Private Company Liquidity Events Explained

Getting the Juice out of the Squeeze

When I first started in the employee equity practice 25 years ago, there was an intense drive for private companies to go public at lightning speed. It was realistic to expect formation to IPO in less than five years. Forget revenue, positive cash flow, or discussions on “readiness.”  Who needs that? Today, the landscape is entirely different. Access to the private markets for funding seems to be very easy, even unlimited, for many private companies. And SEC regulations, increasing disclosure requirements, scrutiny and public company shareholder activism continue to grow. As such, many private companies are delaying IPOs, delaying opening their kimonos for the public and SEC to view and comment, and instead, turning to private markets for funding. But where does this leave employees with stock options and other equity awards when there is no public market to get cash for their company equity?

The Lemon: Equity compensation challenges without liquidity

One of the reasons why many employees decide to work for start-ups and early stage private companies is due to the equity compensation. Stock options are the most prevalent equity awards for start-ups. These awards typically have a term of no more than 10 years from the date of grant. As private companies get closer to an anticipated IPO, some companies switch to “double trigger” RSUs which don’t vest until certain time based vesting conditions plus a liquidity event (i.e., IPO or change in control) occurs. These “double trigger” RSUs typically also have an expiration date which depends on the company’s specific circumstances at the time of grant, but usually 6-7 year term from the time of grant. So what happens when employees can’t afford to exercise their stock option (or don’t want to until they make sure that they can sell their shares) or when the expiration date for the options and/or RSUs is looming around the corner? Twenty-five years ago, we rarely saw stock options with 10 year terms about to expire in the money as companies had gone public within ten years from founding. Today, it’s common to be on the verge of expiring stock options or double trigger RSUs. If only it were easy to extend the term, but thanks to IRC Section 409A, extending the term of stock options and RSUs is generally not permissible.

And even if options or RSUs are not on the verge of expiring, what’s the message to employees who may have agreed to lower base pay and bonuses to work for an early stage private company and receive equity if there is no IPO in sight and therefore, no liquidity? Many late stage private companies have had to face the reality that employees are only so patient and eventually, they want to be able to sell equity and get cash.

The Sweetener: Private company liquidity programs and tender offers

About ten years ago, we started to see mid to late-stage private companies offer liquidity opportunities to employees. They didn’t want their employees to move to greener pastures, and they also didn’t want the pressure to IPO. Nowadays, “tender offers,” “buy backs” and other liquidity opportunities are very common. Sometimes, they only involve stock options or RSUs about to expire but more commonly, these offers are made to all vested option holders (and sometimes time based vested RSU holders). There are many ways to structure these offers including if the company does the buy back, the company lines up investors to purchase the shares or the company simply waives the right of first refusal on the shares to allow employees to sell shares on private company shares trading forums. No matter how these are structured, there are tax, accounting, 409A valuation, payroll tax, and administrative considerations with these programs. Getting the most out of liquidity programs requires careful planning to navigate all of these topics.

Peeling back the Complexities: 

Legal

There are legal considerations in offering a liquidity event. Generally speaking, if the offer is deemed to be a “tender offer,” the offer must be kept open for at least 20 business days, and disclosure of the material terms and tax consequences must be disclosed to offerees. This blog will not address what constitutes a tender offer nor cover any legal considerations beyond these general comments. Please seek legal advice.

Tax

Most liquidity programs offer employees an opportunity to sell their shares (or exercise vested stock options and sell shares) at a price above the current 409A valuation. From a tax perspective, one of the key issues for employees holding shares (not vested options or RSUs) is how the premium between the “offer price” in the offer and the 409A valuation should be taxed. This premium is either a capital gain, or it is compensation income. Of course, employees prefer capital gain tax treatment as the rate of tax is generally a lot lower than ordinary income tax rates that apply to compensation income.

Whether the premium will be considered capital gain or compensation income is a “facts and circumstances” test which considers all facts and circumstances including:

• Who is the buyer (i.e., the employer or new investors)
• How was the price determined
• Who can participate in the offer
• How were the participants selected
• Whether common stock is purchased and immediately converted into preferred stock
• Do the buyers have a significant interest or influence over the company
• Other relevant factors

No one factor is determinative. Informed companies usually try to structure these transactions to obtain capital gains tax treatment for their employee shareholders.

It is important to keep in mind that if a company determines that the premium should be treated as a capital gain (assuming this is the proper tax treatment), the company is reaching that conclusion by essentially taking the position that the offer price is fair market value (“FMV”) of the shares during the period of the liquidity offering. 

For employees with vested options (or time based vested RSUs), if they participate in the liquidity opportunity, all of their cash proceeds will be taxed as compensation income. If the options are ISOs, ISO status may be able to be preserved, but the immediate sale of shares results in a disqualifying disposition.

Please note that for double trigger RSUs, most companies do not allow these types of awards to participate in the liquidity program due to 409A issues. However, it may be possible to allow double trigger RSUs to participate in one liquidity program/waiver of the liquidity vesting condition one time.

409A Valuations

After the liquidity program concludes, the company is strongly encouraged to obtain a new 409A valuation if the premium was treated as capital gain for the liquidity program. There is accounting guidance on factoring in liquidity programs and other share sales into 409A valuations. Until a new 409A is obtained, it is advisable to hold off on additional stock option grants and/or process stock option exercises.

Accounting

Similar to the tax analysis above, the accounting treatment of the premium must be considered. Most of the time, the premium will be considered additional compensation expense and booked accordingly. However, similar to the tax analysis above, depending on how the offer is structured, there may be ways to avoid booking a compensation expense if the buyers are new investors, the company is not involved in the offering, etc. Typically, private companies not moving to an IPO in the near term are not too concerned about having to book an additional compensation expense for the premium amount.

Payroll Tax

If the premium is treated as compensation income, tax withholding and reporting must be made. Also, for non-qualified stock option exercises done during the liquidity event, the company must withhold and report on the spread at exercise.

Administrative

Liquidity events/tender offers take a lot of time and planning. It’s often the case that there is not a full-time dedicated stock plan team for private companies. There are some platforms out there that help with the administration of the offering, but they don’t run payroll or answer employee questions.

Conclusion: Getting the Most Juice out of the Liquidity Event

Whether a liquidity event is right for your company or is the right time is not something that can be answered here. However, if heading down that path, it is especially important to carefully consider:

• Employee tax implications
• Impact on 409A valuations
• Accounting treatment
• Payroll tax obligations
• Administrative complexity

Like with all decisions employees are asked to make, communication is key. Getting the most out of liquidity events means taking the time and effort to educate employees so they can make the right decision for them. 

For more resources, visit the Private Company Stock Plans section on NASPP.com

Disclaimer: This blog does not represent the views of PwC, nor does it constitute tax, legal or accounting advice. Companies and individual must hire their own advisors to advise on the tax, legal, accounting, and other issues resulting from liquidity programs.