Making sense of private ownership structures a tall order

21 October 2020 - 06:09 pm UTC

As companies stay private longer while raising multiple rounds of equity capital, the question arises: who is safeguarding the ownership data?


For public companies, the job falls to stock transfer agents and issuer services companies, two of the largest in the world being Australia-based Computershare [ASX:CPU] and Brooklyn, New York-based AST Financial (formerly American Stock Transfer & Trust), a portfolio company of Pacific Equity Partners. There are dozens of others.


For private companies, ownership records often reside in one or more spreadsheets maintained by the company or its investors, sometimes leading to confusion or disputes. Even worse, verbal commitments made to early investors or co-founders may not have been recorded, but can carry weight in court.


Internal research by Computershare found that 70% of North American private company executives surveyed said that tracking outside investment was a key challenge.


Tim French, a partner with Menlo Park, California-based Seubert French Frimel & Warner, said many private companies have limited experience in managing capital tables and simply learn as they go.


“You can be a founder and capable of lots of things, but have never done a cap table in your lifetime – it doesn’t necessarily come naturally,” he said.


Facebook’s [NASDAQ:FB] startup days are one example of poor or nonexistent ownership record keeping, as dramatized in the 2010 movie The Social Network. Facebook and its founder, Mark Zuckerberg, have paid out billions of dollars to Eduardo Saverin and other early partners and investors who have pressed ownership claims, some of them based on verbal agreements on ownership.


And it’s not just startups. Another example of cap table confusion is the 2014 take-private of Tibco Software by Vista Equity Partners, for an agreed upon price of USD 24 per share. The deal was initially valued at USD 4.24bn. But Tibco advisor Goldman Sachs, using a capitalization spreadsheet, double counted more than 4.1 million shares of one category of Tibco common stock when preparing diligence materials for the bidders and its own fairness analysis, according to court documents. The revised price was USD 4.14bn, or USD 100m less than expected by Vista shareholders, some of whom sued.


“It’s not surprising how often private company ownership tables are poorly maintained, often with significant errors and inconsistencies. We’ve personally settled more than a dozen disputes out of court, with some going to litigation,” noted Seubert’s French.


Growth of private markets


The cap table issue is significant because more companies are staying private longer, a multiyear trend highlighted in a 2020 report on private markets by McKinsey & Company. Private market assets under management, representing private equity and venture investments, grew by 10% in 2019 and a collective USD 4tn in the past decade, the report stated. During the same time frame the number of active PE firms has more than doubled and the number of US financial sponsor-backed companies has increased by 60%. Meanwhile, the number of US publicly traded companies is down nearly 40% since 2000, according to McKinsey.


Marty Flanigan, president and CEO of AST, recently told this news service that private company cap tables can be “a bit of a mess.” As reported, AST is actively raising up to USD 50m for a minority stake in a new business unit focused on private company record keeping, called AST Private Company Solutions.


“Interest in private companies has exploded in the past 10 years and companies are going through many more investment rounds and staying private longer,” he said for the report. The process makes cap table record keeping more complex. In addition, more private companies are extending ownership to employees and offering investors and executives restricted shares and stock options, all of which must be tracked. AST’s new Astrella platform promises to manage it all, using blockchain technology.


In July, Computershare announced the launch of GEMS, its digital platform to help private companies manage investor and employee equity and the associated compliance issues.


“Companies that organize their shareholder and investor information early on can save thousands of hours of work” when it’s time to pursue a public listing, said Jennifer Warren, Computershare’s CEO of Issuer Services for North America.


Technology companies, in particular, are choosing to stay private for longer because they have ready access to growth capital. But as their cap tables grow more complex, they require the kinds of systems usually associated with public corporations: employee equity programs, governance and compliance services, Warren said.


Another player in the space is Carta, formerly known as EShares, a San Francisco-based technology company backed by Andreessen Horowitz and others. In 2019 Carta raised a USD 300m Series E round at a reported USD 1.7bn valuation. Carta said it sells the country’s leading software product for cap table management.


Buyer beware


Ultimately, a bad cap table is a ticking time bomb for the buyer of a private business, the sources said.


“You don’t want any uncertainly on the number of shares” held by founders, employees and earlier investors, French said. If any amount of equity is overlooked after a purported 100% sale, the result is likely to be time-consuming litigation and the potential for a costly settlement, he said.


“If there’s one person that holds one share that you didn’t get, you didn’t purchase the whole company,” Seubert’s French said. “It creates a hold-out problem, where the person says, ‘How much do you want to pay me to get rid of me?’”


As private markets continue to flourish, AST’s Flanigan said more private equity firms are keen to safeguard their investments. AST already provides stock transfer and issuer services to the world’s five largest publicly traded private equity firms, and would like to move many of their portfolio companies onto the Astrella platform.


“The single most important asset a private equity firm has is the proof of its equity ownership in its investments,” said Alex Ovchar, an investor at PEP, which is Australia’s largest private equity firm with AUD 5bn under management.


by Jeff Sheban