The most interesting part of Groupon's IPO filings with the SEC last week wasn't how wealthy the company's executives will become once Groupon goes public -- it was that they already are.
It used to be that a company's founders and early investors had to wait patiently for the day the company went public or was acquired to cash in on their stock holdings. But since the late 1990s, when investor demand for tech companies became insatiable, it's become common for founders to sell their personal stock to new investors during financing rounds.
Groupon CEO Andrew D. Mason received almost $28 million from sale of his stock last year. In all, Groupon executives and investors received $810 million from Groupon stock sold to new investors in two separate financing rounds.
Cashing out before a company has gone public or has even made a profit, as happened with Groupon, isn't uncommon, but it can cause problems. Investors may question the commitment of a company's executives to build the company into a successful business if the incentive to strike it rich is gone, says Steve Blank, who teaches entrepreneurship at Stanford and UC-Berkeley.
"When the [financial] pressure is off the founders, they're not driving for liquidity," Blank said. "If it goes broke, 'Who cares? I got three million dollars out of it.'"
Of course, some argue that there's a very good reason to make founders rich: to keep them from selling out early or rushing to IPO so they can pay the rent.
If the founder of a successful startup is living off of ramen noodles, they might be more inclined to sell their company for a price that is lower than it would be if the founder was financially comfortable enough to wait things out, said Yoichiro Taku, a partner at the law firm of Wilson Sonsini Goodrich & Rosati who represents technology companies.
Executives who don't want to be seen dumping stock and thus risk scaring off investors, have another option to get their hands on cash before the IPO: credit.
Banks routinely extend lines of credit for millions of dollars to individuals who have large, on-paper stakes in highly-valued companies. Some executives continue to live on credit even after the IPO in order to hold onto a large volume of stock in their companies. CEO Larry Ellison is known to live partly off of loans, even though Oracle has been publicly traded since 1986 and is a $164 billion company.
Employees who own stock have a more difficult time monetizing their paper wealth, said Professor Reena Aggarwal, who teaches business and finance at Georgetown University. For instance, employees not expected to become multi-millionaires or billionaires won't receive the same generosity from lending institutions. Credit "is available to potentially high net worth individuals," she said. "Someone worth $100,000 is not going to have that option."
When employees receive stock, they typically have to wait four years before they can sell it, which is called a "vesting" period. But even after their stock vests, they have few options to sell it if the company hasn't gone public.
The stock that employees receive comes with conditions, one of which is that if they want to sell it they have to give the company the "right of first refusal," or the option to buy back the stock itself or divert the stock sale to an approved buyer.
"Most privately held companies do not want the shares sold outside the family," said Cary K. Hyden, a partner at law firm Latham & Watkins who has overseen 100 IPOs over 28 years. Companies don't want employees "to sell shares to a competitor," he said, for fear that a competitor would gain valuable information through disclosures that the company must give to its investors.
While companies have allowed employees to sell their stock on private exchanges like SecondMarket, the practice has become less common in the last year, said Professor Aggarwal. When private company stock is sold, it can potentially multiply the number of investors a company has. If a company goes over 500 investors, by law it must begin regulatory disclosures with the SEC (though the SEC is considering raising the cap). Companies don't want to be forced to act as a public company before they are ready, said Professor Aggarwal.
Once a company goes public, banks require that its executives and typically most employees wait 6 months in what's called a "lock-up period" before they can sell their stock on the open market. The lock-up period is a banking convention, not an SEC rule. The reason for it, Professor Aggarwal said, is that flooding the market with company and employee shares would depress the share price, and because refraining from a sell-off "tells the world we believe in the stock."
One change in recent years is that banks will sometimes allow shareholders, typically private equity investors, who don't have a day-to-day role in a company to sell their stock in the IPO, said Hyden, the IPO lawyer.
Executives do have another option to cash in before the six-month waiting period is up. If an offering is very successful, the company can go back to its bank, request a secondary offering and ask that the lock-up period be waived so personal shares can be sold.
This happened in the case of Volcom, the Costa Mesa, Calif.-based apparel maker, which Hyden helped represent. Less than six months after the company's IPO price of $19, the company held a secondary offering selling shares at around $34 a share. Management raised $170 million in that second offering, Hyden said.
Write to Joseph Walker
