Last week Bloomberg reported that LinkedIn and Zynga may begin placing limits on employee sales of their company shares. In fact, we’ve heard from investors that new Series A documents will begin implementing similar limitations from the start of their portfolio companies, making it harder for employees to liquidate their stock options that they helped create shareholder value within.
Management at LinkedIn and other hot pre-IPO social media startups hope that by adding limits on employee sales of their shares they can keep employees focused on their business rather than their share price. However, the reality is that these employees are largely 20-something year olds earning small salaries but may be sitting on shares worth many multiples of their salary, which they are largely responsible for the value creation of those shares.
So, should the companies be adding limitations on their employees ability to sell the shares that they have helped create shareholder value in? This is a challenging question because generally there is a great disparity between the personal financial alignment of management, the investors and the employees working for these companies. While management and their investors want to keep employees focused on their core business versus the share price, their motives are financially driven to increase the share price for a future exit of the company that they control. The employees seeking to sell their shares within the secondary market are simply seeking to optimize their wealth position so they can remain more focused on the core business versus their personal financial situation. Clearly both parties are acting in their own best interest, so how can they align these interests?
The IPO process has slowed and there are fewer exits due to many factors, including Sarbanes Oxley compliance and higher required revenue run rates, particularly for small cap companies. For many venture backed companies, an acquisition remains a compelling exit strategy. However, the secondary market has emerged as a new form of an exit for investors, founders and employees, and placing limitations on their employees ability to utilize this form of an exit could be driving misalignment sending the wrong message.
One of the most compelling reasons employees pursue a career in the technology startup industry is the ability to create wealth through their stock options. A lot of employees will trade a higher paying salary in another industry for a lower paying salary plus stock options at a technology startup for the upside potential of that stock. Depending on how these companies and their investors draft the limitations on the sale of their shares, it may have a negative impact on the talent the technology startup community has been able to recruit. Or worse, it may engender a lot of ill will.
Companies generally don’t tell their investors when they can sell their shares, in fact, its the VCs who are largely driving the growth in secondary market transactions. Increasingly, you’ll find enlightened companies will leverage stock options, not restrict them to dramatically improve alignment. One company we know well, is in the midst of a large raise, in which $5 million is being used to buy back shares from their employees. However, rather than just purchasing the shares from the employees in a cash transaction, the money will be escrowed for four years, and paid out monthly, if the employee remains with the company. Also, given the dramatic increase in the employee’s monthly income, the employee must agree to no raises over the four year period. What’s the net impact? A happier, more productive employee base, higher retention for the company, and lower costs – and of course, the employees are focused on the business, not the share price. This appears to be a better path than companies like Zynga & LinkedIn blocking their employees from selling their shares. But these are early days in the developemnt of the secondary market. They’ll learn.