Facebook and the Rise of Early Stage Liquidity
Daniel Burstein of Millennium Technology Value Partners describes how Millennium established a liquidity program for Facebook employees and became a pre-IPO investor in Facebook. Excerpts from the transcript are below.
Privcap: Please describe the shareholder liquidity challenges of Facebook prior to its going public.
Daniel Burstein, Millennium Technology Value Partners: Facebook is a great case study for many things. And one of those is the need for, and the efficiency of, providing liquidity to founders and early-stage investors—and employees in the capital structures of venture-backed companies more generally. In Facebook, the process worked remarkably well, actually.
The company is almost nine years old today. And we started making what are called secondary investments, meaning providing cash liquidity to shareholders in the Facebook capital structure, as early 2008. We actually had our eye on it since 2006. But by 2008, there were already some young employees who had left the company and wanted to get some cash for their stock. Yet back in 2008, the Facebook management really didn’t want to go public for many years.
So a very interesting market grew up within the Facebook capital structure. We were among the first, maybe the first, to be an institutional fund providing liquidity to Facebook shareholders. And we worked very closely with the company. A variety of problems rose up about who can sell and to whom they can sell, what information they can provide, if any, etc.
We offered to work with the company to help them find a solution to this kind of annoying, distracting problem, as it was perceived at first, while the company management wanted to focus on running the business. So we were able to develop a liquidity program that actually worked very well. And then, of course, over the subsequent years, liquidity in Facebook became much more commonplace.
Facebook, while it’s a unique, one-of-a-kind company with very unique characteristics in rising so fast from its founding in 2004 to it $50 billion, $60 billion, $70 billion, $80 billion worth of market cap, is typical of many, many start-ups. Thus we have seen the market for secondary liquidity grow from less than $250 million in 2002, when we started making secondary investments at Millennium, to over $9 billion in 2011.
So this market has really grown. And Facebook has been the prototypical company where everybody can see the virtues. People who want to cash out can cash out. People who want to cash some out and hold some can do that. Early-stage investors can take some chips off the table. Management can afford to wait longer for the IPO. In Facebook’s case, that was very important to get them to a stage where they were comfortable going public, where their business model was sufficiently obvious to the world so that the value of the company could be understood.
Secondary liquidity has now become a permanent part of the venture/private company ecosystem. So this is going to happen. It is happening in many other companies. It’s going to happen in many more companies in the future. Basically, the benefits of liquidity that we associate with the public markets are now available in the private venture capital market as well.
The cautionary note is that it’s much more complicated and much more difficult in the private markets than in the public markets. That’s why our firm, as an institution, has focused on doing secondary transactions in a company-friendly way, emphasizing best practices in the “technology” of how you do a secondary transaction, the infrastructure, the legal process, the compliance issues. We make sure when we do secondary transactions, we’re doing them in ways that are thoroughly acceptable, approvable, compliant, and beneficial to companies.
There are a variety of issues out there with less experienced and less institutional buyers in the secondary market causing problems for companies. So that’s going to be one of the issues will play out in the years to come. But secondary liquidity for venture-backed companies in their private stages of development is here to stay.
Privcap: Are early stage company founders typically resistant to allowing their shares to be sold?
Burstein: The market has matured from when our firm began making secondary investments in 2002. Back then, the majority of venture capital investors and board members in companies would have said, “Nobody gets liquidity before we do. And we’re waiting for the IPO. So everybody sit tight and wait.” It would have been almost unheard of in 2002 to do the kind of transactions that have become commonplace today.
Between 2002 and today, a great change has taken place. Today, you have many of the leading venture capital funds who tend to be the investors in the most exciting and interesting companies, who tend to serve on their boards, as well as their law firms and the law firms that represent the companies, saying that at least some early liquidity is extremely beneficial for all constituents. Today there is very little opposition to a CEO or a founder taking 10% of his or her chips off the table.
Privcap: The JOBS Act will allow for greater participation in early stage investing. What is your view of these new rules?
Burstein: I want to see how it unfolds over time, but I’m skeptical about many of its provisions. I think the best thing about it is the ability to expand the number of shareholders in a private company before that company has to become a publicly reporting company. I think that’s a good update to go from the 500 shareholders, previously, to 2000, before you have to start reporting publicly. That’s going to help companies that want to focus on building their company and becoming a bigger, stronger, more mature company before going public. It’s going to allow them to employ more people and still give them shares and options and to take on more investors and not risk running afoul of the 500 investor rule anymore. That’s, I think, categorically positive.
However, I’m very concerned that investors who have typically been protected by a variety of protective provisions (or by their size of their net worth and their experience as investors in traditional venture capital financings)… those kind of opportunities will now be offered to people who may not be qualified or have the experience to understand the risks. And the risks may not be fully disclosed to them. That concerns me.
I think there is some good news in crowdfunding. And again, we have to wait and see, because the actual SEC regulations for how crowdfunding is going to be done are yet to be fully promulgated. I can see some good things coming out of that. But I can also see a lot of challenges and problems.
As to whether it will become an opportunity for secondary investors, I tend to think it will, because people without that much venture capital experience will make investments in companies and then want to reap the benefits of those investments, if they’re sound investments, and if they perform well, prior to waiting the estimated eight to ten years it now takes for a private company to get public. So I think it may be a good opportunity. But on the other hand, as of now, the JOBS Act only permits a million dollars of crowdfunding into these companies. So I don’t know how much opportunity that’s actually going to create for investors.
Privcap: Are LPs in venture capital funds now more eager to cash out of shares?
Burstein: Well, I think limited partners are going to ask, request, encourage the general partner managers that they back to take advantage of the growing secondary market to sell some or all of their holdings in private companies that are promising, where they can take chips off the table profitably. We’ve seen a big trend in the secondary market from doing very few deals with venture capital funds to increasingly transacting some shares from holdings in venture capital portfolios.
The limited partners are favorable to the notion of getting some cash earlier than waiting for the IPO. Of course, they don’t want their managers to cash out too early. And if there is big value, they want their managers to think carefully about how much should they sell now and how much they hold for the future.
The issue of distributing in-kind is actually mitigated significantly by the rise of the secondary market. So even if you are an LP in a fund, for example, that’s winding down, and you get private company shares distributed to you– which is often the case with wind-downs when the company hasn’t transacted yet–the LPs now can sell those shares through the secondary market. Whereas just a few years ago, that would have been an impossibility.