This sponsored post is produced by Microventures.

Secondary transactions offer accredited investors the ability to diversify their portfolios by giving them the opportunity to invest in late-stage private companies. There are a handful of established private equity platforms that provide access to these types of pre-IPO investment opportunities, but their methods vary in ways that you might not expect – or even know about. And some of those methods aren’t all they’re cracked up to be.

Forward contracts fall into that category because they add unnecessary risk to an already inherently risky transaction. At MicroVentures, we’ve facilitated secondary transactions for companies like Facebook, Twitter, Yelp, and Box prior to their IPO, all without using forward contracts.

Forward contracts in private equity transactions

Forward contracts are very common in commodity and currency trading, but they work very differently in the context of a private equity transaction. For one thing, the investors are essentially paying someone today to deliver shares at a specified future date or event. But a lot of things can happen between the execution of the contract and the delivery of shares, and most of that risk is completely outside an investor’s direct control.

Let’s take an example. A former employee of Vandelay Industries is tired of waiting for the company to go public and wants to sell her considerable number of shares now so she can get liquidity at a known price-per-share versus waiting for a company-driven exit at a later date. Vandelay doesn’t want employees to sell shares, so the employee can’t just find a buyer and sell the shares. So instead she signs on with a platform that specializes in trading pre-IPO shares using forward contracts, and that platform turns around and offers her Vandelay shares to one or more willing investors.

How does this arrangement play out in a perfect situation? In the short term, the investors pay for the Vandelay forward contract on the shares at the agreed-upon price and the seller walks away happy with cash in her pocket. In the long term, events are determined by the terms of the contract, but when a liquidity event takes place, the seller is likely obligated to either deliver the shares to the investors, or liquidate the shares and deliver the proceeds.

The problem(s) with forward contracts

There are a handful of potentially problematic scenarios associated with forward contracts. First and most obviously, the potential value of the stock could appreciate dramatically, and the employee could realize just how much money she stands to lose if she delivers the shares or the proceeds. In short, she changes her mind. Can she do that? Of course she can, and the only legal remedy the investors have is to sue.

What else could go wrong? A handful of things. For example, the seller could get divorced after executing the forward contract. If her shares are considered community marital property, they may be divided as part of a divorce decree, making it impossible for her to deliver the full shares or the full amount of proceeds. At a minimum, the spouse could challenge the forward contract, at which point the fate of the investment hinges on the outcome of a domestic dispute.

Another possible situation is that Vandelay Industries, who didn’t authorize the transaction, could find out about the forward contract, which may be a violation of the terms of the company’s bylaws. Worse, the seller could still be employed by the company, which could fire her for the violation, contest the agreement, or both — leaving the investors high and dry.

Finally, and more grimly, the seller could die, and what happens to the shares then depends on who inherits them — and what Vandelay’s bylaws allow. Some companies have restrictions on the transfer of shares, allowing the directors to refuse registration of the shares or to impose pre-emptive rights. If the shares go back to Vandelay, the company has no legal obligation to honor the forward contract. Even if the beneficiary is allowed to register the shares, he or she may likewise decline to honor the agreement.

A safer alternative

Forward contracts aren’t the only option for secondary transactions. At MicroVentures, for example, we often source secondary investments in late-stage companies from existing investors, providing liquidity to early investors or former employees by purchasing their preferred or common shares outright. In some instances, we participate in tender offers, in which current employees sell shares in the secondary market to institutional investors. In all cases, these secondary transactions are transparent to all parties involved, and the process eliminates the risk associated with future delivery.

Mitigating the risks of forward contracts

Despite the inherent risk of a forward contract, some investors may feel that the opportunity to get in on a pre-IPO company like Vandelay Industries is well worth it. In cases where investors want to proceed with this type of transaction, there are a handful of ways to mitigate the risks of losing out to a bad actor or other unforeseen disasters in a forward contract:

  • Payment for the shares could be placed in escrow. This approach makes the deal less compelling for the seller – especially if the goal is quick liquidity – but it also renders the deal significantly less risky for the investors.
  • Investors may make partial payment upfront and make the remaining payment upon delivery of the shares or proceeds. This “meet me halfway” approach may satisfy the liquidity needs of the seller while minimizing the investors’ risk exposure.
  • Other terms of the agreement may be modified to provide additional protections against bad actors. Because forward contracts are not standardized, they can theoretically be customized in any way the investors see fit.

Needless to say, use of these mitigation strategies is contingent on the transaction platform’s willingness to implement them. At a minimum, the investors should ask to see the seller’s proof of shares, should ensure that the company in question is aware of — and approves of — the forward contract, and should insist that the contract itself include appropriate terms for handling the most common worst-case scenarios.

Who uses forward contracts — and how can you tell?

Some private equity platforms companies use forward contracts only for certain deals, and some use them as a standard business practice. But part of the danger of purchasing private equity through a forward contract is that you may not even know you’re doing it. Platforms that rely on forward contracts tend to obscure that fact, using confusing or deceiving language in an effort to conceal the true nature of these transactions. Falling just short of misrepresentation, they may refer to these transactions as “participation agreements,” “participation interests,” or “alternative derivative instruments.”

The best way to know for certain if the secondary transaction you are entertaining is a forward contract is to ask point-blank how the shares were acquired. If the shares were purchased outright, you’ll be in the best possible position for a successful secondary transaction. You’ll be put on the cap table — or at least be part of a special-purpose vehicle that’s put on the cap table — which makes the whole transaction transparent to all parties.

The future of forward contracts

Despite the risks, forward contracts are perfectly legal and show no sign of disappearing from the private equity landscape. As long as shareholders are willing to sell and investors are willing to buy, the SEC is not going to come between them. Not yet, anyway. Given a recent probe launched by the SEC, the organization is clearly no longer turning a blind eye to this alluring but problematic business practice.

Bill Clark is the CEO and founder of MicroVentures, an equity crowdfunding platform.

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