Common Stock Ownership Spreads Among Start-Up Investors

NY Times December 27, 2015 6:00 am

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 start-up stock: common shares.
The competition among investors to get into hot start-ups has been so fierce that many hedge
funds, sovereign wealth funds and others have been unable to participate when the up-andcoming 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 start-ups often from workers directly 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 is paid out only after the preferred
shareholders get their money.
The trend has gained steam in recent years. Firms that buy employee shares, like Equidate and
EquityZen, have proliferated in the past few years, competing with established firms like VSL
Partners and Millennium Technology Value Partners. These firms have collected employee
equity from scores of start-ups 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 who get the stock to hedge funds, family offices and investment firms in Asia
and the Middle East.
The spreading of common stock may have some unintended consequences, especially as the air
begins to come out of the Silicon Valley boom and some companies get sold for modest amounts
of money. For one, institutional investors who own common stock could take home much less
than other investors in the same company who have preferred shares. That gap, in turn, could
lead to more litigation between investors.
The gulf between what preferred and common shareholders are paid has already led to an
increase in shareholder versus shareholder litigation over the past two years, said Patrick Gibbs,
a partner at the law firm Latham & Watkins in Menlo Park, Calif., without providing examples.
In most cases, preferred shareholders 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 of anything, said Nizar
Tarhuni, an analyst at the data company PitchBook.
The interests of the common and preferred shareholders are often not aligned, especially when
investors who hold preferred stock want to get their money out, said Dennis White, a partner at
the law firm Verrill Dana.
Preferred shareholders have rights that let them time a sale of a company, even if its not at a
time when they can get a deal done that pays common shareholders, too, he said.
Professional investors owning more common stock puts a new twist on this dynamic, said James
Hutchinson, at law firm Goodwin Procter. Its a totally new world when sophisticated, wellheeled investors own a lot of common stock, he said. Individuals often dont 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
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 board got more than $3 a share.
Employees have not sued Good, which is based in Sunnyvale, Calif. But Goods 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 that they want the suit
to be recognized as a class action.
Mr. Bogosian and the funds allege that Goods board breached its fiduciary duty by only
considering the needs of preferred shareholders when doing the deal with BlackBerry. Good,
they alleged, 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.
Latham & Watkins Mr. Gibbs is representing Goods board and Goods then-chief executive,
Christy Wyatt, 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 Baron, an attorney 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 start-ups have occurred in the past. In the aftermath
of the late 1990s dot-com boom, common shareholders sued preferred stockholders, said Mr.
White.
In 2005, a suit was also brought by common shareholders against directors of a translation
software company called Trados, he said. In that case, the common shareholders got nothing and
the preferred shareholders got most of the money from a sale. Common shareholders lost the
Trados case largely because the judge ruled that the company wasnt worth enough in the end for
a larger payout. But Mr. White said the case was a wake-up call for that generation of
dealmakers.
It raises the question about where your duties lie if youre a venture capitalist and a director,
Mr. 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.