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Considerations for Private Company Equityholders During Periods of Market Volatility

Let’s face it: market volatility is a fact of life. Periods of economic stability coexist with periods of economic upheaval, just like the one we are experiencing today. Rising interest rates in the U.S., global inflation, geopolitical strife in Russia and Ukraine, and ongoing global supply chain issues are wreaking havoc on the markets. For younger generations who grew up in a period of consistent asset appreciation, it can be difficult to remember that markets go down, but they do. In fact, in 2022, the NASDAQ Composite has dropped by more than 20 percent, leading some analysts to warn that a bear market is on the horizon.

As a result, private company values are compressing, and investor sentiment is beginning to sour. Unlike publicly traded companies, the value of private companies is difficult to ascertain until these companies raise additional operating capital. For many private companies, this may mean a “down round” that better reflects the company’s value considering the current market environment. In such an environment, cash is king and we are already seeing private companies cut headcount to reduce cash burn and preserve operating capital. In the end, the fittest companies will survive and the excesses will be addressed, such is the nature of efficient capital markets.

If you work in the already uncertain world of start-ups, market volatility might feel like an added stressor, but it doesn’t have to. Whether you’re an entrepreneur at the helm of a new, private company, or an employee of a venture capital-backed business, there are paths to personal liquidity to help weather the storm and/or take advantage of unexpected opportunities.

Crucial access to cash for private company shareholders

Personal liquidity needs are rarely in sync with market movements and IPO underwriting calendars. In strong markets, liquidity opportunities abound. Conversely, when markets are down, buyers tend to disappear. Inexperienced investors and “venture capital tourists” exit, perhaps after getting burned, and return to their core business. Timelines to reaching IPO and other exit opportunities can extend. This leaves entrepreneurs and shareholders with fewer paths to liquidity precisely when they need it the most.

While it’s generally best to hold off on selling your shares until the value of your company is peaking, accessing liquidity when markets are volatile can act as a hedge against uncertainty brought about by factors beyond your control.

As previously stated, cash is king during periods of economic instability, so it’s often wise to focus on decreasing your spending, increasing your savings, and acting fast when needed. Deeper market downturns may mean fewer opportunities for secondary sales. However, there are alternatives. As volatility appears, consider generating liquidity from your private shares. 

Liquid Stock offers an alternative path to liquidity that does not require the sale of your shares. We are a team of experienced investors who can help make your equity work for you when you need it most.

A valuable opportunity for option holders

Believe it or not, there is a potential upside to market volatility for option holders, especially if they choose to exercise early (as opposed to waiting for an exit event). Start-up valuations often fall during periods of market instability. This means your company’s internal 409A valuation (also called fair market value) may be revised down, so the tax cost to exercise your options may drop alongside it. That’s because when you exercise your options, your taxes are generally based on the difference between the strike price and their fair market value.1 The closer the 409A is to the strike price—while also staying above it, of course—the less you’re likely owe in taxes when you exercise.

The days of racing to exercise options in the face of steadily increasing 409As is behind us for now. One prudent strategy in today’s environment may be to wait and be ready to capitalize on a possible downward 409A adjustment. Even if this value is not revised, it may be worth waiting until valuations stabilize and the company’s future potential is in better focus.

In general, exercising your options early is a good idea because it allows you to save on taxes. But remember: it costs money to exercise your options. At Liquid Stock, we understand that nobody wants to pay to exercise their options early—especially when markets are volatile—only to see their company fail to ever IPO or be acquired. That’s why we offer a non-recourse solution.2 We give you the cash you need to purchase your options early and benefit from preferential tax treatment without requiring repayment above the value of your shares if your company goes belly up. Our experienced team members have worked with private company shareholders and option holders through several market cycles and have first-hand experience navigating volatility. We’re always focused on long-term success, no matter the current state of the markets.

About the Author:
Robert Pitti, Founding Partner at Liquid Stock, is an experienced wealth manager who has provided advisory services to many successful entrepreneurs and venture capitalists.

This blog post is intended for general informational and education purposes only.  Liquid Capital Management, LLC (together with its affiliates, “Liquid Stock”) makes no representations as to the accuracy of information in this post, and no representations or guarantees as to specific outcomes from relying on this post. No content in this post is intended or should be construed as tax, investment, legal or accounting advice by Liquid Stock, or as an offer to sell or solicitation of interest to purchase any securities offered by Liquid Stock. Liquid Stock does not provide tax or other financial, legal or regulatory advice to its transaction counterparties. While reasonable steps have been taken to ensure that the information herein is accurate and up to date, no liability can be accepted for any errors or omissions. All views and information contained herein are as of the date hereof and subject to change. Information contained in third-party links has not been independently verified by Liquid Stock and inclusion of such links should not be interpreted as an endorsement or confirmation of the content therein. Prospective investors considering an investment in a Liquid Stock fund should not consider this content as fund marketing material.

1The tax impacts of option exercise are complex and differ based on individual circumstances. Whether an option-holder will be taxed in connection with exercise or only upon a later sale of the shares, and the applicable tax rates, depend on various factors including the type of option grant, the time of grant, exercise and sale, and the option-holder’s income. Individuals considering exercising stock options should consult with a tax advisor.”
2The Liquid solution is non-recourse, other than in certain enumerated events of default