ESOP Academy 16: Liquidity in Private Markets

Written By:
Amit Majumder, CFA
April 9, 2023

How can you cash out your employee equity?

Earlier articles in this series have all been written to help you understand how ESOPs are structured and to highlight that employee equity you receive has value. Sure, understanding the grant acceptance worfklow and vesting schedules is helpful, but let’s get to the important part - how can you actually realise the value of your equity awards?

Ultimately, the value of assets one holds is tied to their ability to cash out and utilise the resulting proceeds to pay bills, boost savings, or fund purchases and other investments. For that reason, liquidity matters. But what is liquidity and what do you need to know about being able to convert your ESOPs into cash? Let’s go through it all.

What is liquidity?

Simply put, liquidity refers to how easy it is for a specific asset or security to be converted into cash. The textbook definition would also point that besides the ease of conversion, liquid assets and securities can be transacted in without a significant impact on its price.

The more liquid an asset is, the easier it is for you to cash it out. Illiquid assets, on the other hand are not so easy to sell. With this in mind, are ESOPs liquid or illiquid? It depends.

Listed Companies

If you hold equity in a listed company, you’re in luck, your ESOPs are highly liquid. Note that not all listed companies are made the same. Some shares have higher trading volume on exchanges and are a lot easier to transact in than others. But generally speaking, listed company shares are liquid and you only need to be mindful of abiding by the plan rules and your company’s securities trading policy before you transact. Simply put, you will likely be able to liquidate your holding as soon as your ESOPs vest.

Private Markets

If you read about startups and venture capital investments, you will likely see mentions of long-term investment horizons. One of the reasons for this is the lack of liquidity in the private markets. Unlisted startups investors are willing to take a long-term view and park their money in companies for years and even decades with the understanding that they won’t be able to easily cash out, especially in the short term. In return, they expect to earn higher returns.

As an ESOP holder, you should also think of yourself as an investor in your own company. So how might you be able to take some money off the table if there are no prospects for your company to go for an IPO or get taken over anytime soon? You may have a chance to participate in several types of transactions. Let’s go through them in detail.

1. Cash settlement

The simplest way you may be able to liquidate your ESOPs is via cash settlement. Cash settlement is a process of your equity being converted into cash without delivery of underlying securities. You might be familiar with the concept of an exercise of an option, where a share is allocated to you for every option your exercise. With cash settlement, no shares are issued to you – you simply receive the cash payment for the value calculated as the difference between the current share price and the option cost (if any). See an illustrative example below/

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As part of this transaction, no equity is allocated, and you simply receive a payment from your company’s payroll. Note that tax may also be withheld from the payment.

Keep in mind: cash settlement transactions may be company initiated, and not processed upon your request. Check if the cash settlement process needs to be initiated by you or it will be triggered by your employer. For some plans, it is the Board that has the discretion to cash settle awards. For others, cash settlement is the only option available (e.g. Share Appreciation Rights aka SARs). Sometimes, cash settlement is not even allowed. Always read the plan rules.

In some countries, cash settlement is referred to as surrendering your ESOPs – you give up your equity in exchange for a cash payment.

2. Company share buyback

An alternative to cash settlement may appear to be the same thing at a quick glance. And the end result would be practically the same. Company buyback is a process where your employer can buy back your equity. This involves of them acquiring your ESOPs (generally immediately after conversion of them into underlying shares).

What’s the difference? Well, there could be differences in how these transactions are reported for tax purposes. After all, for cash settlement, you are receiving a cash payment from your employer (think cash bonus), whereas in buyback, equity is involved.  It is important to read all the relevant communications and documents you receive prior to engaging into any ESOP transactions and seek appropriate advice.

Ultimately, company share buybacks is another way your employer can allow you to exchange your equity for cash.

3. Secondary transactions

Primary transactions occur when an investor receives shares with the funds going to the company in return. For secondary trades, a third party is involved and acquires your shares. The funds for the sale go to you, and the company’s role is limited to facilitating these liquidity programs in the private markets.

Your employer can help facilitate these secondary transactions, and they often come as part of structured liquidity programs. These work quite similar to the buybacks we discussed above, but with the main difference being that your shares are transferred to a third party (could be an existing or a new investor in the company) instead of the company itself.

These are several types of programs, and you might come across names like tender offer, or simply liquidity program. In all cases, these events present you with an opportunity to sell some of your shares in the private markets.

What about an exchange?

Can you open up a trading account and just lets you sell your shares in your startup whenever you need the cash? For now, that might be a thing of the future. While plenty of progress in recent years has been made to facilitate liquidity in the private markets, there is no free-flowing marketplace just yet where you can easily trade your ESOPs, as you would if you worked for a listed company. For that reason, startups equity will remain an illiquid asset class. Your employer will play a key role as they would need to initiate structured liquidity programs to give you a chance to cash out your equity. And access to such programs will differ significantly across borders – this will primarily be driven by local regulatory regimes.

What do you do with all this information?

What does this all mean for you? First of all, it is important to understand that if you work at a startup, your ESOPs are illiquid. As a result, you should take a long-term view on your investment in your own company. Thinking like an investor is a good approach to take. VCs who invest in startups have long investment horizons and have limited need for liquidity. They are willing to wait for years before being able to exit their investment.

Despite this, your needs to liquidity could be quite different from institutions. You may want to put down a deposit for a house, pay for your child's education, or take care of other major expenses. You should be aware of how your company will approach liquidity.

As private markets develop and the access to capital improves, more and more companies opt to stay private for longer. It is not uncommon for companies to not file for IPO for 10+ years. Are you prepared to hold on your ESOPs for that long? You probably would want an opportunity to take some cash off the table earlier. Have a chat with your employer and ask them questions about their approach to liquidity.

Your current or prospective employer is planning to provide liquidity to you down the track? Great. What if they are not planning on offering cash settlement, share buybacks, or facilitate any secondary transactions? Uses this knowledge when you negotiate with them. Just like VCs, you might need be in position to demand a higher premium as a result of lack of liquidity, and this, for you, can come in a form of higher ESOP allocation.

Lack of liquidity may sound like a massive risk and downside to equity ownership in startups. That is true, but there are plenty of reasons to be optimistic. Private market liquidity is no longer rare, and it is not only available in the US markets. India has been leading the way across Asia, with US$400M+ worth of ESOPs bought back in 2021 alone. The trend of more access to liquidity for startup employees will spill over to other countries and will only grow from here.

Amit Majumder, CFA

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