If you work for a late stage start up, you are most likely suffering from both mental and physical fatigue. You’ve worked for many years with the expectation of a big payout from your stock options, but the company doesn’t seem in any rush to go public. “Unicorns” (private companies valued at more than $1 billion) are no longer rare and in recent years we’ve even seen the rise of “decacorns” (private companies valued at more than $10 billion). There are two ways to get relief, one is through assistance via an employer, and the other is through working with outside parties. In Part I of this post we’ll talk about assistance via an employer, mainly tender offers and buy backs, and when it makes sense to participate.
Why Tender Offers and Buy Backs Are So Valuable Today
Simply stated, companies aren’t going public at the same rate as in the past, they are staying private for a longer period of time, growing sales, and trying to increase valuations. But what happens when companies grow and delay their IPO? Some employees may feel stuck. On one hand, the paper value of their stock is significant, on the other hand they may want to buy a new house, send their kids to college, have enough to retire, travel, or do any number of things that require their assets to be in a more liquid form.
What choice does the employee have? They’ve spent a lot of time and energy at the company and if they leave now, they may have to forfeit their hard-earned (albeit on paper) money. Thankfully, some employers have begun to realize this and have moved to address the issue in an employee friendly way. This usually comes in the form of a tender offer or a buy back.
Tender Offers versus Stock Buy Backs- An Example
What is the difference between a tender offer and a stock buyback? A tender offer is typically money originating from a new investor in the company where the employer is partially facilitating the transaction. A buy back is employer money offering to buy your stock. An example of a tender: A private equity group wants to invest in your company, they are willing to invest $100m. Your company may not need the money, or want to dilute it’s shares further. They may instead decide to offer their employees the opportunity to sell some portion of stock, up to an aggregate of $100m, at the current valuation. In this case, the private equity group is able to take their stake and employees have the opportunity for liquidity. The company has happy employees, happy investors, and the ability to better align the desires of their investors and the company.
The company will get to decide who participates in the tender and at what percent. If done equitably, all employees and early investors may have an opportunity to tender up to a certain percentage of their shares. This would allow employees to take some money off the table for personal use while still retaining stock as an incentive for further company growth. There are logistical concerns, like how to match the number of shares an investor is willing to purchase with the number of shares employees would like to sell, and there are expenses to the company to facilitate a tender offer, but the employee and company benefits are significant.
In contrast, the buyback is done through cash the company has on hand. Perhaps the company is very profitable: a buy back allows employees to realize some liquidity while also giving the company more leeway in attracting new key employees. (They can issue shares to these new hires without diluting existing shareholders.)
The nature of tech companies is that they are usually reinvesting sales into growth, therefore, buybacks don’t usually make sense for employees at the companies we typically work with. Still, they can be a great benefit to employees of companies that fit a certain profile.
Should You Participate in a Tender Offer?
Tenders on the other hand are becoming more frequent as companies stay private longer. If offered, should you participate, and how much? The answer will obviously depend upon your personal financial situation, but we will discuss some parameters which will allow you to consider your opportunities.
First, you need to understand that most people considering participating in a tender have a concentrated stock position. In other words, if your total illiquid stock value is $50k but you have other investments worth $50M, you may not participate simply because the stock represents a small portion of your overall portfolio. (Or, depending upon your feelings regarding risk and company growth, you may still want to participate). However, if the opposite is true, and you have $50M in illiquid company stock and $50k in other investments, you should be looking hard at a tender.
Having your future tied to so closely to the value of one stock is inherently very risky. Nobel Prize winners have shown that having more than one stock in a portfolio increases return and decreases volatility overall, demonstrating why diversification is so important. And in this way, the question of tendering shares vs holding onto all of the company stock is one of risk.
I’ve heard financial professionals and employees alike tell me “Jeff Bezos didn’t get mega wealthy by diversifying.” This is true, but for every Jeff Bezos there are dozens of other high-tech executives that wish they had diversified. Besides, tenders rarely offer full redemption, so employees will still have significant holdings in the company stock. In addition, there is other unvested stock compensation on the horizon that will take off if your company does well.
Putting risk aside, from a financial standpoint, time value of money should also be a consideration. Money is more valuable today than it is in the future. Therefore, the longer you hold an investment, the higher the price should be when you sell it. So your money needs to be growing, i.e. the price you sell your options for needs to be higher than the price of the tender. Just to break even.
For investors, opportunity cost is an even bigger concern. In other words, if your money wasn’t tied up in your company stock, what else could it be doing? A broad stock market index, like the S&P 500, has averaged over 10% per year over the past 50 years (with dividends reinvested). If you shift towards investments with higher expected return, like small cap value US stocks, the 50 year return jumps to around 12% per year, compounding. So, again, the price of your options needs to be significantly higher when you sell your shares than it is at the tender price, due simply to the time value of money.
Waiting for an IPO has its pitfalls. Since stock trading is usually blacked out for employees for 6 months after the company goes public, employees cannot take advantage of an initial jump in price. Prior to the 6 month lock up ending, the price of a newly public stock will often go down (due to the anticipation of a lot of selling by employees and investors at their first opportunity). There are times when we see the tender price was actually higher than the price employees can sell at once the blackout is over. But what if the employee simply waits for the stock price to go back up? Unfortunately, studies show that after an IPO, the stock usually underperform the broader market for the next 5 years+. (Initial Public Offerings: Updated Statistics, Jay R. Ritter, April 9, 2019)
Therefore, when the tender is offered, an employee must not only take time value of money into consideration, but also the opportunity costs of other investments, the illiquidity premium, and finally the reality that to get equal value, the employee may need to wait much longer to sell their stock than originally anticipated. This all makes late stage tender offers very attractive.
How Much Should I Tender If I Want To Participate?
For reduction of risk, for financial optimization, and for lifestyle reasons it may be beneficial to participate in a tender. But how much do you tender? Usually an employee has the choice of tendering a certain percentage of their stock, up to a predetermined maximum amount. Do you max your tender or use a smaller percentage?
Having a coherent financial plan is important. Goal setting is the first step. Working backwards to find the minimum amount to tender is the second step. For instance, many employees have a goal of retiring comfortably at an early age. In this case, you’d want to calculate living expenses (adjusted each year upwards for inflation), then determine how much volatility you can afford to take, this will inform you on the ideal investment mix from which you can determine projected returns. Once you know your expenses and investment return (using Monte Carlo analysis to see the range of possible outcomes) you’ll know what you need in today’s dollars to support your goal. Other employees may want to use money to buy a house and, if so, they’ll need to determine whether to pay for the house in cash up front, take a loan and look to pay off the house when the company goes public, or keep a loan for the maximum tax write off. Still others think about securing their legacy by either providing for grandchildren’s educations or supporting their favorite charities.
We’ve found that employees who have established goals fare better than those who simply hope for a high price in the future, not defining what that means or having a sales strategy to support it.
Before making any decision on how much of your shares to tender, you should talk to a fee-only, independent financial planner who can help you set or clarify goals and show you the path for achieving those goals. With that ammunition, you’ll be better able to determine how much to tender.
Don’t Forget About Taxes
When an employee knows how much they need to support their goals, that number is an after-tax number. A tax calculation needs to be done to determine how much needs to be tendered pre-tax to net the right amount. Shares sold through a tender offer are no different than those sold via an exchange, you’ll owe taxes on the gains. The amount of tax depends on several factors, such as if the stock is owned by you or you only own the option to buy the stock, when you were granted the stock, how long you’ve held it, your income, and any other financial transactions you may have made. The type of options you own could also impact your strategy. For instance if you have both ISO’s and NSO’s, there are strategic considerations in determining which options to sell in a tender and which to hold. It’s of the utmost importance to consult a CPA to determine your tax liability. If you need a CPA who specializes in these types of calculations, feel free to reach out to our tax partner, WRP Tax.
Other Liquidity Options
Tender offers can be very employee friendly and are a wonderful opportunity when made available. Unfortunately, most companies still don’t put a high priority on creating liquidity for their employees. In this case, sometimes employees have to take matters into their own hands. Part II of this post will look at one way employees can create their own liquidity, via secondary market sales.