With the continued volatility in the public markets, which are now on a strong upswing, it’s tempting to look at the stock prices and investments on a regular basis. Great, the market is up 2% today, how’s my portfolio? Bummer, the market is down 1% today, how’s my portfolio? Of course, it’s outside our control and should be ignored, save for a periodic annual or quarterly review. But, the fact that it’s there, at our finger tips, makes it distracting and compete for our attention.
In the startup world, we have a few measures of the value of our equity. The most common, and often misunderstood, is the valuation from the latest funding round. Let’s say a venture firm invested $5M at a $20M pre-money valuation, such that the company is worth $25M. Well, that’s for preferred stock which often has a number of special features that make it more valuable than common stock (features like dividends and anti-dilution). The next type of valuation that’s well known is the 409A. The 409A is an independent appraisal of the fair market value of the common stock that’s accepted by the IRS so that employees will get long-term capital gains. Put another way, it’s an independent valuation so that employees can be granted stock options at a lower valuation and save on their taxes if everything goes well. As a ballpark, the 409A valuation is 40-50% of the last round’s valuation.
Even with these valuations, there’s often no way to sell stock. Sometimes, at the later stages, existing or new investors will offer to buy some of the employee stock. In addition, there are different marketplaces to buy and sell private stock, but they are often limited to the most well known and desirable startups (read: only famous startups have much trading activity) and many startups prohibit selling stock without approval (startups don’t want to violate government rules around too many shareholders and other challenges with unknown shareholders).
The biggest downside to lack of liquidity with startup equity is that it’s worthless most of the time and thus there’s no financial gain from it. The majority of startups fail, even after raising money from investors. Startups sell for less than the capital raised making the common stock worthless. Many startups are zombies where they continue to operate but don’t make enough progress to create substantial value, and thus no opportunities for liquidity.
Even with these illiquid challenges, for startups that work out, illiquidity is a feature. Why? When a startup succeeds, there’s a tremendous amount of compounding value. If there were opportunities to regularly sell shares, like with a public company, it’s too easy to do so and lose the upside. Compounding value is one of the most powerful forces. Forced deferral of selling startup stock, in scenarios where the startup is successful, is a feature because it creates the most value and wealth for the team.
Illiquid startup equity is a feature, not a bug, when the startup works out as there aren’t daily distractions of the stock price and the team benefits from compounding the value of their equity at a high rate for the life of their tenure. The next time someone laments about not being able to sell their startup stock, focus on the upsides.