Got Liquidity? An Overview of Private Market Investment Structures
They say that the only constant is change.
Nowhere else does that aphorism ring true than in the fast-moving world of founding and funding startups. From Roots to Rippling, Atmos to Anduril, shareholders large and small are increasingly tapping more accessible, collaborative, and transferable funding mechanisms in order to increase their flexibility and satiate their desire for liquidity.
As storied executive Jim Barksdale famously said, “The only way to make money is bundling and unbundling.” According to quantitative and qualitative data, private markets are trending in the direction of the latter. Much like the rise of liquid super teams, novel, liquid (super) structures of privately held companies increase optionality, access, and well…liquidity.
Though there are many roads to Rome, not every structure is created equal. After all, both a paved highway and a dirt path allow for transportation, but the former is superior to the latter.
In this piece, we delve into the differences between direct transfers, forward contracts, and— the new kid on the block—equity-linked financing notes.
As Stonks attacks the complexity, opacity, and illiquidity of private markets with vim and vigor, stay tuned. Some of these features may well appear on this Stonky site sooner rather than later.
While opportunities for retail investors to invest in private market, pre-IPO startups have greatly expanded over the last several years, still lacking is sufficient structural diversity that allow for optimized, risk-adjusted exposure.
In public markets, there exist myriad different investment structures to fit different investors’ objectives:
- Common stock exists for investors who want 1:1 exposure to the market capitalization of a company
- Options (and multi-option structures) enable investors to obtain levered exposure to a company and/or a stock’s price variance
- Corporate debt for fixed-income gives more risk-averse investors access to fixed cash flows at a higher rate than that offered by US government debt
Given this panoply of options in public markets, it stands to reason that there should be some diversity in the private market investment structures. Unfortunately, as you will see, dear reader, this is still far from the case. What follows is a brief look at the two most common investment structures today for pre-IPO stock: direct transfers and forward contracts – and introduce a third structure growing in popularity – equity-linked lending – which, in many cases, can offer the best of both worlds.
1) Direct Stock Transfers
The first structure we’ll explore is also the simplest: direct stock transfers. This is when an investor, or the SPV to which an investor is subscribing, acquires company shares directly and gains a proverbial seat on the capitalization (cap) table. This resembles when you buy stock in the public markets; you obtain direct, 1:1 (mostly, depending on your share class) exposure to the valuation of the company and own your shares outright on the cap table right adjacent to VCs! That said, it’s not always so easy to secure this desirable, VC-adjacent position. Many companies – including high-flying unicorns such as Stripe, SpaceX, and Ramp – disallow direct stock transfers per their bylaws.
Even when direct transfers are allowed, VCs very often have Right of First Refusal (ROFR) privileges, meaning they have thirty days from when a buyer and seller agree to a trade to snatch the shares for themselves.
At best, this introduces a multi-week settlement delay.
At worst, it blocks investors from obtaining exposure to those companies on which they are the most bullish.
Not to mention, this is often far from ideal for existing shareholders (e.g. employees) looking for liquidity. The long ROFR period gives buyers ample opportunity to back out of the trade and both high broker fees (5-10%) and tax bills resulting from secondary sales eat into shareholders’ liquidity and net profits.
2) Forward Contracts
In the early days of secondary markets, forward contracts addressed many issues that plagued direct transfers. These contracts are very simple – since it can be difficult to transfer stock today, a buyer and a seller simply agree to trade N shares at $X/share at some point in the future when the shares become liquid/unrestricted (such as upon a company exit/acquisition/IPO) with the variables N and X agreed upon today. Since this does not trigger a direct cap table change, it needs not go through either the company approval or ROFR processes. This means investors can obtain access to the best companies that would normally get restricted or “ROFR’d” and shareholders can tap liquidity for their stock much more quickly and easily.
That said, caveat emptor! If this sounds a bit gimmicky to some of you, you may well have a future at the SEC. Recent guidance suggests that the regulatory body is starting to crack down on forward contracts that serve only to circumvent transfer restrictions.
Finally, most forward contracts are structured in a way that introduces some level of counterparty risk. While very rare, there have been isolated cases of shareholders selling forwards on their equity (sometimes multiple times over to different buyers), then fleeing the country and failing to deliver the shares upon a company liquidity event.
3) Equity-linked Financing Notes
Lastly, we have the latest and greatest innovation: equity-linked financing notes. Also known as a variable prepaid forward contract (PFC), these instruments allow private company shareholders to access liquidity in exchange for some of their equity both today and at a later date.
At a high level, this is similar to a shareholder receiving a loan for a portion of their equity–collateralized by their stock–but instead of paying recurring interest payments, the shareholder pays a special kind of interest that takes the form of a percentage of their shares upon the company’s exit/liquidity event. The investor effectively advances cash to the shareholder today in exchange for a portion of the equity collateral later and repayment of the principal. Similar to a plain vanilla forward contract, this does not trigger a direct cap table change, so does not involve the company approval or ROFR processes.
This aligns incentives quite nicely between both the investor and the underlying shareholder. The shareholder maintains exposure to the company (and any future upside) in addition to instant liquidity for his/her shares while the investor obtains access to a promising company’s future cash flows from a seller who still has skin in the game. This is key.
Ironically, both direct transfers and plain vanilla forward contracts contain an element of adverse selection risk (i.e. an investor is deciding to buy from an insider who has an information advantage and is deciding to sell). PFCs mitigate this risk— if a shareholder is bullish on their company, they are often economically better off tapping liquidity and retaining upside, whereas if bearish, their best option would be to sell out of the position via a direct transfer or a plain vanilla forward contract.
Finally, this lending structure offers the investor significant downside protection, as repayment of principal takes first priority on the shareholder’s collateral upon a liquidity event. Put simply, the value of the stock has to decline significantly before the investor starts losing money. Of course, there’s no free lunch – this added downside protection means there is a tradeoff in PFC returns versus buying via direct transfers for the most bullish company exit scenarios. That being said, the tradeoff tends to be asymmetric in the investor’s favor.
In a future piece, we’ll dive deeper into how PFCs can offer superior returns for both investors and shareholders seeking liquidity, and look at analyses of how PFC-based investment strategies perform relative to those of the most successful direct investors.
As the menu of opportunities that comprise private company investment structures broadens, Stonks can continue narrowing the gap between retail investors and the top VCs!
See you on the moon!