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🫱🏻‍🫲🏽 What does an acquisition mean for your equity?

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Hey, everyone!

Chris here this week. Recently, I’ve been soaking up the bonfire season & spending a lot of time on my bike as the season changes to my favorite time of year here in St. Louis. It’s been a minute since I’ve written a newsletter, and I’m excited to be back this week to chat about an important topic that affects startup professionals. Acquisition events & liquidation preferences.

We recently had two clients share that their former company was being acquired. Payday - WAHOOO!! They were anticipating this meant they would finally receive cash proceeds for the value of their vested equity. While acquisitions are usually viewed as a positive liquidity event, liquidation preferences can often put a damper on that excitement once you run the math on what’s left over for common stockholders.

In today’s newsletter, we’re going to dive into what actually happens to the equity when a company gets acquired & how employees actually make money in acquisition events.

While the IPO is the coveted “exit event” for venture-backed startups, the reality is that only a small percentage of companies that take on venture capital go on to reach the IPO milestone. A more common liquidity event for companies is an acquisition which can come in a variety of flavors such as an all-stock deal, an all-cash deal, or a hybrid acquisition of cash & stock issued by the acquirer.

Additionally, an acquisition could be from a strategic buyer (i.e. another operating company, either private or publicly traded) or a financial buyer (i.e. private equity investor). Depending on who the buyer is, the terms of the acquisition, and what the objectives are from the acquirer, these can all influence what current and former employees, who hold equity, actually receive (or don’t receive) upon the closing of an acquisition.

Let’s start by discussing an important term for all startup employees to understand.

🤔 What is a liquidation preference?

A liquidation preference is a right that one class of stockholders may have which allows them to be paid ahead of other class(es) of stockholders in the case of a liquidation of the company.

So what does this mean for current or former employees?

If you were issued equity in your company, you likely received the right to purchase common stock in the company (stock options), or you received common stock directly. Common stock is a different class of stock than what investors receive in exchange for capital to fund the company. Instead, investors usually receive preferred stock in the company.

The term “preferred” in the venture capital world means that investors have a liquidation preference that allows them to get their invested capital back in a liquidation event (i.e. acquisition) before any proceeds are distributed to holders of common stock. In finance parlance, “preferred stock” ranks ahead of common stock in the company’s capital structure.

The most common form of liquidation preference is 1x the committed capital investment. For example, if investors committed $100 million to fund the company, they will receive their $100 million from any liquidation event before any proceeds are paid to employees. It’s important to note that just because 1x liquidation is the most common structure, this could vary based on the terms the investors negotiated with the management during the funding event. If the investors have a 2x liquidation preference, they would receive $200 million of proceeds from a liquidation event before common shareholders receive any profits.

💸 Who gets paid first in an acquisition?

In addition to liquidation preferences, it’s also important for employees to understand how other forms of investments could potentially affect what they receive in the event of an acquisition.

Over the past 2 years, it has been a challenging fundraising environment for a lot of companies. During the ZIRP era of 2020 and 2021, many companies raised capital at valuations that were significantly higher than what is typical in today’s more conservative fundraising environment.

To avoid raising a “down-round” or to “bridge the gap” with an immediate capital injection to fund operations until the fundraising environment becomes more friendly to founders or the company grows into the previous valuation, some companies took on venture debt or may have raised a Simple Agreement for Future Equity (SAFE).

In a liquidation event, the first priority goes to debt investors. Once any outstanding debt is paid off, then any investors who received a convertible instrument (i.e. SAFE) are next in line to receive a payday. SAFEs are a form of convertible debt that can be converted to equity at the next funding round. A common incentive for SAFEs is to include a discount rate on the company’s next priced funding round or upon a liquidation event.

One reason that SAFEs have been attractive to founders over the past few years is that SAFEs do not assign a current valuation to the company. This instrument can buy time for the business to grow into their valuation or delay a priced round fundraise until the market improves.

So let’s review the “waterfall effect” of who gets paid out first in a liquidation event.

  • Debt Lenders - Venture debt lenders have a senior claim on the company's assets and will be the first to get paid from the acquisition proceeds.
  • SAFE Holders - SAFE holders have a claim on the company's assets and will be next in line to receive payouts from an acquisition or liquidity event.
  • Preferred Shareholders - After the venture debt lenders and SAFE holders are paid out, then preferred shareholders with liquidation preferences will be next in line to receive their payouts. Again, the preferred shareholders' liquidation preferences will determine how much they receive before common shareholders.
  • Common Shareholders - Finally, any remaining acquisition proceeds will be distributed to the common shareholders, including employees holding common stock. However, the amount left for common shareholders may be significantly reduced or even wiped out.

✍🏽 How do the different kinds of acquisitions impact you?

Now that you know how proceeds are allocated in an acquisition, let’s unpack the types of acquisitions & their tax implications.

All-Cash Acquisitions:

Nothing beats cold, hard cash money, right?! This is the cleanest & easiest to understand of all the acquisition methods. In an all-cash acquisition, the acquiring company purchases the target company’s assets or stock using cash.

If you have exercised your stock options (i.e. now own shares of common stock), this will typically result in capital gains tax on any appreciation in the value of the company’s stock since the initial exercise date. The type of option you were issued (Incentive Stock Option or Non-Qualified Stock Options), the date you exercised, and the company’s 409a valuation on the date of exercise, are all important factors in determining your tax consequences. If you have unexercised options, this will likely result in ordinary income tax on the profits you receive.

All-Stock Acquisitions:

In an all-stock acquisition, the acquiring company issues its stock to the target company’s shareholders in exchange for shares. This type of transaction could qualify as a tax-free or tax-deferred event under Internal Revenue Code (IRC) Section 368, which governs tax-free reorganizations. In some situations, this could be an “acqui-hire” scenario, where the acquiring company is primarily seeking to attract key employees, so they may issue new equity grants to incentivize key employees they hope to retain.

The acquiring company’s stock value may impact the target shareholders’ tax consequences, so it’s critical for shareholders to understand the terms of the acquisition or work with a qualified tax or financial professional to evaluate the tax consequences resulting from the acquisition.

Hybrid Cash & Stock Acquisitions:

A lot of acquisitions aren’t as straightforward as all cash or all stock unfortunately and some structures can be very complex. The tax implications will vary depending on the structure and terms of the transaction.

If there is a cash component paid out, that portion will likely generate capital gains or ordinary income tax treatment, depending on if you hold shares or unexercised options. If the acquiring company is publicly traded, you may receive a pro-rata conversion of Restricted Stock Units (RSUs) for any unvested stock options.

Depending on the terms of the acquisition & timing of when the deal closes, there could be tax planning opportunities to offset or defer the capital gains consequences. In addition to understanding the tax & financial implications of the acquisition, it’s also important to understand when you could expect to receive liquidity for the equity in your new company & evaluate what steps you could take to prepare for the next liquidity opportunity.

If you made it this far, congrats, acquisitions can introduce some serious complexity and there is a lot of gray area. When it comes to an acquisition, there is no, “one size fits all” answer for what it means. The answer is always, “It depends” and at Secfi Wealth, our focus is on helping you make sense of what it means for your equity and your overall finances. We’re here for you so feel free to reach out if you need any help!

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