Liquidity is the most important input into the price of an asset.
The great investor Sam Zell once said, “You can have all of the assets you want, but if you have no liquidity it doesn’t matter… liquidity equals value.” I agree. Liquidity is not only the most important input into the price of an asset — liquidity is the price of an asset. I always wince when I hear someone say “My house is worth X or my car is worth Y.” The reality is a house or car is only worth what someone else is willing to pay for it.
The same applies to shares, or in the world I live, start-up equity. Start-up equity is one of the most complicated asset classes out there. It is unfathomable how hard employees work for something that most employees have no idea how to value or even whom to trust when it comes to assessing that value. Having spent decades on Wall Street building new products and leading businesses in public equities, I know a thing or two about liquidity. And after having built two start-ups, I’ve come to appreciate a few important principles as it relates to start-up equity.
- Nothing matters until you have money in your bank account
One of the preeminent sources of wisdom for start-up employees is the aptly named Startups.com. Their recent article “The Value of Actually Getting Paid,” offers some golden wisdom:
“All startup hype aside, actually getting paid kinda matters. That’s the part of the story no one likes to talk about — actually getting paid. Building a startup is synonymous with deferred compensation and equity fortunes, but it masks a very real truth which is very few of those paper fortunes ever become liquid.”
Imagine owning a few shares you got when you were hired and vested over four years of grueling work, with no ability to sell those shares. You can’t upgrade your apartment with words from management that says “The stock is worth X. Keep on working.” Every employee should challenge statements they hear from management that sound like this. Ask whomever is saying this for actual details around those assumptions. For example, “Can we have a company presentation on why you think the stock is worth X.” “What are the reasons why you think an IPO is happening in X months/years?” “What happens if there isn’t an IPO or sale? Who are the potential buyers of our stock?”
If you are met with unspecific answers — or worse, answers that start with “I have X years of experience,” this tells you only one thing → they too have no idea and are just hoping for the best.
You only have yourself to blame if you get to the end of the road and there’s no liquidity for you and your loved ones.
2. Your exit price depends on the order of when you get paid
One of the things that is never discussed with employees is the company’s capital structure. “Capital structure” sounds like a complicated term but it’s really not, and it’s a critical input into liquidity and value. Let me explain.
The “price” of a share of private company stock does not guarantee this is the price YOU will get in a liquidity event. If liquidity is the number one input into value, then capital structure is the second. What capital structure refers to is who gets paid before you do. Let’s take a hypothetical company who has both debt as well as third party preferred investors, e.g venture capital firms, and assume the example of an acquisition. In that scenario, debt lenders and venture capital firms and are paid FIRST, and what is left over is then parceled out to the employees. And so what you have to do is add up all the debt the company has and all the capital it has raised to determine the point AFTER WHICH the employees start to participate in a liquidity event. It’s like this → Imagine a ticket window where there are only 10 tickets. The line may be 20 people or 2,000 people. It doesn’t matter. Only the first 10 people in line will get those tickets. Everyone else goes home without seeing the show.
3. An IPO is not a liquidity event if the company is smaller than $5 billion
First off, IPOs are much further and fewer than in days past….and by days past, I’m not just referring to low interest rate days of a few years ago. In the two decades before Sarbanes-Oxley (SOX) made it harder to go public, an average of 118 tech companies went public every year. In the two decades since SOX, that number has dropped by 66%, to 38 IPOs a year. Public market equiy investors simply don’t have the capacity or funds to invest in more IPOs than that. So to put these numbers into context, consider there are 655 tech unicorns in the U.S. who all think they’re going public. That represents 17 years worth of IPOs in the post-SOX world. It is just not realistic to expect an IPO, even if you have unicorn status.
But more importantly, even if a company were to go public in an IPO, it takes a really long time for employees to sell their shares following that event if it’s a sub $5 bn company. For starters, employees have a 180 day lockup on those shares. That means employees are prohibited from selling their shares for at least 6 months following the IPO. 6 months of active trading as a newly public company is a lifetime. The second reality is most companies will not have the underlying trading liquidity to support both investors and employees looking to sell their shares. Based on historical precedents, recently IPOd companies trade about 0.50% of their market cap on a daily basis. So let’s say your company IPOd at $2 billion → you can expect your company to trade on the exchange about $10 million a day. Brokers will tell you that a stock will go down if there is a seller for more than 10% of the daily trading volume, or in this example, $1 million (10% of $10 million). Now, your average venture backed company will have ~60% owned by private investors, or in this example, $1.2 billion (60% of $2 billion). For those investors to get out of their investment, they will have to pound the market every day over the course of 3.2 years. That’s how long it would take to sell $1.2 billion of stock, at $1 million a day.
Have a look at this $2 billion fintech company that went public in 2021 and experienced the exact fact pattern I described:
The company went public on August 3, 2021. All of the private investors (venture capital firms, etc) claimed this was the greatest company ever to be built in fintech. And you will see the stock price hung in there for the first few months…..that’s because all the investors and employees were prohibited from selling, pursuant to the IPO lockup. But as soon as they could, the stock dropped precipitously. It lost 95% of its value in a few months, received a de-listing notice from the New York Stock Exchange (uh, that’s bad), did a reverse stock split to artifically increase its share price (lol), and will never reach its private market valuation of $2 billion. Here we are three years later, and investors are still trying to jam out stock into the market, depriving employees of any value.
So what do you do if you’re an employee of a start up with some shares. There are really two main ways you can do to reliably get liquidity:
- Hope your company is acquired for cash. Cash is king. At a minimum, hope that there’s some portion of the value that is cash (e.g. half cash and half stock). This gets to price. Your stock is worth zero if it can’t be sold today. Literally zero. It’s like owning a house where there are no buyers, but only worse…at least you get to live in your house. So if there’s a deal to be acquried, you should take it. I would rather take a deal today, invest my money in the liquid S&P 500, and earn 10%-20% on my money compounded, than wait years for a hypothetical better deal while my startup equity doesn’t grow.
2. If your company is being acquired for stock (or has a portion of stock), hope that the acquirer is both big and public (or going public soon), and if it is, take the deal. I can’t stress how important this is → big companies (>$5 billion) have underlying trading liquidity which makes it easy for employees to get into the market and sell shares “undetected” without moving the price in the market.
Start up equity is all about liquidity. It’s your responsibility to make sure you get some.
