Liquidity Event Playbook: Steps For Financial Success

Liquid assets, such as cash or publicly traded company stocks, can be readily converted into cash, while illiquid assets, such as real estate or private company stock options, may pose challenges in quickly converting them to cash and might incur a loss in expected value upon sale. A liquidity event occurs when an investor holding illiquid assets transforms them into liquid ones. For private companies, a liquidity event signifies shareholders converting their equity into cash, typically through exits like mergers and acquisitions (M&A), initial public offerings (IPOs), or dissolution.

These events can also serve as part of a startup's compensation plan, offering employees and shareholders a chance to realize the value of their stock compensation on the secondary market before an exit. Various types of liquidity events exist, including public offerings, M&As, and secondary transactions, which companies and investors may pursue. Here, we'll delve into the most prevalent liquidity events for private companies:

Public Offerings: Routes to Becoming Publicly Traded

An initial public offering (IPO) marks the transition of a private company into a publicly traded one by listing its stock on a public exchange. While an IPO is the conventional method, direct listings, and SPAC mergers offer alternative avenues for companies to list their shares on the public market.

Initial Public Offering (IPO)

Traditionally, an IPO involves a private company issuing new shares of its common stock to underwriters, who then sell them to institutional and retail investors on a stock exchange. This process enables shareholders to sell registered shares and access liquidity in the public market. IPOs typically impose a lock-up period of 90 or 180 days, during which existing shareholders are restricted from selling their shares. The IPO journey itself spans a lengthy period, typically lasting 18-24 months.

Direct Listings

In contrast to an IPO, a direct listing, or direct public offering, doesn't rely on underwriters to purchase an initial block of shares at a predetermined price. Instead, the company directly lists its shares on a stock market for trading at prevailing prices. Other investors can then purchase shares directly from the public market, and existing shareholders generally face no lock-up period. Unlike in an IPO, a company undergoing a direct listing does not raise new capital.

SPAC Mergers

A special purpose acquisition company (SPAC), often termed a shell company, raises funds through an IPO solely for acquiring a private company. Referred to as a blank-check company, a SPAC enables a private company to go public without following the conventional IPO route.

Mergers and Acquisitions (M&A)

Mergers and acquisitions are commonly grouped together, yet they represent distinct transaction types. A merger occurs when two or more companies unite to form a single entity, possibly adopting a new identity in the process, while an acquisition arises when one company assumes control over another. Terms such as buyouts, consolidations, acqui-hires, or restructurings are encompassed within the broader scope of M&A activities. There are two prevalent structures for acquisitions:

Stock Sale

In a stock sale, the stockholders of the target company sell their shares to the buyer, leading to the target becoming a wholly owned subsidiary of the buyer. In certain instances, a stock sale might involve the buyer integrating the target, thereby eliminating its distinct existence.

Asset Sale

An asset sale involves the target selling all or most of its assets to the buyer, typically resulting in the dissolution of the company, with proceeds distributed to its stockholders during the winding-down process.

Secondary Market Transactions

Secondary market transactions occur when investors purchase stock in a company from existing shareholders, bypassing direct involvement with the company in a primary stock sale. Common sellers in venture secondaries include venture capitalists, executives, and employees. While venture secondary transactions can occur at any time, they frequently take place within 90 days of a primary funding round. Companies often impose caps on traditional venture rounds, prompting secondaries to offer an opportunity for those previously excluded or unable to secure their desired allocation in a recent capital raise. Venture secondaries encompass various forms but can be categorized into two main groups: structured liquidity programs and direct secondary sales.

Structured Liquidity Programs

These events are typically initiated by the company and are then structured, negotiated, and overseen by management. Tender offers represent the most common type of structured liquidity program, while auctions are less frequent.

Tender Offers

In a tender offer, multiple sellers, typically including employees and early investors, are given the opportunity to sell their shares to one or more groups of investors or back to the company at a predetermined price within a 20-business-day offering period. Companies conducting tender offers exercise full control over participant selection, pricing, and disclosure, ensuring interested parties receive pertinent financial information to inform their decisions.

Auctions

Auctions utilize supply and demand dynamics to establish the price and volume of a secondary transaction. These transactions are typically orchestrated by the company, with buyers submitting bids and offers based on their valuation. Third-party market operators and secondary platforms often assist in determining prices that align with market dynamics.

Private secondary sales

In a private secondary sale, also known as a bilateral trade, one investor directly sells shares in a company to another investor without the involvement or endorsement of the company itself. These transactions can pose challenges for companies seeking to maintain control over their capitalization table and equity ownership. With private secondary transactions, aside from certain circumstances dictated by securities law for marketable securities, standard disclosures are typically absent, and sometimes no information is provided to potential buyers at all. Unlike in a tender offer, where the company or a third-party sets the price, in a private secondary sale, the price is negotiated solely between the buyer and seller. Consequently, this negotiation process can lead to varying implied valuations across different transactions.

Impact of Secondary Transactions on Company Valuations

Historically, secondary transactions have influenced 409A valuations for companies. However, this isn't always the case today. Implementing separate valuations for compliance with 409A and ASC 718 can mitigate the impact of secondary deals on a company's 409A valuation. We advocate for this separation of valuations as it removes a significant hurdle for companies concerned that a rising 409A valuation might hinder their ability to attract top talent with stock options.

The Role of Founders and Venture Capitalists

A venture capitalist (VC) is an investor in private equity who injects capital into companies with substantial growth potential in exchange for an equity stake. This investment often supports startup ventures or expansion endeavors. While investors typically view a liquidity event favorably, it's not always the primary goal for company founders, who have more risk tolerance. Some founders may prioritize maintaining control over their company rather than pursuing a liquidity event, despite pressure from early investors. For instance, Mark Zuckerberg and his cofounders, along with various venture capital firms and individuals listed as shareholders in Facebook's (now Meta) pre-IPO Form S-1 filing in 2012, were enthusiastic about the company's liquidity event. The IPO raised $16 billion, valuing the company at $107 billion on its first day of public trading. Zuckerberg, who owned 28.2% of Facebook (now Meta) before the IPO, saw his net worth increase to approximately $19.1 billion.

Control Over the IPO Timeline

Typically, a company has control over the timeline for an IPO. However, if a company surpasses $10 million in assets and has more than 2,000 investors (or 500 shareholders who aren't accredited investors), the Securities and Exchange Commission (SEC) mandates the filing of financial reports for public access restriction known as the 2,000 investor limit. In 2023, there were 153 IPO deals in the United States, raising $22.7 billion, with 132 on U.S. exchanges.

Conclusion

A liquidity event provides an opportunity for early investors to cash out some or all of their equity and secure an early retirement. This can occur through an acquisition, merger, or initial public offering (IPO). Typically, companies file SEC Form S-1 in anticipation of their IPO.

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