A Down Market: When Liquidity Matters

Shriram Bhashyam
Feb 25th, 2016
We've read throughout tech, mainstream, and social media about how we've hit "peak VC" and that the halcyon days of the Unicorn are coming to an end (JP Morgan's chart below artfully makes this point). Plenty of ink has been spilled on this topic, so I'll instead focus on how employees and early investors in pre-IPO companies should think about liquidity in a down market.

Public and Private Market Conditions

We recently discussed in these pages the rough start to 2016 for public stocks, particularly tech stocks, with the Nasdaq (down 11.5% through mid-month) outpacing the S&P 500 for losses (down 7.4% through mid-month).

*Adjusted closing prices.
Source: S&P Down Jones Indices LLC, Yahoo! Finance

To underscore this point, we highlighted that many 2015 IPOs are trading below their IPO price (you can read that informative post, which looks at the market from an investor's vantage point, in its entirety here).

Source: IPO Registration Statements; Yahoo! Finance; Forbes; WSJ

The pain is not limited to public markets. Private tech markets have also been hit. In the primary markets, we have seen the pain manifest in many ways. While 2015 was overall a banner year for venture capital, with $58.8 billion raised, Q4 deal activity slowed down with $11.3 billion raised across 962 deals, representing a 32% downtick in dollars invested and 16% slide in deals versus Q3 of 2015 (more on this here). And that's not all. Valuations are weakening too. Large public institutional investors such as T. Rowe Price and Fidelity, are writing down their startup investments. Further, according to the venerable law firm Fenwick & West, venture capital valuations in Q4 were up on average 70% over the previous round of financing, which while strong, is markedly lower than than the 116% average increase observed for Q3 2015 (see chart below). Fenwick's insightful venture capital survey is available here.

Source: Fenwick & West

We're also seeing more down rounds. Fenwick observed that 12% of venture deals in Q4 2015 were down rounds, compared with 4% in Q3 2015. Foursquare, DoorDash, and Jawbone are recent examples. If you want the blow-by-blow, CB Insights has a handy Downround Tracker.

And there have also been layoffs. To name just a few in the pre-IPO space: Tango (9% of its staff), Evernote (15%), Jawbone (15%), and Practice Fusion (25%) are among the startups and Unicorns to cut staff in recent months, in the face of a tighter fundraising environment and calls from VCs to tighten belts and achieve positive gross unit economics.

Private Secondary Market Observations

What happens in the primary markets for startups impacts the secondary markets. At EquityZen, we're seeing more shareholders, who are interested in selling their shares, sign up. We've seen seller sign ups increase 31% from Q3 to Q4 2015, and 52% from December 2015 to January 2016. Employees and ex-employees are seeking liquidity for various reasons. One of these reasons is structural: departed employees generally have 90 days to exercise their options or forfeit them altogether. They are in a tough position: get what you can for your shares, or get nothing at all.

And the uptick is not limited to current and former employees. We're seeing more angel and seed investors seeking liquidity as well. The reasons for the professional and institutional folks are also varied. Seed and venture funds must return capital to their limited partners within 10-12 years. The capricious IPO window has meant fewer exits, so fund managers are turning to the secondary markets for liquidity. Additionally, many fund managers are looking to lock in some gains thinking the market has peaked, and also make some distributions to help raise the next fund.

These forces conspire to create a shift in the supply curve on EquityZen's platform.  Sellers are willing to take deeper discounts to achieve liquidity. The discount in these markets are in reference to the valuation paid by venture firms for preferred stock in the most recent round of fundraising. Where as in the first half of 2015, a 0-15% discount for secondary transactions (typically, but not always, for common stock) was the norm, in recent months we've observed that discounts have widened to 20-30%. 

Why Liquidity Matters

In the face of strong headwinds, employees, ex-employees, and early investors in startups need to think critically about what's going on. This is not just a founder problem; market conditions are impacting livelihoods and net worths.  The current environment is reminding us that in the pre-IPO market, your stock is only worth what someone's willing to pay for it right now.

There are a few reasons why discounts are increasing and may compound going forward:
  • The wave of supply may increase in the short term, putting further downward pressure on prices. Layoffs compound this, as ex-employees have a limited window to exercise their shares and reap some value for their efforts.
  • Down rounds are a fresh data point that also drive down secondary market pricing.
  • Investor friendly fundraising terms (liquidation preference > 1X, participations) render common stock less valuable than preferred stock.
And when there is an exit, it doesn't mean everyone will be making it rain. In down markets where cash lifelines are harder to come by, soft landings and down exits increase. For a holder of common stock, this means there is a greater chance that the value of stock will be substantially lower or even be worthless. Good Technology and Gilt Group serve as cautionary tales. Because the venture firms typically have a liquidation preference, which allows them to get their principal back before anyone else gets paid (in certain acquisition scenarios), where a company is sold for less than the total amount it has raised from venture firms, the common stock holders are likely to be wiped out. 

But all is not lost. When there is substantial downside momentum, liquidity becomes an important tool to manage risk and minimize loss.

  • A startup employee's net worth is often extremely concentrated in the illiquid stock of a single company.  Diversifying out of the single company will mitigate this concentration risk.
  • It's also prudent to consider locking in some gains. Employees and early investors have generally seen fortunes rise tremendously over the last few years. With an exit increasingly uncertain, taking a profit, through a sale of some shares, might make sense.
Further resources are available below.

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Valuations are down, it's harder to raise money, and funding terms are getting tighter. In the face of these headwinds, liquidity is an important tool in risk and loss management. It's all the more important in the startup world, where liquidity is hard to come by. Venues like EquityZen can be valuable resources for startup employees and investors.

Many thanks to Bryan Weis for his research assistance.

Additional resources:

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