If you are considering a liquidity event, it is time to ask yourself some important questions, from both a personal and financial perspective. At William Blair, we have worked with many startup executives and entrepreneurs. Through this experience, we have identified important considerations on both ends of the spectrum. Once you have answered the personal questions to consider before entering a liquidity event, it is time to ask yourself these financial questions.
How Much Should You Sell?
From a business perspective, the first consideration may be how to take your company’s growth to the next level. This could mean selling a minority interest to an institutional investor who has the right balance of capital and expertise to be a great partner. Alternatively, it may be finding the right strategic partner who may acquire the entire business. From a personal perspective, this can be one of the most challenging decisions executives—and founders in particular—face. Generating the liquidity necessary to achieve portfolio diversification and accomplish other wealth goals often means selling a portion of the company's equity. While this helps limit your risk, it also means giving up some opportunity to participate in the company’s future growth.
Balancing these factors is challenging but having a clear picture of your true risk exposure and the potential outcome under various scenarios makes this decision much simpler. In many cases, entrepreneurs will sell a portion of their equity, allowing themselves to benefit further down the road as the company continues to grow.
What Are the Tax and Cash Flow Implications?
When planning for a liquidity event, one of the most important considerations is understanding the amount and timing of cash you will receive after taxes have been paid.
The earlier you and your advisors start doing this the better. You want to give your advisors enough time to assess the tax and cash flow consequences of potential transactions and create projections for how much after-tax wealth you will receive under a range of valuations for the business and transaction structures. This work is especially important for transactions that involve equity compensation, vesting schedules, or earn-outs rather than all cash.
You will need to identify how much of the proceeds will be treated as ordinary income versus long-term capital gains. A major part of this is understanding how the company is structured.
Is There Anything You Can Do to Minimize Taxes?
While taxes should not be the main driver of your decision regarding how and when to achieve liquidity, they are a major factor in how much you can achieve with your wealth.
One of the main benefits of working with your wealth advisors early in the process to understand the potential tax consequences of a liquidity event is that it gives you more time and more options for implementing strategies to lessen the tax bill and maximize the amount of your wealth. You also want to give your wealth advisors adequate time to lay the groundwork for establishing any trusts, foundations, and other legal structures that will be used in executing your wealth-management strategy.
Some tools for managing the tax consequences of a liquidity event include:
- Qualified small business stock exemption
- Pre-transaction valuation discount for wealth transfer
- Offsetting gains with charitable gifts
Also, if you are rolling equity into the acquiring company, that equity presents an ideal asset to consider for longer term wealth transfer planning.
What Are Your Paths to Future Liquidity?
Assuming you did not liquidate all your equity in the transaction, it is important to start thinking about how you can eventually maximize the value of your remaining equity and convert it to liquid wealth in the future. Completing another recapitalization or selling the company may certainly be an option.
While going public is the outcome that many entrepreneurs dream of, an IPO (initial public offering) is a reality for only a handful of companies. In most cases, it is difficult to generate liquidity from stock in private companies because the stock is not registered with the U.S. Securities and Exchanges Commission and the company imposes restrictions on reselling the stock.
As companies are staying private longer or delaying sales, companies are looking for ways to allow executives and other employees to cash in on the value of their equity. Pre-IPO companies are increasingly taking steps to facilitate mechanisms that allow employees to unlock liquidity from their stock through:
- Stock buy-back programs
- Internal company stock exchanges
- Opportunities for employees to sell shares directly to outside investors
- Sales through private secondary exchanges
Often, when companies create opportunities to sell the stock, participation comes with additional restrictions on what can be done with the remaining stock.