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Equity in early startups tends to be highly illiquid, meaning you can’t easily convert investments into cash. It’s tough to know a startup’s true value until someone, or something tells you.
Building a startup is similar to building other things – art, an invention, a house. You know what time and money you’ve invested, but until you get an external valuation and find buyers, its value is intangible. Your investment is illiquid, locked up until you find an exit – a liquidity event.
If a startup decides to offer share options to employees, they’ll need to consider both vesting schedules and liquidity events. Liquidity events enable the conversion of illiquid shares into liquid assets, which is what we’re going to discuss here.
The risks and rewards for shareholders for investing in startups are high because their equity remains intangible until the business starts heading in the right direction.
As startups grow, they’ll approach milestones in their journey – liquidity events that enable shareholders to cash out some of their illiquid shares and investments into real cash.
In other words, these startups will suddenly have value that can be bought, sold and traded on markets.
A liquidity event is typically an acquisition, merger, initial public offering (IPO), or another event that enables anyone with illiquid equity in a company to cash their shares. That could be founders, investors and employees.
Consider a young Mark Zuckerberg. He, his co-founders, his early investors, and venture capital firms held illiquid equity in the company until its Initial Public Offering (IPO).
Facebook raised $16 billion at IPO and began its first day trading publicly with a valuation of approximately $107 billion. Zuckerberg owned 28.2% of the company, making his net worth $19.1 billion – a pretty remarkable liquidity event – especially for a 27-year-old.
Here’s an explanation of the three main types of liquidity events.
The first type of liquidity event – and the most relevant for businesses aiming to grow and exit – are mergers and acquisitions (M&As). M&As occur either:
M&As can be transacted through cash, stock, or a mixture of the two. The consequences for investors and shareholders vary depending on the transaction.
Generally speaking, if an employee or key individual is granted exit-only share options, they can be exercised at an M&A, and if the shares have risen in value, they’ll benefit from that uplift in value when they sell them.
Planning for an exit is complex and involves advanced planning to ensure everyone’s interests are met, including any members of share schemes. Startups building towards an M&A should have an exit plan in place.
Another significant liquidity event is an Initial Public Offering (IPO). IPOs mark the first time a company sells shares to the public. Following the IPO, shareholders can sell their shares on the public stock market.
IPOs are often viewed as the “pot of gold at the end of the rainbow” for startups looking to establish long-term credibility and awareness. If they go well, they can result in huge gains for investors and shareholders.
However, IPOs also carry disadvantages related to the business going public, such as regulatory pressures, loss of autonomy and lock-up periods, which prevent founders from ‘abandoning ship’.
As such, they’re not always the target for budding startups. In fact, the IPO market has slowed significantly in recent years, and 2022 was dubbed the worst year for IPOs since the 1990s.
A third liquidity event is bankruptcy or insolvency. If the business becomes bankrupt or insolvent, shareholders typically end up with nothing. If any capital remains, external investors are usually paid out before internal shareholders like founders and employees.
Some companies remain private entities for decades, but confronting a liquidity event is inevitable for most businesses that grow and progress.
Even without a significant liquidity event like an M&A or IPO, it’s nearly always necessary for maturing businesses to create liquidity so private shareholders can realise the value of their shares.
But therein lies the issue. How can businesses offer liquidity to key shareholders if IPOs and M&As aren’t desirable? What happens if they want to create some liquidity before one of those events?
This is highly relevant for shareholders created through share options schemes.
Options can be granted and exercised, but a liquidity event is required to exchange illiquid shares into cash. Let’s discuss that in detail.
Share options schemes grant employees and other key individuals a stake in the business. However, that stake is illiquid until certain milestones and conditions are met and a liquidity event enables them to convert their stake into cash.
The process varies depending on whether options are exit-only or exercisable.
Exit-only options can be exercised upon an exit event, such as an acquisition, merger, management buyback, significant change in control, or a partial or full floating on the public exchange.
Some of these events also create a liquidity event. Employees exercise their options and buy their shares when the exit event, such as an M&A, is agreed upon. They then proceed to sell their shares to the business buyer, liquidating them and turning them into cash.
When granting exercisable options, a business is typically aiming for long-term growth. And they may not have their sights set on an exit.
Liquidity events for exercisable options are typically less clear than for exit-based options, where the M&A triggers the exercising of shares and potentially also their sale for cash.
Exercisable options are usually vested upon individual and business milestones, at which point they become exercisable.
Options can also be exit-only with the added provision that the options can be exercised after a certain number of years. However, just because employees gain the right to exercise their shares doesn’t mean they should.
For example, they may want to hold onto their options if they anticipate a lucrative liquidity event or otherwise feel the market price will grow. There are many different ways to benefit from share schemes, such as receiving dividends from shares.
It’s also worth highlighting that some options will expire eventually, so you can’t wait forever. Under EMI schemes, employees typically have 10 years from the option grant to exercise options and buy their shares.
While businesses with exercisable options may still head towards M&As and IPOs, they can liquidate shares in other ways, too. Businesses can create their own liquidity events, which enable shareholders to liquidate their equity in the absence of an M&A or IPO.
Liquidity events help businesses combat the illiquidity of shares when a company aims for long-term growth.
For example, what happens to shareholders if the business remains private and doesn’t go public for longer than expected, and they don’t want to merge or sell to an acquirer?
What if an employee’s share market price already exceeds the grant price, and they need a house deposit or new car now, but a merger or IPO is still a couple of years away?
In such cases, employees with some vested shares might be daunted by the prospect of waiting to liquidate them.
There is a solution, however, as the business may buy back some of its shares, either regularly (e.g. once a year) or on an ad-hoc basis.
Buybacks are a credible method of liquidating shareholders’ equity at any point they see fit. Of course, whether or not this will be possible depends on the business, its growth, cash flow, etc.
Businesses may also permit founders, employees and investors to sell some of their shares to other investors without offering a buyback.
Here, employees may be allowed to sell their shares through the secondary market to a third party without the need for an acquisition, merger or IPO.
In the UK, private secondary share transactions have rocketed in popularity as shareholders seek methods of liquidating their shares without an exit or IPO. Some of the world’s hottest startups list shares on secondary markets like Seedrs.
The transactions and changes that occur at a liquidity event are complex. Moreover, since the business has likely matured and attracted multiple stakeholders by the time of the event, interests can clash.
There are important tax implications and requirements for different types of liquidity events, too.
For example, share buybacks are a popular means to enable shareholders to realise the value of their shares – including shares earned through options schemes.
But buybacks rely on the company having enough post-tax cash to execute the buyback, and tax varies depending on when the options were issued.
Likewise, utilising markets for private company equity trades and transfers carry their own tax implications.
Planning for liquidity events is essential to avoid surprises. The Vestd platform simplifies the process of offering and managing share schemes which is helpful for planning an exit, IPO or other liquidity events.
If you want to discuss anything about equity and share schemes and whether they’ll work for you, get in touch.
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