Demystifying Private Investing
Welcome back to “Demystifying Private Investing”, a series of informational articles that will provide definitions and use-cases of the common terms employed in the field of private investing.
The practice of raising funds in exchange of company shares. Aside from obtaining additional capital, private placements can also have a goal of adding, with minimal regulatory constraints, new select private investors. The investors participating in a private placement usually are institutions and accredited investors.
Despite being privately held, private placements function like stock offerings. As a new generation of shares is being issued, existing stockholders will eventually get diluted and result in lower price per share.
For example, Company A has a total share outstanding of 20M shares and decides to issue an additional 200K share in a private placement, existing investors will see themselves diluted by 10%.
Right of First Refusal (ROFR)
An ROFR is an agreement providing the option to an individual of transacting with his counterpart an asset before anyone else. In this instance, the ROFR is a form of insurance guaranteeing the hoder to not lose their priority over the underlying asset.
Right of First Refusals are useful for risk averse individuals or companies who wish to secure an opportunity, but would rather see how the latter evolves before completing any transactions. In private investments, ROFRs work like a restriction that gives stock issuers the right to purchase the security at the same price, and that before the shareholders are allowed to transfer their holdings to a third party.
The ease of transferring an asset between two or more parties. An asset will be considered illiquid when there are not enough buyers and sellers to transact the asset.
For example, stocks listed on the public markets are deemed liquid because of their ability to be traded easily between buyers and sellers. On the other hand, private stocks are considered less liquid due to the limited number of individuals willing to sell and purchase.
Employee Stock Option
A form of compensation issued by a company to its employee instead of shares outright or a salary compensation. The employee stock option (ESO) is a derivative contract (call option) that grants the ability to the employee of perceiving the shares of the company at a specific price within a finite period of time.
This practice defines how the company will distribute its shares periodically while outlining its shareholders’ obligation and rights. Note that ESOs come to termination when the employee leaves the company, and they provide no voting rights.
There are multiple forms of ESOs, which include:
- Employee stock purchase plans, that have a goal of enabling the employees the ability to purchase the company’s stocks at a discounted price.
- Restricted stock grants are options providing the employee to perceive their stocks after certain work-related criterias are met. For example: the number of years an employee has worked in the company.
- Stock appreciation rights, which allow the employee to augment the value of the underlying assets associated with the stock options.
ESOs are common practice for early stage startups, because it incentivizes their employees to add value to the company.
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