Startup stock options: Liquidity options
Last week’s post covered the basics of stock options and how they are used as a compensation tool at startups.
Today’s post will cover various liquidity options for holders of startup common shares. Before that, a quick primer on the differences between preferred and common shares and how preferred rights can impact common shareholders, especially when transacting with common shares.
Preferred vs Common shares
Before looking at the various options to transact with common shares, its essential to understand, at a very high level, the difference between Common and Preferred shares. Broadly speaking Common shares are ones that startup employees receive, while Preferred shares are ones that investors receiver. Preferred shares offer many advantages relative to Common including Voting Rights, Liquidation Preferences, Participation Rights, Conversion Rights and more. We’ll cover the Liquidation and Participation perks later in this article. For now, we’ll only cover one particular right that has significant implications on Common shareholders: the Right of First Refusal (ROFR).
A Right of First Refusal (ROFR) is a contractual right that allows a specific party (or parties) the opportunity to enter into a business transaction with a person or company before anyone else can. When a Common shareholder in a company wishes to sell her shares, a ROFR can significantly affect how the sale process is conducted. Here’s how it works.
A Right of First Refusal (ROFR) is activated when a common shareholder decides to sell her shares, requiring her to first offer them to the ROFR holder(s)—often the company or its current investors—under the same terms as proposed to a potential third-party buyer. The ROFR holder(s) have a predefined period to assess the offer and decide whether to buy the shares at the proposed terms. If they choose to exercise the ROFR, they notify the selling shareholder, and the transaction proceeds with them, preempting the sale to the external party.
Should the ROFR holder(s) decline the offer or not respond within the allotted time, the shareholder is then free to sell her shares to the third party, provided the sale is completed within a certain timeframe and the terms do not become more favorable than those initially offered to the ROFR holder(s).
There’s another perk that is even more obstructive than a ROFR. The company and its investors can have the right to block share transfers altogether. A ROFR forces the holder(s) to buy shares in the event that they do not want to transact with the third party. Blocking alleviates the need to transact altogether.
These mechanisms - blocking or ROFR - serve to control the shareholder composition, prevent unwanted third-party stakes, and maintain the balance of power within the company by offering a layer of protection to the interests of the company and its existing shareholders. It does however mean that as a Common shareholder you might not be able to transact with your shares. Even post-exercising and owning them!
With that out of the way, let’s explore the various options to transact with Common shares.
IPO (dreams)
The obvious and most popular avenue is that of an IPO. However, this is probably the least likely outcome. Even in the best of times, it’s exceptionally rate for startups to IPO. The current environment of high interest rates makes that outcome even harder to attain, with the IPO market a standstill. Case in point, there were 83 VC-backed IPOs in 2023, down from 309 in 2021. A few years ago I looked at the US IPO market and made this observation:
Not only are IPOs becoming exceedingly rare, but companies that do IPO take longer than ever to do so. The average age of a US company doing an IPO today is ~11 years vs ~8 historically.
In the event that your startup does IPO, then rejoice you can transact with your shares at will. The public markets are far more liquid than private ones and your shares are subject to trade or transfer of ownership restrictions that are prevalent with private company shares.
M&A
If a startup is acquired, employees with stock or stock options may receive cash or shares of the acquiring company, providing a liquidity event. The specifics depend on the terms of the acquisition and the nature of the stock or options held. This route is more likely than that of an IPO, but still not as prevalent as pre-2021. There were about 600 VC-backed firms purchased by companies last year, according to PitchBook, down from ~1300 in 2021. Recent regulatory scrutiny (Figma, iRobot..etc) will likely reduce the number of M&A transactions, especially by the larger firms like Amazon, Apple, Google and Microsoft amongst others.
Tender offers
In a tender offer, a third party or the company itself makes an offer to purchase shares from shareholders, including employees. These offers are usually at a premium to the estimated fair market value and provide a way for employees to sell a portion of their shares. I suspect that this route to become increasingly popular, especially for startups that are well positioned to IPO, once that window returns. Consider Stripe, who in June 2023, conducted a tender offer to provide employees with liquidity and to cover tax obligations related to the pending expiration of restricted stock units (RSUs). Companies like Stripe are opting for tender offers as a means to providing their employees with liquidity, and more importantly addressing the impeding 10-year option expiration deadline.
The expiration period for stock options can vary significantly, depending on the terms set forth in the stock option agreement. It's common to see expiration periods ranging from 5 to 10 years from the date of grant
Private share sales
Employees might find opportunities to sell their shares privately to individual investors, family offices, or investment firms specializing in private company shares. There are many private share marketplaces including the likes of Hiive, Forge Global, CartaX, Nasdaq Private Market, Equity Zen and more.
These sales often require legal and financial advice to navigate securities laws and company restrictions. The almost certainly require the company and its board to approve (e.g. waive the ROFR) these transactions. Finally, because of the relatively low liquidity of private shares relative to public ones, the transaction fees can be much higher. On the order of a few % points of the overall transaction.
Equity financing
Another option is to go down the route of obtaining a loan that is collateralized by private shares. These financial instruments are particularly aimed at employees who wish to exercise their stock options but may not have the necessary liquidity to cover the exercise cost and associated taxes. By using their private shares as collateral, employees can access the funds needed to exercise their options without having to pay out of pocket immediately. Examples of firms offering this service are Secfi, EquityBee and Quid.
These financing solutions are designed to be non-recourse, meaning that if the value of the shares does not realize the expected returns, or if the employee is unable to repay the loan, the only recourse for the loaner is to take the shares used as collateral. This setup reduces the personal financial risk to the employee in the event that the startup's value decreases or if it fails to go public or get acquired at a valuation that would make the stock options profitable.
This option can be very expensive. Although the loan is collateralized by the shares, the loaner reserves a portion of these shares (10%+) as a fee over and above the initial loan serving fees. This route is also subject to the company and board approvals.
Liquidation Preferences and Participation Rights
Earlier I mentioned some of the preferred shareholder rights and how they can impact common shareholders from transacting with their shares. There are two additional preferred rights that can dramatically alter the outcome for common shareholders, especially in M&A or IPO scenarios. These are the Liquidation and Participation rights.
Liquidation Preference: This ensures that preferred shareholders receive their investment back (sometimes with a multiple on their original investment) before common shareholders get anything in the event of a liquidation, sale, or merger of the company. Liquidation preferences are crucial in determining payout order and amounts during exits.
Participation Right: This offers preferred shareholders a unique combination of benefits that go beyond the basic liquidation preference. This feature allows preferred shareholders to receive their initial investment back before any distributions are made to common shareholders in the event of a liquidation, sale, merger, or other exit event, and then to also participate in the remaining proceeds alongside common shareholders on a pro-rata basis. This essentially gives them a "double dip" in the distribution of a company's assets.
An example can illustrate the power of these benefits and how they can alter the outcome for Common shareholders. Consider a startup valued at $100, with a single investor who owns 10% of the startup and an employee with a 1% stake. The startup is sold (M&A) for $100. Should the employee then receive $1? The answer depends on the liquidation and participation preferences the investor has. The scenarios below illustrate the payout to both the investor and shareholder at various liquidation preferences. The scenarios also assume that the investor has a Participation Right.
1x Liquidation Preference: The investor receives $19 (their initial investment of $10 with a 1x multiplier, plus a 10% share of the remaining $90), leaving $0.81 for the employee.
2x Liquidation Preference: The investor receives $28 (their initial investment doubled to $20, plus a 10% share of the remaining $80), leaving $0.72 for the employee.
3x Liquidation Preference: The investor receives $37 (their initial investment tripled to $30, plus a 10% share of the remaining $70), leaving $0.63 for the employee.
4x Liquidation Preference: The investor receives $46 (their initial investment quadrupled to $40, plus a 10% share of the remaining $60), leaving $0.54 for the employee.
5x Liquidation Preference: The investor receives $55 (their initial investment quintupled to $50, plus a 10% share of the remaining $50), leaving $0.45 for the employee.
These rights have the potential of completely wiping out common shareholders.
Putting it all together
The table below summarizes the options that I went through in this article. The list is by no means exhaustive, but outlines the most popular avenues for liquidity for private shares. Some of the these options aren’t available to employees and are at the discretion of the company like an IPO or tender offer. There are several that the employee can initiated, but all require the board and company to approve. Alas, there’s no simple, quick and inexpensive manner in getting liquidity from private shares.