A primary goal of many, if not all, founders of start-ups and similar early-stage companies is to grow the company in a way that makes it an attractive target for outside investment and/or acquisition. For many companies, the founders play a key role in the growth of the company, and much of the success is directly tied to their efforts, acumen and goodwill. Accordingly, in a venture capital/private equity investment or acquisition, the investor will typically encourage the founders to continue their roles as new minority partners with the investor. It is also common practice for the investor to reward the founders with a separate cash bonus, either in the form of a change in control/retention bonus or as an immediate cash redemption of founder equity, in the latter case, allowing founders to unlock earned equity appreciation prior to exit. We have noticed a recent trend in which non-founder management, key employee and, in certain cases, rank-and-file employees participate as well. Investors contemplating a financing or acquisition should be aware of, and consider acquiescing to, a request for early liquidity for a broader group of equity holders than just the founders.
From what we have seen, early liquidity for this expanded group appears to be a negotiated benefit. Especially now, this early access to liquidity can help employees alleviate the daily financial pressure associated with inflation and a rising cost of living. For the investor, this use of cash engenders employee goodwill and provides the additional benefit of reducing dilution.
Mechanically, there are several ways to structure the early liquidity: with stock options, the investor can settle the stock options with cash; with equity, whether corporate stock or partnership/membership interests, the investor can offer to buy the shares or interests held by the employees. Note that where “incentive stock options” are outstanding, an exercise followed by a redemption is a strategy that may be favorable for both sides involved, as both the selling employee and the purchasing company will save their respective portions of payroll tax.
Early liquidity is not limited to equity, and we have also recently seen an uptick in application of so-called “synthetic equity” in the form of early settlement of restricted stock units or purchase/cancellation of stock appreciation rights for cash. Considering that many private companies utilize forms of synthetic equity rather than traditional ownership, investors (and to the extent possible, founders and other employees) should seek to use a structure that optimizes tax and economic concerns within the confines of the deal. However, because these synthetic equity instruments (and in some cases, even stock options) can be subject to Internal Revenue Code Section 409A, extreme care must be taken in structuring any early cash out.
In summary, venture capital and private equity investors often reward founders of portfolio companies with early access to cash while excluding the broader group of employees. Now, however, it appears that investors are factoring in some level of potential employee participation as well. The shift is subtle but significant; it remains to be seen if persistent.
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