A Founder's Guide to Equitable Liquidity Events
Ann Lucchesi
Senior Director
At almost every stage along the path to an IPO, venture-backed companies can face the pressure of liquidity for founders, employees and even early investors.
On the other side of the equation, investors expect that founders and employees are committed to building the company given their equity stake. As a founder, your challenge is to create a win-win scenario for both groups.
Healthy avenues for liquidity access
As a founder, you're tasked with growing your business, attracting and retaining employees through employee equity, and protecting the firm. This means finding the right avenues for liquidity at various stages, communicating with your investors and receiving their support.
Most investors are open to liquidity if the company continues to grow rapidly. You just need to be mindful of the various considerations in planning liquidity for various stakeholders.
Early-stage liquidity options for founders
In a recent virtual webinar, Ann Lucchesi, senior director with First Citizens Wealth, led a discussion on the nuances of tender offers, secondary sales and liquidity programs. In the excerpt below, she asks about the timing of founders' requests for liquidity.
Exploring lending options
Lending against equity may seem like the simplest way to help an employee get liquidity because it doesn't involve the transfer of shares—and if it's a third-party provider, the company can remain at arm's length.
Unfortunately, most external lenders prefer to have a line of sight to a liquidity event within 2 to 3 years. This excludes most early-stage companies. Even for companies in later stages, most lenders request access to financial data, which may not be something you want to allow.
However, you should be comfortable releasing transfer restrictions because the lender will have the right to the shares if the employee can't make required payments. It's important to understand the negative consequences of a loan in default.
Alternatively, the company itself can provide a loan to the employee, even in early stages. This approach has its own set of issues, starting with the fact that the capital lent to the employee can no longer be used to grow the business.
There's also an administrative burden with company loans to ensure that the qualifying metrics are satisfied because a loan in default will become a compensation item to the employee.
Loan terms and employee departures
Companies should carefully consider the term of the loan and the possible scenario of employee termination. Many loans require payment in full upon any separation of service. While this can be a retention tool, it becomes an issue if the employee needs to be dismissed for any reason.
These are recourse loans that require proper documentation and administration. Keep in mind that if the loan is forgiven, it becomes compensation to the employee.
Controlled liquidity events
In this portion of the webinar, Lucchesi asks for insight on the driving factors behind broader employee liquidity events.
Pursuing secondary market transactions
Companies may consider secondary transactions. However, they're rarely one-time events unless the company stops growing. There will likely be ongoing demands, so it's important to carefully weigh the pros and cons of allowing secondary transactions.
Here are a few examples of the various forms these secondary events can take:
- Stand-alone transactions between one or more sellers to one or more buyers that can be paired with a fundraising event—often used to allow investors the opportunity to buy shares beyond those available in the fundraising round
- Direct seller-to-buyer transactions through a secondary market—such as Forge Global, Nasdaq Private Markets or a broker who connects buyers with sellers
- A corporate repurchase of shares at a price set by the company
In any of these scenarios, the company will have some say as to whether the transaction can take place because it must transfer the shares.
Most companies have the right of first refusal, or ROFR, in place and only allow board-approved transfers. Many firms also have co-sale rights in place, which can significantly complicate an individual's ability to sell shares without going through the company.
In late-stage companies, it's important to make sure a liquidity event doesn't trigger restricted stock unit, or RSU, vesting by triggering the liquidity vesting parameter—which would cause an immediate and likely significant tax liability for the company or RSU holders.
Whether the sale is a direct sale to an investor or a coordinated company liquidity event, the following topics should be examined:
- The impacts of the company's 409A valuation
- Any accounting issues
- Tax, legal and regulatory concerns
- Human resources matters
Regardless of the approach, there will be pros and cons for the company and any shareholders involved.
Corporate repurchases
Corporate repurchases create some unique challenges for companies. They may impact QSBS qualifications and taxation for sellers if the sale price exceeds the 409A value. Certain state laws may also limit the size of any corporate repurchase.
There may also be disclosure issues when filing for an IPO if the repurchase occurred within the previous 3 years. Additionally, repurchases require a significant amount of administration—including tax withholding and submission for any incentive compensation and issuance of applicable tax forms.
Potential tax issues
Tax consequences may become complicated even with direct secondary transactions, underscoring the importance of tax and legal advice. Consider tender offer rules when multiple sellers are involved, and make sure all legal implications are covered—including antitrust rules that may come into play.
Foreign buyers or sellers may trigger a different set of reporting and tax issues that should be examined, and late-stage companies may need to consider the number of shareholders they have and whether that will trigger new financial reporting requirements.
Secondary transaction considerations
In preparation for any secondary event, companies should evaluate the eligibility requirements and restrictions they want to place on who can sell—and how much they can sell.
If your goal is to clean up your capitalization table, then you might make a restriction that previous employees and early investors can participate only if they sell their entire position.
If your goal is to reward and retain employees, then you may want to require a certain number of years of service and a maximum number of vested or owned shares. Whenever employees are included, consider allowing cashless transactions to make the process more accessible.
Companies that are granting RSUs have much more complexity to consider. First and foremost, you want to make sure a liquidity event doesn't trigger a vesting of all RSUs and the obligatory tax payments that accompany the event.
The inclusion of RSUs would also likely require the board to waive all or part of the liquidity event provision—and future waivers may be preempted. In addition, this may provide only one opportunity to fold RSUs into a partial liquidity event. Getting proper legal and tax advice around these decisions is critical.
Final thoughts on liquidity access
Companies should consider the structure, price and timing of the liquidity event. These events will often be timed with a fundraising event, and demand from investors sets the price of liquidity. The larger the event, the more beneficial it might be to include a third-party platform in the process to reduce the administrative burden.
Understanding the level of required company disclosures, the potential tax and legal implications and the impact on the company's 409A is critical. This takes time and due diligence to make sure the event runs smoothly. Having the appropriate partners through this process can provide welcome support.
Precise messaging to employees and investors is also paramount. Create a sense of fair play for employees by clearly communicating your rationale and emphasize the importance of keeping employee and investor values aligned.
Engage the right partners to provide education to eligible participants. Employees often look to company leaders for help in deciding whether to participate, so engaging outside resources for education and communication can protect the leadership team as well as the company.
Finally, having a game plan for addressing liquidity as the company grows can make these decisions easier at every step.
How We Can Help
Liquidity event workshops
We've developed complimentary workshops to help leadership teams and employees navigate the complex process of an upcoming liquidity event, such as an IPO or acquisition.
Pre-IPO for Leadership Teams |
Prepare your leadership team to navigate IPO complexities, including insider trading rules, equity plans and personal financial planning. |
|---|---|
Pre-IPO for Employees |
Provide employees with the knowledge to understand insider trading rules, internal policies and the ways an IPO may affect their equity compensation. |
M&A for Leadership Teams |
Gain insights on how to successfully navigate M&A transactions, including the impact of equity compensation and risk reduction. |
M&A for Employees |
Help employees understand how M&As impact their equity, supporting them to make informed decisions during the transition. |
To learn more about scheduling a liquidity event workshop for your company, speak to a First Citizens wealth consultant today.
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