Now that technology companies are staying private longer, the pressure to create liquidity options for founders, investors, and employees is intensifying.
The average time for a fast-growth startup to enter the public markets has stretched out to more than 10 years, according to some estimates. Facing a competitive hiring market, management teams and company directors now regularly field requests to “release the pressure valve” and unlock liquidity several years before an IPO is planned, if one is planned at all.
Visionary private companies are getting ahead of the curve to solve liquidity challenges. Choosing the right path can:
There are various ways to enable a company to stay private as long as it deems fit while rewarding those who got the company where it is today. Consider these tips for creating a pre-IPO liquidity plan that will help the company achieve its goals.
For employees: Secondary liquidity is increasingly employed for retention purposes and to reward loyalty. Granting more options impacts dilution from the early investors’ and founder’s point of view. But that can be at least partially mitigated by providing a liquidity opportunity for existing equity and vested options.
For founders: Consider the case of the founder who is still with the company but hasn’t had any meaningful liquidity, or the one who left years ago and is getting anxious for some liquidity. Founders often have significant personal pressure to get some liquidity after taking reduced paychecks for several years.
For investors: Be mindful of early investors and others who may have to fund wind-down periods. Often, early-angel and seed-stage investors will happily trade liquidity today for a future upside with an unknown timeline.
Who participates: One of the toughest decisions for company leadership is identifying who should be given the option to sell shares in a partial liquidity event. There is no right answer, although if employee retention is a chief goal, a more inclusive arrangement will likely be more successful. The more inclusive it is, however, the more likely the company will have to make a tender offer that triggers disclosure rules. That may require making more information public than the company would like, which could negatively impact the company’s value at sale time.
How much can they sell: A key consideration with a tender offer is striking the right balance between allowing participants to sell enough shares so the rewards are meaningful and ensuring that they retain “enough skin in the game” in the form of illiquid stock options. The company should want to give them an incentive to stay. Setting a price benchmark may also build confidence in prospective and new hires that their options will be worth something.
What’s the impact on company valuation: From the founders’ and investors’ point of view, granting a liquidity path often is preferable to granting more options. In other words, it may be more advantageous to provide liquidity for existing equity than impacting ownership dilution. On one hand, a large secondary sale can cause the 409a valuation to increase, as the “illiquidity discount” on the common stock is reduced. On the other, the sale may provide a basis for valuing the common shares should you wish to use them in an M&A transaction.
Advantages: Combining a secondary offering with a primary round often makes sense, because the company can take advantage of a concurrent due-diligence process. Also, there typically is more interest in supporting a secondary when it’s tied to the primary. The proceeds from the sale of preferred shares allow the company to purchase common shares from founders, employees, and early investors. This can be a great way for employees to pay off any personal loans from the company that they used to exercise options. (There is a cost and likely a tax consequence to exercising an option; often the latter is the bigger problem, but an individual with limited liquidity needs to cover both.)
Disadvantages: Consider, however, what stakeholders need to know about the “cost” of timing a secondary with the primary; venture capitalists, board members, and outside investors may balk at the idea. The downside may be a sizable haircut, since full value transparency seldom translates to a higher price. Still, it’s an avenue for allowing liquidity.
When a company repurchases shares, there may be complicated tax consequences. Additionally, exercising options in order to sell shares often leads to large unplanned tax consequences for the sellers. Educate employees on seeking proper tax advice, regarding both option exercises and the proper treatment of the sale proceeds. Transparency combined with advance planning means more value realized.
Expect some blowback: Typically, board members have a diversity of opinions about when, how, and even if the company should go ahead with a liquidity plan for employees. It’s a good idea for the CFO to have prepared a strategy for navigating board opposition and defending the decision. In the best cases, board members will want to purchase employee shares.
Educate the employees: Employees may have misguided (often exaggerated) estimates of stock values and may not clearly understand the differential between preferred pricing and common stock valuation. Education is the best policy for setting expectations.
Be flexible: As an alternative to a company purchase, some companies allow employees to exercise options using a recourse note — usually with a small interest rate — allowing them to borrow to pay the tax on the differential between the strike price and sales price. It’s another mechanism to help retention, as employees will have to pay the loan back should they leave the firm. Or, an executive recruitment strategy might include giving an early exercise feature for options coupled with a guaranteed loan or cash buyback in the future.
Ann Lucchesi is a managing director with SVB Wealth Advisory.