Four solid tips for managing risk before a liquidity event
Plan for what you might ― and might not ― receive in a liquidity event
Following is an excerpt from the Wells Fargo Private Bank report “From startup through IPO or acquisition: Wealth planning before and after a liquidity event.”
Being aware of risks to your pre-IPO or pre-acquisition stock is critical in planning for what you might ultimately receive, if anything, in a liquidity event.
Consider the following:
1. Stock splits
When analyzing the equity component of an employment offer from a pre-IPO startup, many may think a large number of shares equates to a lot of value. But the number of shares outstanding in a private company is arbitrary. Many companies implement a stock split prior to an IPO to set a per-share price within a range preferred by the public marketplace.
Remember: Focus on the percentage of company ownership represented by your shares (or options or restricted stock units), and not the number of shares, to help estimate the potential value of your options, RSUs or stock.
Be aware of the dilutive impact of future stock and option issuances to employees and investors. For example, if an early stage hire is granted restricted stock or options representing 5% of the company, subsequent issuances to employees and investors could reduce that percentage by the time of the liquidity event. Potential dilution is specific to each growth company.
Remember: Be aware that your percentage of company ownership may decrease (be diluted) as more stock is issued to investors and employees after an initial grant of shares, options or RSUs.
3. Preferred stock liquidation preferences
Venture capitalists (VCs) and other cash investors buy convertible preferred stock when they invest in a private startup. The preferred stock has a liquidation preference. When the company is sold, VCs can either:
Take the sale proceeds (cash and/or stock) “off the top” and get their investment back (often with a specified additional return)
Convert to common stock and receive what the common stockholders get for each share.
Since the 2001 tech crash, VCs are also more commonly using two variations to convertible preferred stock:
Participating convertible preferred stock: VCs get their money back first and then convert their preferred stock to common stock and share in what’s left, if anything.
Multiple liquidation preference: VCs have an opportunity to get two, three, four, or five times their investment back before common stockholders get any proceeds from a sale of the company.
Immediately prior to the acquisition, preferred stockholders may decide whether to convert to common stock based on which route pays more.
If the company is acquired for a price lower than what preferred stockholders invested , the preferred stock will not be converted to common stock. Also, common stockholders may receive substantially less or nothing at all. In most IPOs, all preferred stock is converted to common stock right before the IPO, rendering the liquidation preference irrelevant.
Remember: Review the details of the preferred stock liquidation preferences and how many shares are outstanding in order to estimate how those liquidation preferences may impact what you ultimately receive for your common stock in a hypothetical merger or acquisition.
4. Vesting restrictions and acceleration triggers
Vesting restrictions are usually imposed on all grants of restricted stock, RSUs, or options. If an employee’s service is terminated before the option fully vests, the unvested portion is forfeited. Founders and senior executives commonly negotiate accelerated vesting on a sale of the company, but such provisions don’t typically exist in a company’s equity incentive plan. Such a plan is set for the benefit of all workers and not commonly negotiable by individual employees.
Single trigger acceleration: The unvested stock or options vest (partially or wholly) ahead of schedule if the company is acquired.
Double trigger acceleration: Vesting is accelerated only if the employee is terminated (or materially demoted) without cause after the acquisition.
If your stock options don’t have these provisions, you must remain an employee of the acquiring company for the remainder of the vesting period to receive the full benefit of the option grant. In rare cases, the equity incentive plan may even provide that unvested options are canceled upon an acquisition.
Remember: To help plan accordingly, determine whether or not your RSUs, options or restricted stock have accelerated vesting in connection with an acquisition.
Investment and Insurance Products: Not FDIC Insured. No Bank Guarantee. May Lose Value.
The information in this report is for educational purposes only and should not be used or construed as financial advice or a recommendation to participate any strategy mentioned herein. Wells Fargo does not guarantee that the information supplied is complete, undertake to advise you of any change in its opinion, or make any guarantees of future results obtained from its use. The concepts discussed in the paper require the assistance of qualified legal counsel and tax advisors, and investors should consult their own attorneys and tax advisors with respect to their own situations.
Wells Fargo Private Bank provides products and services through Wells Fargo Bank, N.A. and its various affiliates and subsidiaries.
Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.
Wells Fargo & Company and its affiliates do not provide legal advice. Please consult your legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared.
Because of the short-term nature of options, it is likely that they will be traded more frequently than stocks and bonds. With each option-related trade, a commission will be incurred. Commissions on option transactions generally amount to a higher percentage of the principal than commissions for normal stock trades.
Trading in options can result in losing the total amount of premiums and commissions paid. Additionally, when covered call options are sold, the underlying securities must be delivered at the strike price upon exercise of the option.
Additional information is available upon request.
©2019Wells Fargo Bank, N.A. All rights reserved. Member FDIC.