Early Liquidity Options

Companies are taking longer than ever to IPO. Learn about opportunities to receive liquidity before your company goes public.

Up until just a few years ago, if you held shares in a privately held startup, you had to wait for an IPO or acquisition until you could convert those shares to cash. It's a model that worked when the average time for a startup to IPO was just 7.3 years like it was from 1995 through 2005. But that time has gotten longer and longer. For the past five years, the average startup age at IPO never dipped below 11 years old and the average has been 12 years old.
Twelve years is a long time to hold shares that you can't convert to cash. Most of what we do in our normal lives requires cash, and it's not just the day to day needs like groceries. You may have student loans that you need to pay off. Maybe you joined the startup fresh out of college and now you're thinking about getting married or buying a home or starting a family. You can't pay for those things with equity. You need cash.
It's a situation many early startup employees find themselves in - equity rich and cash poor. Thankfully, a robust market for early liquidity options has emerged to help.

Early Liquidity Options

Most startups tightly control early liquidity options. Well-structured early liquidity can be a major perk for startup employees that also helps the company attract and retain key talent. Poorly structured, it can cause problems for the startup and investors alike.

Startups have three main concerns around early liquidity:

  • Shareholders - startups want to be deliberate about who they invite in as shareholders. They often put restrictions in place to prevent shares from ending up in unknown hands.
  • Employee alignment - startups want to incentivize employees to think and act like owners who benefit as the company grows. If the employees no longer own equity, that alignment disappears.
  • Regulatory - depending on how a startup raises capital, it can be subject to different restrictions including minimum holding periods before shareholders can resell their equity and a limit on the total number of shareholders. Poorly structured or unrestricted liquidity programs can land a startup in hot water.

Before a startup establishes a formal liquidity program, it’ll typically focus on preventing possible problems. The most common way to do that is to prohibit sales or pledges without company approval. Pledging includes committing shares to a loan and signing an agreement today to sell the shares in the future.

Beyond outright prohibition, two other restrictions are common:

  • A right of first refusal is a startup's right to buy back your equity at the same price a buyer is willing to pay. Even if you've already agreed to sell to a third party, the startup gets to jump in front and buy your shares instead. A right of first refusal is so common that it's typically referred to as an abbreviation - ROFR, pronounced "roh-fur". While you are still able to sell with a ROFR, some buyers will not engage unless the startup preemptively agrees to waive their right to jump in front. A buyer’s bid - the price they’ll pay for the shares - can be valuable information. They may not want to give that away unless they’re reasonably certain they’ll close the deal.
  • A right of co-sale requires that when one shareholder attempts to sell, they must first notify all other shareholders who then also have a right to participate in the sale. It both slows down any potential transactions and gives shareholders confidence they'll all get equal access to early liquidity if it becomes available.

Once a company chooses to offer early liquidity, there are three main options:

  • A secondary market sale - often shortened to just secondary, is a sale of your shares for cash. When the buyer is the company rather than a third party, we call it a tender.
  • A forward contract is an agreement today to sell shares in the future. Most forward contracts for startup equity are structured as prepaid variable forwards, meaning you receive cash today and sell the buyer an agreed-upon number of shares in the future. The variable comes from the fact that the future value of those shares is indeterminate at the time the contract is signed.
  • An asset-backed loan is a loan secured by the shares themselves that typically does not have to be paid back until a liquidity event. Different than the other two options, you get to keep your shares.

Each of the options comes with tradeoffs for both the company and its employees.

Secondary Market Sales

Secondary market sales are by far the most common of the three options. In 2021, the four largest marketplaces for secondaries facilitated over $20 billion in sales.

We call it a secondary market to differentiate it from the primary market. The primary market is how a startup raises money from investors - it sells shares of the company in return for cash. The equity compensation you receive is also a primary market. The startup is "selling" you shares instead of more cash compensation as payment for the services you provide to the company.

Secondary markets are different. A secondary market is one where the seller is an existing shareholder, not the startup. That means the shareholder receives cash rather than the startup.

For a startup, secondaries can be relatively straightforward to facilitate with the right partner but invite challenges related to all three key concerns - shareholders, employee alignment, and regulatory risk.

For employees, the experience is frequently sub-optimal despite massive improvements in the market over the past decade. Secondaries are generally high cost and high friction, a particularly bad combination.

Costs manifest in two forms - transactional costs and taxes. Transactional costs on the leading secondary market platforms are typically 5%. Taxes are dependent on how long you've owned the shares. You can learn more about taxes here.

The exception to high cost, high friction secondaries is a tender. When there is just one buyer - the company - most of the challenges evaporate. The exception is taxes. You'll incur the same taxes in a tender.

The biggest upside for employees is the simplicity. Once a secondary is completed, there is no further relationship between employee and buyer. And the employee gets immediate cash.

Prepaid variable forward contract

Prepaid variable forward contracts are complex instruments. It sort of looks like a sale and sort of looks like a zero-interest loan. It inherits attributes of both.

A word of warning - many startups do their best to prohibit forwards. Secondary sales and asset backed loans are often simpler transactions that achieve similar outcomes and give the startup greater control over equity.

A forward is an agreement between a buyer and a seller to transact in the future under terms agreed upon today. Prepaid variable forwards are a subtype with nuances specific to when they're structured for startup equity.

  • The buyer delivers cash to the seller today, but the seller won't deliver the shares until a future date. For startup equity, that future date is usually defined as a liquidity event.
  • The number of shares that the seller will deliver is agreed upon today. The value of the shares is variable - it'll be dependent on the price of the shares at the future date.

There are critical points here. First, this is a long-lived agreement between two parties. Unlike with a sale that's over once it's completed, both parties remain exposed to one another until the shares are ultimately delivered. Second, a seller may end up transferring a lot more value in the future than they had intended if the shares become very valuable.

Like with most forward contracts, the seller's loss exposure is limited to the shares that are pledged. In a worst-case scenario for the buyer where the startup goes bankrupt and the shares are worthless, the seller is off the hook and the buyer takes the loss. As a result, forwards for startup equity tend to be priced very conservatively - not a lot of cash compared to the potential value of the shares.

Forwards like this do come with a tax advantage for the seller - they don't have to pay taxes on the sale until the future date when the shares are delivered to the buyer. Be careful though. While it's great to defer taxes, it does mean that a seller can be caught out with a big tax bill for cash that was delivered much earlier.

Asset-backed loans

Asset backed loans enable employees to get access to cash and keep ownership of their equity. That's a particularly powerful combination. They're most often used to help employees get access to the cash needed to exercise options and pay the associated taxes, although they're increasingly being used to get employees early access to cash for general expenses.

Loans can be structured in many ways. Asset backed loans for startup equity tend to be consistent in how they're structured, but there can be exceptions. Most are collateralized by the startup equity, do not have personal recourse, and the loan repayment is triggered by a liquidity event. Let's unpack what each of those means.

Collateralized means what's at risk if the loan isn't paid back. In the case of a mortgage, the loan is collateralized by the house. In this case, it means the lender gets to take ownership of the startup equity if the employee cannot pay back the loan.

Personal recourse is when a lender can go after a borrower's assets generally, not just the loan collateral. Most asset backed loans for startup equity do not have personal recourse. Be extremely careful if a company offers you a loan that does.

Loan repayment at a liquidity event means that the borrower doesn't have to pay anything until there's a liquidity event for the startup. Any interest payments accrue to be paid later.

For employees, what this all means is that you can get loaned cash today that you don't have to repay until there's a liquidity event. The only thing at risk is the equity. If the startup does well and the liquidity event is a success, you'll be able to sell the shares needed to pay back the loan and any interest. If the liquidity event is not a success, you forfeit the equity. If the company goes bankrupt, you're off the hook and the lender takes a loss.

What this means is that asset backed loans, while potentially a great option for employees, may not be available. Lenders tend to only lend against those companies they think have a high likelihood of completing a successful liquidity event in the next five years or so.

If you're considering an asset backed loan, there are many more important details to explore. You can find out more here.

Choosing the Right Option

The right liquidity option depends on your wants and needs. Assuming your company allows you to pursue any of the three models, you should consider the risk and cost tradeoffs.

We've put together a cheat sheet that compares all three: