Should Zynga and LinkedIn Limit Their Employees From Selling Their Stock?

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.

New Exit Door Opening

The National Venture Capital Association recently released data highlighting that Q1 2010 VC fund raising dropped 31% from Q1 2009, to $3.6 billion.  Upon reviewing the data, technology blog TechCrunch wrote that “Until exits pick up again, investors will remain cautious on venture capital as an asset class.”  First, let’s take a look at the data in terms of total funds raised by quarter over the last two years.

A different perspective is looking at the quarterly change in funds raised, relative to the same quarter in the previous quarter.

The funds raised by VCs dropped again in the first quarter in 2010 relative to the Q1 2009,  which had already dropped significantly from Q1 2008.  However, if I were a VC I’d be heartened by two facts.  First, traditional exits for VC’s picked up dramatically in Q1 2010 compared with previous quarters.  The chart below shows exits via M&A (per Thomson Reuters):

In addition, IPO volume picked up in the first quarter, with information technology (4) and biotech (3) leading the charge in terms of number of IPOs:.

The second fact that should be ncouraging to VCs is the emergence of the secondary market as a third option for exits.  All three “exits” are rife with peril.  To paraphrase a recent comment from Zynga’s CEO Mark Pincus, “Going public is not an exit its an entry”.  Inferring that it’s an entry in to a new hell with rules and regulations and costly filings and mindshare suck for management.  In a merger, the VCs are happy, but management now has a new boss with limited context, and the usually leave and their baby withers (MySpace being the classic example).  The issue with the selling of shares in the private market is the mis-perception that the seller must know something bad about the company or must not care about the company (if its an employee).  Why is selling shares in the private market perceived so differently differently than an IPO or merging?  Its perceived differently because its relatively new.  However, the companies leading the social media revolution (e.g. Facebook, Zynga, LinkedIn, Twitter…..) have all seen dramatic increases in interest in buying their shares in the nascent private market , The fact is, selling shares in a private market transaction is a win for everyone, and the sooner everyone opens their eyes to that fact, the faster our little ecosystem of private shares will grow.

Buyer Beware: SharesPost Index Under Values LinkedIn By Billions

Earlier this month SharesPost announced SharesPost Index, the industry’s first value index for venture backed companies.  After watching their valuations over the last few weeks, I’m a little concerned.

In June 2009, TechCrunch wrote that SharesPost reported LinkedIn’s valuation at $1.4 billion, which was $400MM above LinkedIn’s July 2008 $1 billion valuation from their $53MM round they had raised from Bain Capital Ventures, Sequoia Capital, Greylock Partners and Bessemer Ventures.  Below is a video taken shortly after the $53MM round, interviewing the investors that participated in that round with their justifications for the $1 billion LinkedIn valuation.

What I find odd is that SharesPost pegs a current valuation of LinkedIn at practically the same valuation that they had nearly 10 months ago.  In the same June 2009 report by SharesPost, they put a valuation of $4-6 billion on Facebook, and today, SharesPost reports Facebook’s valuation at $11.96 billion.  At least they agree that Facebook has created shareholder value in the last 24 months, that’s hard to dispute.

To be fair, SharesPost’s valuations are weighted and based on four inputs, which are transactions, research, financing and post inputs on their exchange.  But that’s the premise of this post, I’m not certain their weighted system is working properly for determining accurate valuations to potential buyers on their secondary market exchange.  Their website explains the weighting system as:

The SharesPost Venture-Backed Private Company Index is a modified market capitalization weighted index—the maximum percentage value of the index any company represents is 25%. The index value inputs for each company are an average of the four data inputs broken out above. Where data is unavailable or out of date (i.e., more than 120 days old), that input is omitted from the calculation and only the remaining inputs are used. So for example, where a company has not recently closed a venture financing, only the recent transactions, current posts and research report estimates are used as inputs into the SharesPost Index Value formula. SharesPost updates the Index Values on a weekly basis.

Their research valuation for Facebook is only $5.7 billion, whereas we recently reported a $50 billion valuation on Facebook.  I’m not quite sure how they determined their $5.7 billion valuation on Facebook when recent private transactions have been above $17 billion.

According to SharesPost, they do not use data that is over 120 days old (which is why the transactions and/or financing input is missing for several companies on their Index.).  The “post input” appears to be based on the recent posts on their secondary exchange, which is clearly not indicative of the overall market, although it seems close.

While in theory a Secondary Market Index seems like a great idea to help buyers on the secondary market understand what they’re buying, but providing incomplete and insufficient data when determining valuations is unprofessional at best, and potentially very dangerous to these potential buyers on their exchange.

SharesPost does list a disclaimer on their website about the valuations within their Index (see below), but I would think that they would want to ensure the most accurate valuations to help create investor confidence in their services.

The SharesPost Venture-Backed Index and the individual Index Values are only a reference point and should neither be construed or relied upon as an estimate of valuation of any company or group of companies nor as investment advice.

That said, we disagree with the SharesPost LinkedIn valuation and will be publishing a full report and valuation on LinkedIn very soon.  But I think its safe to say that LinkedIn has created shareholder value since their $1 billion round in 2008, in fact the SharesPost valuation is off by billions of dollars… if they’ve undervalued a company by billions, could they overvalue companies by billions in the future?  Buyer beware.