Companies are taking longer than ever to IPO. Learn about opportunities to receive liquidity before your company goes public.
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:
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:
Once a company chooses to offer early liquidity, there are three main options:
Each of the options comes with tradeoffs for both the company and its employees.
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 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.
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 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.
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: