Sustainability
<10%

US Govt
RiskFree
<2%

TheDCFmodelisconceptuallysimple.Thebasicpremiseisthatadollarinthehandtodayisworthmore
thanadollarpromisedtomorrow.Toconstructamodelshowinghowmuchlesstomorrowsdollaris
worth,onemustdiscounttomorrowsdollarbyacertaincostofcapital.Asdescribedabove,costof
capitalisderivedbyexaminingtheriskofagivenventurerelativetootherpotentialinvestments.A
companyraisingmoneyatinceptionmayonlyattractinvestmentfrominvestorsiftheycanshowthat
everydollarinvestedtodaywillresultin50%growthinvalueofthatdollar,yearoveryear,untilexit.
Intheillustrationbelow,aninvestoriswillingtofinancethecompanysnegativefreecashflowby
investing$500,000inyearone,$525,000inyeartwo,$1,050,000inyearthree,and$150,000inyear
fourasthecompanyfinallyapproachescashflowbreakeven.Attheendofyearfive,afterthecompany
hasturnedasignificantprofit,thecompanyintendstosellitselffor1.5xrevenues,or$6,000,000.These
cashflowsyielda50.7%internalrateofreturn.Inotherwords,thecompanypromisesthateverydollar
investedwillexperiencecompoundedannualgrowthofover50%.Thatisquiteanattractiveinvestment,
ifyoubelievethecompanysforecasts.Butwhatistheriskthatthiscompanywillnotachieveits
forecasts?Inthiscase,wecanconcludethattheriskisequivalenttoa50%discountrate.Anotherway
ofputtingitisthatthecompanyscostofcapitalis50%.

ToexplaintheconceptoftheDCFfurther,andthetimesensitivityofreturnsoninvestment,welltake
thesameexamplebutrequirethattheinvestorponiesupforthefullinvestmentonDay1ofYear1.The
samecompanywillrenderjustshyofa30%return:

Nowthatwehaveanappreciationfordiscountrates,letsconsiderwhathappenswhenaninvestor
makesaninvestmentinanentrepreneurialventure.Evenattheearlieststageofcompanydevelopment,
investedcapitaldoesnotcomprise100%ofthevalueofthecompany.Toillustratethis,wewillassume
thatanangelinvestoriswillingtoinvest$500,000upfrontinanentrepreneurialventureinexchange
for50%equityinthecompany.Aftersettingasidesharesforanoptionpool,thecompanycapitalization
table(captable)lookslikethis:

Angelopurchasedthesesharesat$0.05pershare.Thecommonstockisthensaidtobeworth$0.05per
share,andthepostmoneyvaluationissaidtobe$1million.
AtthebeginningofYear2ofthisventure,thesamecompanyattractsanadditional$2millionofventure
capitalfinancing.Thisinstitutionalcapitalismadeasapreferredequityfinancing,withcontroland
preferencefeaturesattachedthatgivetheVCsenhancedreturns,controlanddownsideprotection.This
isthecompanysPreferredAfinancinground,andinexchangeforthe$2.5millioninvestmentthe
companytradesaway10,000,000sharesofPreferredAstockpricedat$0.25pershare.Nowthecap
tablelookslikethis:

Notethatthepostmoneyvaluation,whichisequaltothepricepersharepaidinthelastroundof
financingmultipliedbythetotalnumberofshares,isnow$7.5million.Thatssignificantappreciationfor
theentrepreneurialteamsefforts.Thecompanysprospectshavechangedconsiderably,andalongwith
heightenedforecastsoffutureperformance,thecompanyalsorequiresmorecapital.

10

Twoyearslater,thecompanyclosesonitsPreferredBfinancingof$7.5millionat$0.50pershare,an
uproundwith100%appreciationinstockprice.Nowthecaptablelookslikethis:

Wearenowthreefullyearsintotheventure.Aftertwomoreyears,andwithamezzanineroundof
growthcapitalonthehorizon,itcouldbesaidthatAngeloisfeelingfatigued;soaretheearly
employees.Recallourpriordiscussionregardingearlystagespecialistsfounder,investors,and
marketingninjasalikearebeginningtotireofthisadventure.Inordertoconsiderthepossibilityof
cashingoutearlyinvestors,wemustconsiderthevalueoftheirequity.
ValueIsAllocatedAccordingtotheCapitalStructure
Equityparticipantsaredividedamonggroupsofinvestorsaccordingtotheirseniority.Muchlikedebt
canbelayeredinsenior,subordinateandunsecuredclasses,equityvalueisallocatedaccordingto
differentsecurityclasses.Becausethepreferredstockgetspreferentialpayoutsuponliquidation(andin
thiswaysomewhatfunctionslikedebt),liquidationtablesmustbecreatedtodescribehowinvestors
willbepaidoutgivencertainliquidationscenarios.Thisexerciseiscalledtheallocationofequityvalue.
Inthisexample,wellassumethefirst$10millionisallocatedparipassubetweentheSeriesAandSeries
Bpreferredstock:

11


Thenext$5millionisallocatedtothecommonstock:

12

Thenext$7.5million,whichtakestheequityvalueto$0.50pershare(thesamepriceasthelastround
offinancing)issplitbetweenthecommonandSeriesApreferredstock:

AndeverydollarthereafterissplitparipassubetweentheSeriesA,SeriesBandcommonstock:

Thus,ifthecompanystotalequityvalueisdeemedtobe$10million,thepreferredAissaidtobeworth
$0.25pershare,thepreferredBworth$0.50pershare,andthecommonstockzero.Thepreferred
stockata$0.25valuepershareactsmorelikedebtthanequity,sincetheytakeallthevalueandthe
commonstockgetsnone.However,atatotalequityvalueof$30million,thecommonstockhascaught
uptothepreferredstockonapersharebasis,andisnowworth$0.67pershare.

13

Agraphicaldisplayoftheabovemaylooklikethefollowing:

ExitStageLeft
Whichbringsusbacktothecornerstonequestion:atwhatpointwillearlyemployeesandinvestorscrave
liquidity?Recallthebelowtable,wheretimeisrepresentedontheXaxisandexitvaluationsarerepresented
ontheYaxis.Whenoneviewsthebelowtableinthecontextofadiscountedcashflowmodel,andthetime
valueofmoney,60quartersoftimestartstolooklikeaneternityforsomeoneexpectinga50%IRR.

Earlyemployee
&angelliquidity

Midstage
liquidity

ExitZone

14

Inthisillustration,earlyemployeesandangelsseekliquidityasthecompanyliftsofffromavaluationof
nearzerotoapproximately$30million,afterabout20quarters(fiveyears)ofinvestment.Letsexamine
thisdesireforliquidityinthecontextofthecapitalstructurefromabove.Inthisexample,commonstock
comprises20,000,000sharesofatotalof45,000,000sharesoutstanding.Ata$30,000,000valuation,
thecompanysfullydilutedvalueisequalto$0.67pershare(identifiedbythedottedgreenlinebelow).
Nowanewinvestormakesanoffertoangelsandearlyemployeesat$0.60pershare(identifiedbythe
dottedblacklinebelow).

Forfounderswhostartedwithnothing,andforAngelowhopurchasedsharesat$0.05pershare,a
$0.60pershareofferrepresentsanIRRofover64%.

15


Whomightacceptsuchanoffer?Eachpotentialsellerorfundwillhavetheirowndecisioncriteria,buta
simplifiedviewmightyieldtheconclusionthatthefoundersandangelswouldbemotivatedtosellsome
oralloftheirholdingsatthe$0.60pershareoffer.
Inthissimpleexample,thenewinvestorsoffering$0.60persharearemotivatedtobuyintothe
companyatanattractiveprice(~10%discounttothefairmarketvalueofthestock).Thesellersare
motivatedtosellbasedontheattractiveIRR,andrealdollars,representedbytheoffer.

16

Meanwhile,theboardofdirectors,representingallstakeholders,maywishtoswapouttheangel
investorswithnew,longterminvestorseagertoparticipateinthecompanysforecastgrowth.Inthe
end,atransactionofthiskinddoesverylittletoimpacttheownershipstructureofthecompany:

Atransactionofthistypeimpactsthestructureanddynamicsofthecompanyinthefollowingways:

Foundersandmanagementarepartiallyrewardedfortheirefforts.
o Vestedstockoptionsmaybesold.Bydefinition,thisisonlyasmallportion(ornoneat
all)ofrecentlyhiredemployees,andpossiblyagreaterportion(upto100%)of
foundersstock.Thepressuretoexitisthusreducedmaterially,whichisoftenviewed
positivelyinthesamewaythatpatientinvestorsareviewed.
o Earlystagespecialistsaregiventheeconomicfreedomtoinvesttheirtimeandcapitalin
theirnextventures.
Angelsarepartiallyorwhollyrewardedfortheriskstheytookattheformationofthecompany,
andthiscapitalisredeployedintotheentrepreneuriallandscape.
NewinvestorsareallowedexposuretoprivatecompaniesatattractivepreIPOvaluations.This
isanexcitingareaofinvestmentformanyinvestors,whereriskadjustedreturnscanbehigh.
Companieshavetheopportunitytoremovefatiguedinvestorsandemployees(knownasdead
cap)fromthecaptableinexchangefornew,longterminvestorseagertoparticipateinthe
companysforecastgrowth.

17

Asdiscussedbefore,newinvestorsatthisstageofinvestmentrequireareducedIRRdue
tothereducedrisksassociatedwiththecompany.Inourexample,anIRRof25%isa
meaningfuldifferencefromtheexpensivecapitalthecompanyacquiredatitsfounding.
o Replacingdeadcapwithpatientcapitalisnearlyalwaysviewedinapositivelight.
Theboardofdirectorsremainsunchanged.Controlstillrestswiththepreferredstockinvestors.
o

OtherExitsNotAvailable8
DavidWeildandEdwardKim,twosenioradvisorsatGrantThorntonCapitalMarketsandformer
NASDAQexecutives,haveanalyzedthecausesofthecurrentIPOcrisisintwosubsequentwhitepapers.
Intheirpapers,WhyareIPOsintheICU?andMarketStructureisCausingtheIPOCrisis,WeildandKim
identifyregulatoryandtechnologicalshiftsthathaveirreversiblyalteredthemarketforIPOs,including
theneardisappearanceofVCbackedIPOsafterthedotcombustof2000andthetelecombustof2001.
ThedisappearanceofsmallerIPOshasdirectlyledtolongertimestoexit,termedtheIPOGap:

Onlinebrokerages,decreasesinbrokersspreads,anddecimalizationreducedtheprofitabilityof
providinginvestmentresearchandliquidityforsmallerstockstwocriticalelementsforsmallcap,
recentlypublicfirms.ThesestructuralchangesprovidedanantagonisticenvironmenttosmallerIPOs
and,byextension,toagreatmanyventurebackedIPOs.
TheRoleofPrivateCompanyLiquidityintheUSEconomy
AstheIPOwindowforcompanieswithequityvaluesbetween$100millionand$1billionhasbeen
effectivelyshut,andasM&Aactivityhasnotprovidedanequivalentvolumeofexitoptions,therearean
increasingnumberofattractivecompaniesgrowingthroughthesmallcapvaluationrangeasprivate
companies.Withoutaviablesecondarymarketforprivatecompanystock,thesecompaniesareholding
hostagecountlessfatiguedearlystagespecialists,investorsandemployeesalike.

DreanandHege,TheSecondaryPrivateMarketsNewPlayersintheVentureCapitalEcosystem,coledes
HautestudesCommercialesdeParis,2011.

18

WhileIPOandM&Aexitsarestillavailabletoprivatecompanies,theyhavebeencomplementedand
insomecasespossiblysupplantedbythisnewlyrecognizedformofliquiditycalledthesecondary
tradingofprivatecompanystock.AhealthyprivatecompanyliquidityenvironmentintheUS,where
investors,employees,directors,regulators,andlawmakersunderstandthebenefitsandrisksassociated
withprivatecompanyliquidity,wouldbeofimmensevaluetotheUSeconomy.Thelegalexchangeof
privatesharesofstockhasbroughtnewefficiencytotheprivatecapitalmarketsbyallowingearly
employees,foundersandearlystageinvestorstoexitalloraportionoftheirholdings.Thebenefitsof
allowinganexitatearlierstagesinacompanyslife,andatvarioustimesingraduatedfashion,are
numerous:

Earlystageinvestmentspecialistsareempoweredbyallowingthemtorecycletheircapitalinto
thenextgenerationofpromisingstartups.

Earlystagestaffareempoweredbyallowingthemtoleaveacompanytheyvehelpedbuildand
puttheirenergyintonewearlystageventures.

Entrepreneursandfoundersareempoweredbyallowingthemtoreceiverepaymentforwhat
areoftenlargepersonalinvestments,thusmakingiteasierforthemtogiveupthereinsof
controltoexecutivesmoresuitedtomanagementofmidandlaterstagestartups.

Thecompanyisnotpressuredtopushforexaggeratedgrowthatthecostofsustainable
businesspractices.

Conclusion
Stockoptionprogramsareanimportantcomponentofcompensationpackagestoemployeesofhigh
growthcompaniesbecausetheyaresoefficientandeffectiveinaligninginterestsamongstakeholders
andallocatingwealthamongthosewhohelptocreateit.Forstockcompensationtowork,however,
equitymustbeconvertedtocash.Foremployeesoflargepubliclytradedcompanies,suchconversionis
notaproblemasthereisaliquidmarketinwhichindividualsmayselltheirstock.Thispaperillustrates
theincreasinglywellacceptedmethodsthatallowprivatecompanyshareholderstoaccessaready
marketinwhichindividualsmayaccessliquidity.Thereasonsthatprivatecompanyemployeeliquidity
programsaretakingholdarenumerous,includingthelongtimehorizonsthroughwhichearly
employeesandangelshavetowaituntiltheircompaniesexperienceanexitthroughM&AorIPO.
Thenegotiationofpriceandterms,structuring,andthemaththatunderliesprivatestocktransactions
arecharacteristicofthecomplexitiesoftheprivatemarketsthemselves.Butintheend,itsallmath;
specifically,itstheapplicationofadiscountedcashflowmodeltoexpectedfuturereturnsatan
appropriatediscountrate.Atleast,itsallmathasfarasthetransactionisconcerned.Thetruevalueof
aninvestmentcanneverbeforetold;itisalwaysultimatelyuptomanagementtomakeorbreakany
opportunity;tomakeorbreakanycompany.
Increasedacceptanceandprevalenceofprivatecompanyliquidityprogramsshouldbeembracedasa
highlypositivedevelopmentforallmarketparticipantsincludingcompanymanagement,shareholders,
boardsofdirectors,andnewandoldinvestorsalike.TheUSeconomyasawholewillenjoysome

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measureofliquidityagaininthemarketforcompaniesthatareworthlessthan$1billioninequity
value,therebyrewardingearlystagespecialistsandliquefyingcurrentlyfrozencapital.

BoBrustkernisFounderandManagingDirectorofArcstonePartners,anindustryleadingbusiness
valuationandinvestmentresearchboutique,wherehedirectsstrategyanddevelopmentforthefirm.
Mr.Brustkernhasleddirectandsecondaryinvestmentsinprivatecompaniesthroughhisprincipalroles
atBACEIndustriesandRusticCanyonPartners.Hehasperformedinvestmentresearchleadingto
successfulinvestmentsinsecondarytransactionsthroughArcstoneEquityResearchandHighStep
Capital.
Formerly,Mr.BrustkernwasaninvestmentprofessionalatventurecapitalfirmRusticCanyonPartners
andmiddlemarketprivateequityfirmBACEIndustries.Priortohiscareerasaprivateequityinvestor,
Mr.BrustkernwasasenioranalystatWellsfordResidentialPropertyTrust(NYSE:WRP),wherehe
focusedonacquisitionsanddevelopmentforthefifthlargestresidentialREITinthecountry.Boholds
anMBAwithdistinctionfromTheAndersonSchoolatUCLAandaBAfromDartmouthCollege.

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