Investors give up rights for shares in startups4 min read . Updated: 29 Dec 2015, 01:33 AM IST
Institutional investors began buying common stockgenerally owned by employees of startupsoften directly from workers or from platforms that sell employee shares
When institutional investors put money into companies backed by venture capital, they typically end up owning a type of stock called preferred shares. Now, institutional investors are also becoming owners of a different class of startup stock: common shares.
The competition among investors to get into hot startups has been so fierce that many hedge funds, sovereign wealth funds and others were unable to participate when the up-and-coming companies sold preferred shares, a kind of stock that generally comes with many protections.
So to make sure they got a stake in private companies like Palantir Technologies, Dropbox and One Kings Lane, the institutional investors instead began buying common stock—generally owned by employees of startups—often directly from workers or from platforms that sell employee shares.
In doing so, the investors chose to forgo the protections that come with preferred shares. Common stock usually comes with no guarantees and payouts come only after the preferred-share holders get their money.
The trend has gained steam in recent years. Firms that buy employee shares, like Equidate and EquityZen, have proliferated in the last few years, competing with established firms like VSL Partners and Millennium Technology Value Partners.
These firms have collected employee equity from scores of startups including Airbnb, Spotify, Pinterest, Dropbox and Palantir, according to their websites. In some cases, they hold the shares in their own funds, and in others they act as brokers that convey the stock to hedge funds, family offices and investment firms in Asia and the Middle East.
The spread of common stock may have some unintended consequences, especially as the air begins to come out of the Silicon Valley boom and some companies are sold for modest amounts of money. For one thing, institutional investors that own common stock could take home much less than other investors with preferred shares in the same company. That gap, in turn, could lead to more litigation among investors.
The gulf between what preferred and common shareholders are paid has led to an increase in shareholder-versus-shareholder litigation over the past two years, said Patrick E. Gibbs, a partner at the law firm Latham & Watkins in Menlo Park, California, without providing examples.
In most cases, preferred-share holders walk away with rewards, or at least with much of their money back. For common stockholders, however, companies must sell for a relatively high price or have a successful public offering for common stock to be worth much, said Nizar Tarhuni, an analyst at the data company PitchBook.
The interests of the common and preferred-share holders are often not aligned, especially when investors who hold preferred stock want to get their money out, said Dennis J. White, a partner at the law firm Verrill Dana.
“Preferred-share holders have rights that let them time a sale of a company, even if it’s not at a time when they can get a deal done that pays common shareholders, too," he said.
Professional investors’ ownership of more common stock puts a new twist on this dynamic, said James A. Hutchinson, at the law firm Goodwin Procter. “It’s a totally new world when sophisticated, well-heeled investors own a lot of common stock," he said. “Individuals often don’t sue, but institutions budget for litigation. They are more motivated to sue."
That happened in the case of Good Technology, a mobile-security company that was sold to the mobile software and device maker BlackBerry for $425 million in September, far less than its last private valuation of $1.1 billion. Employees and other common shareholders, including family offices and institutional investors, received about 44 cents a share. The venture investors on the company’s board got more than $3 a share.
Employees have not sued Good, which is based in Sunnyvale, California. But a former chief executive, Brian Bogosian, a significant shareholder of common stock, teamed up with two venture firms, Harvest Growth Capital and Saturn Partners, which both acquired common stock, to sue most of the board in October. In their complaint, the plaintiffs said they wanted the suit to be recognized as a class action.
Bogosian and the funds claim that Good’s board breached its fiduciary duty by only considering the needs of preferred-share holders when making the deal with BlackBerry. Good, they said, was sold to BlackBerry because the venture investors chose to get the protections they knew they would reap in a sale instead of the uncertainty of raising more money or going public and seeing their stock potentially lose value.
Gibbs of Latham & Watkins is representing Good’s board and Christy Wyatt, Good’s chief executive at the time of the sale, in the case. In a legal filing, he called the suit a case of “Monday morning quarterbacking."
BlackBerry did not respond to requests for comment. Randall J. Baron, a lawyer who is representing the plaintiffs, said: “The decision to sell to BlackBerry for woefully inadequate consideration was clearly self-interested" on the part of the board and management.
Shareholder-versus-shareholder suits in tech startups have occurred in the past. In the aftermath of the dot-com boom of the late 1990s, common shareholders sued preferred-stock holders, White of Verrill Dana said.“
It raises the question about where your duties lie if you’re a venture capitalist and a director," White said. “Your duty is to represent all shareholders, and that can conflict with your duty to the folks who invested in your fund. This is an area where inside investors have to tread carefully."
© 2015/The New York Times