Startup Liquidity Events: What to Expect

When you work for a startup, receiving equity compensation can feel like a gamble. While it’s exciting to get a piece of ownership in your company, it’s also uncertain how much your assets will be worth by the time you can sell.

In a startup liquidity event, you’ll finally get a chance to cash out your holdings. However, the avenue your business chooses will impact what will happen to your equity in the process. Let’s talk about what to expect from each type, from IPOs to SPACs.

What is a liquidity event?

A liquidity event is a transaction that allows shareholders of a private company to trade in their illiquid investments for cash. While liquidity events may include exit scenarios such as going public or getting acquired, that’s not always the case.

In a tender offer, one example of a liquidity event, investors or business owners will repurchase shares directly from employees so the business can avoid issuing new shares. This event can take place in public and private companies alike.

Many factors can affect what happens to your employee stock options (ESOs) or restricted stock units (RSUs) when you reach liquidity.

Let’s go over some of the most common types of liquidity events:

• IPO
• SPAC
• Merger
• Acquisition
• Tender offer

What to know about IPOs

An IPO, or initial public offering, is an event in which a private company first makes its shares available to the public. Before that, the company is typically only investable by private equity firms like hedge funds and venture capitalists.

In order to launch an IPO, the business must file with the U.S. Securities and Exchange Commission (SEC) and provide required financial documents. The organization will also hire an underwriter, or an investment bank that will help them prepare for the IPO.

The underwriter will determine an issue price, purchase shares and sell them through a distribution network. This group often includes institutional investors such as hedge funds, banks, and mutual funds. Once the initial public offering is complete, the securities will be opened up to be traded by retail investors on the stock exchange.

How an IPO affects your equity

When your company undergoes an initial public offering, the terms of your equity will typically continue as planned. Most of the time, your vesting schedule will remain the same, and your existing shares will convert to public stock on the market.

Shareholders will often be subject to a lock-up period until a set amount of time after the IPO. This prevents the share price from sinking due to a sudden influx of equity on the market. A typical lock-up period lasts between 90 and 180 days, but it may vary depending on the company.

You'll also be subject to blackout periods — typically 4 times per year — when you won't be able to trade if you have access to material nonpublic information. These periods often last weeks or even months, leaving many employees with small trading windows.

What to know about SPACs

The term SPAC is an acronym for a special purpose acquisition company. This “blank check company” is launched with the sole purpose of merging with or acquiring an existing organization.

Founders of a SPAC will raise money through an IPO and put the funds into a trust account. From there, they typically have between 18-24 months to find a target company. Otherwise, they’ll have to return the funds to investors.

Once a SPAC finds a private company, it needs to gain approval from shareholders. Then, it’ll initiate a merger or acquisition using the capital that it raised. Once the transaction is complete, the combined entity will take on the SPAC’s public listing. At the end of this process known as de-SPACing, the SPAC itself will cease to exist.

How a SPAC merger affects your equity

The implications of a SPAC merger can vary depending on the terms of the deal. For many investors, their shares will convert to equivalent stock in the public company.

Additionally, if your shares are subject to single-trigger acceleration, your equity may vest more quickly due to a change in control. However, SPACs also tend to have extended lock-up periods, sometimes up to a full year.

What to know about mergers

A merger is a combination of two or more companies into a single entity. Unlike a SPAC, the businesses involved don’t necessarily have to exchange funds. However, each organization’s power will be diluted in the transaction.

Whereas SPACs and IPOs are exclusive to private companies, public corporations undergo mergers all the time. For instance, one of the most successful mergers of all time was Heinz and Kraft in 2015. The company has since rebranded to The Kraft Heinz Company.

How a merger affects your equity

Similar to SPACs, what happens to your equity in a merger depends on the agreements made between the combining companies. In a stock-for-stock merger, your vested company equity will be converted to equivalent shares based on the two businesses’ relative valuations. In other deals, you may receive cash in exchange for your holdings. Oftentimes, it may be a combination of both.

What to know about acquisitions

The terms merger and acquisition are often referenced interchangeably or even grouped into the category of M&A. This terminology can make the two methods difficult to distinguish. However, an acquisition is typically defined as a transaction in which one corporation purchases a majority stake in another company.

While some acquired companies will be folded into the bigger corporation, others will retain their brand or organizational structure. For instance, Whole Foods largely maintained its operations and branding even after being acquired by Amazon in 2017. Similarly, LinkedIn has seemed to remain its own company despite its sale to Microsoft in 2016.

How an acquisition affects your equity

As an employee, what happens to your equity depends on how the acquisition is completed. If the company is acquired for cash, you’ll receive money for your vested shares and options. On the other hand, if it’s acquired for stock, your securities will convert into stock in the acquiring company. It could also be acquired for stock and cash, in which case you’ll receive a combination of the two.

What to know about tender offers

Many investors may be familiar with tender offers through Softbank’s investment in Uber in 2017. In this deal, employees and early investors agreed to sell their own equity to the venture capital firm.

In a tender offer, shareholders can sell their equity directly to a buyer, whether it be an investor or the company leadership. Because these shares aren’t available to the public, the event can take place when a company is still private.

When a tender offer is sponsored by the company itself, it’s known as a share buyback. Late-stage startups may hold share buybacks in order to combat dilution and reward employees by offering liquidity.

How a tender offer affects your equity

Unlike exit strategies like IPOs or acquisitions, tender offers are often pretty straightforward. Employees participating in a tender offer will receive compensation for their equity according to their company’s fair market value at the time of the event. However, they’ll only be able to sell a limited number of shares depending on the terms set by the buyer.

How to prepare for a liquidity event

In order to guarantee you’re prepared for your company’s liquidity event, it’s important to conduct your due diligence when you first receive your offer:

1. Specifically, take a look at the liquidation preferences to find out what would happen to your equity in the case of a merger or acquisition.
2. You’ll also want to look for what’s known as a clawback clause, or a situation in which your company might be able to repurchase your vested shares.

Before going public

If you have any vested, unexercised options prior to your startup going public, many financial advisors suggest exercising them early on for tax purposes:

• Once you’ve held an investment for at least one year, you’ll be taxed on your profit at the long-term capital gains rate, which ranges from 0-20%, depending on your taxable income.
• On the other hand, if you sell assets you’ve held for less than a year, you’ll be taxed at the short-term capital gains rate, which ranges from 10-37%.

With the tax benefits in mind, it can be advantageous to exercise your options sooner in order to unlock a more favorable rate. Of course, this reasoning won’t apply if your options are out of the money, meaning that the stock’s fair market value is below the strike price. In that case, you’ll want to keep an eye on your potential gains and make a decision accordingly.

Final thoughts

When it comes to startup liquidity events, your outcome often depends on the scenario and the terms of the agreement. No matter what type of event your company undergoes, it’s important to conduct thorough financial planning beforehand. Review your offer letter, and stay up-to-date on your company’s announcements throughout the process.