Liquidity Events
Startup founders and employees dream of a big liquidity event that changes their fortunes. Learn about the variety of possible exit events and what they mean for you.
A liquidity event is when your startup shares transform into cash or publicly tradable shares that can be sold for cash. If the company is IPOing, it’ll continue on as an independent entity. If the company is being acquired, it’ll be folded into the acquirer.
Liquidity is the key term. Something is liquid if it's cash or easy to sell for cash. Something is illiquid if it's difficult to convert into cash. A liquidity event is when your illiquid startup shares transform into something more liquid.
There are three main liquidity events:
- An Initial Public Offering (IPO) is when a startup registers with the Securities and Exchange Commission (SEC) as a publicly listed company and the shares can now trade freely. A direct listing and merging with a special purpose acquisition vehicle (SPAC) are common alternative ways to "go public."
- An Acquisition is a sale of a company to another company. The acquiring company may be private - like a startup or private equity backed company - or may be publicly listed. Acquisitions are often referred to as mergers when the companies are of similar size.
- A Secondary Market Transaction is the sale of shares before the startup goes public. This could either be the startup buying back shares in a tender or a sale to a third party. You'll often hear it referred to as just a "secondary."
Your experience as an employee can be different depending on the type of event.
Initial Public Offering
An IPO is often seen as the ultimate mark of success for a startup. It's an opening up to the world. The previously private financials and governance of the company are now publicly available. Any investor can buy shares and become a shareholder. Existing shareholders can sell their shares for cash after years of investment and hard work.
The U.S. averaged about 200 IPOs a year from 2008 through 2020. 2021 was an atypically active year for IPOs, boosted by almost 600 SPACs.
As a startup employee or investor, you typically cannot sell your shares immediately upon IPO. While not required by law, most startups institute a lock-up period of about 180 days. There are often modifying terms where the lock-up ends early if the new share price stays elevated above the IPO price for a period of time. After the lock-up ends, you're free to sell your shares.
Keep in mind: if you own the shares for longer than a year - including while the company is still private - you may owe less in taxes when you sell. At the federal level, shares that are held for at least a year before they're sold are taxed at a lower capital gains tax rate. Shares held for less than a year are taxed as ordinary income. You can learn more about taxes here.
The point of the lock-up is to prevent existing shareholders from selling their shares en masse on the public market. It can take time for a robust trading market to develop. A lock-up gives the market time to develop so it can absorb new sales without a material impact on the share price.
Once a company goes public, future employee compensation will often change. Taxes are one of the biggest reasons that startups structure employee equity as options and RSUs - other structures like equity grants and RSAs can trigger large tax bills that employees may not be able to afford.
Once a company goes public, employees can sell shares for cash to pay for taxes and other obligations. Total compensation often reflects that shift - employees typically receive shares as they vest and the company will withhold the amounts necessary to pay the tax bill.
IPO Example: Airbnb Goes Public
Airbnb was among the largest IPOs in 2020. The company went public on Thursday, December 10th, 2020 just over twelve years after it was founded. The company sold 51.5 million shares at $68 a share for $3.5 billion. The IPO valued the company at $47 billion, a value known as market capitalization that’s calculated by multiplying the total number of the shares outstanding with the price per share.
Day-of the IPO, the share price skyrocketed as high as $165 per share before closing the day at $144.71.
The lock-up period for Airbnb fully ended 180 days after IPO. The company permitted windows where shareholders could sell portions of their holdings in advance of the expiration. The share price dropped more than 6% the day the lock-up period ended, closing at about $132, about 8% below where it closed the day of the IPO. Such price drops the day the lock-up period ends is not unusual - it reflects many new sellers coming into the market all at once.
SPACs
A SPAC is a special type of public company designed to acquire another company. They're complex structures whose full details go beyond what we'll cover here. You can review PwC's overview for more details.
The terminology for SPACs is a bit loosey-goosey. You'll hear of companies "getting SPAC'd" or of a "reverse merger." It all means the same thing - a publicly listed SPAC is acquiring another company.
For an employee, a SPAC can be similar to an IPO. You will exchange your startup shares for public company shares that can be sold for cash. Like with a traditional IPO, most SPACs will have a 180-day lock-up period for the acquired startup shareholders. Keep in mind that there is another, unrelated lock-up period for investors in the SPAC that does not impact you as an employee.
That said, there were many SPACs in 2021 with non-standard terms that may have resulted in more complex considerations for the acquired employees. When in doubt, talk with the company or a tax advisor if you're unsure.
SPAC Example: Lucid
Lucid was SPAC'd on Monday, July 26th, 2022. The electric-vehicle startup was acquired by Churchill Capital Corp IV, a SPAC, for $4.4 billion under terms agreed to in February of that year. After the acquisition, the SPAC changed its name to Lucid and trades under the ticker LCID.
SPACs have come under increasing regulatory scrutiny by regulators. Lucid was subpoenaed by the SEC in December 2021 for documents pertaining to an investigation related to the company's merger.
Acquisition
When your company is acquired, you'll become a part of the acquiring company. A lot goes into an acquisition and different employees at the acquired company may have different experiences.
The terms of the acquisition are up to the two companies. They not only have to agree on the price but also on whether it will be paid for in cash or shares and if there will be any restrictions. If the acquirer is a public and/or regulated company, some of the restrictions may be so they can continue to meet their regulatory obligations.
A common restriction for senior executives at the acquired company is called "golden handcuffs" - you only receive payment for your shares if you stay at the acquiring company. A less common but highly impactful term is an "earn out" - additional bonuses that can be earned post-acquisition depending on performance. The goal of both is to retain key employees after the acquisition.
Depending on how the acquisition is structured, it can trigger tax liabilities for the acquired employees.
- If an acquisition is all-cash, then employees are "cashed out." Shares and options are converted to cash and you'll owe taxes. If you owned shares for longer than one year, you'll be taxed at the long-term capital gains tax rate. If you owned shares for less than a year, the proceeds will be taxed at the ordinary income tax rate.
- If an acquisition is all-stock, then the tax liabilities can become more complex. It depends on several factors including the cost basis of the shares you previously owned versus the cost basis of your newly acquired shares. Talk with the company or a tax advisor about your situation.
- If the acquisition is a blend of stock and cash, then you'll be taxed separately on each component. Refer to the bullets above for each component.
Most of the time an acquirer is interested in purchasing the entire company - products, services, and the team. Occasionally, they only want specific parts of the company. If the acquisition is primarily to acquire just the product or patents, we informally call it an IP Acquisition. If the acquirer primarily just wants the team, we call it an Acquihire.
An IP Acquisition is essentially a big, complex sales deal. The selling company receives cash or equity for the sale, which it may or may not distribute to its investors and employees. Unless there are additional deal terms like licensing of the IP, the two companies go their own ways.
Acquihires are more complex and will likely have bigger implications for you as an employee.
Acquihire
Most acquihired companies are smaller and the outcome is less lucrative for investors than a full acquisition. For retained employees, acquihires can be very lucrative.
Most of the deal structure focuses on how to appropriately incentivize and retain key employees. Employees ultimately get to choose whether or not they want to stay at the acquiring company.
An acquirer is particularly sensitive to the risk that the exciting new employees they’re trying to bring onto the team may leave soon after the deal closes. Deal terms often include both upfront compensation in recognition for work already done and additional compensation that vests over time to encourage the employees to stay.
Sometimes that “over time” compensation is structured as an earnout. Earnouts sound like what they are - additional payments that can be earned if the acquiring company achieves agreed upon metrics. Keep in mind that earnouts can be bigger on paper but are riskier - you might not meet metrics and won’t earn the payment.
Secondary Market Transaction
A secondary means you’re selling your shares. It enables you to get access to cash without waiting for an IPO or acquisition. Unlike with shares you may own in public companies, your shares in the startup are likely subject to restrictions.
Secondaries can typically only happen if permitted by the company. If allowed, the company will likely set up a formal process through which sales can happen. That may be a one time event when you’re allowed to sell or it may be a regular, recurring event.
Unlike in the public stock markets where millions of participants bid on shares, the number of participants in a secondary is typically much more limited. Sometimes there’s just one allowed buyer - the company itself - a process called a tender. The more limited pool of buyers makes price discovery - determining the price for the shares - more difficult. Secondaries will often be scheduled concurrent with a capital raise to help provide more information on the correct price.
A secondary is a sale. If you sell all of your shares, you’ll no longer have the benefit of being a shareholder in the company including any potential increase in the share value as the company grows. You may also incur significant taxes at sale which could cause you to sell more shares than you had planned. You can learn more about the taxes at sale here.
Prism is a different way to access cash without selling your shares and without the tax headaches.
