Liquidity Event: The 3 Ways To Monetize Investment
A liquidity event is when an investor or group of investors sells their shares in a private company for cash.
This can happen when the company goes public through an IPO, or when another company acquires it. A liquidity event can also happen when a private equity firm or venture capital firm invests in a company and then sells its stake later on.
In this blog, we’ll break down what a liquidity event is, what the main types of liquidity events are, when these events typically occur, and what else investors should know about exiting investment positions.
Liquidity events are the most important event in venture capital. This is the only time that investors make money, and they are incentivized to maximize the value of their equity whether that is through initial public offerings, mergers and acquisitions, or selling their equity positions on secondary exchanges.
There are three types of liquidity events. A company can make its equity liquid by going public through an IPO, being acquired or merging with another company, or selling a portion of its equity through secondaries.
It takes on average at least five years for companies to have an exit event. Only a small handful of companies exit, but for those that do, it takes time. Early investors have to be comfortable with long lockup periods where they are holding illiquid assets.
What is a liquidity event?
Liquidity events are the reason that venture capital and private investing exists. It’s the only way that funds make money, and it provides evidence that investors are good at spotting potential winners.
A liquidity event happens when a portfolio company’s equity becomes liquid and investors are able to cash out on their position.
The benchmark of a good liquidity event differs by the stage a fund invests, and earlier-stage investors expect larger liquidity events to compensate for the risk they took on when first investing in the company.
What are the common types of liquidity events?
Liquidity events typically can only occur three ways:
Going public (IPO)
An IPO (initial public offering) is when a company raises money by selling shares to the public for the first time. After an IPO, anyone can buy or sell the company’s stock on the open market.
A company usually goes public when it wants to raise a lot of money quickly to fuel growth.
Getting acquired (M&A)
This happens when a company is bought by another larger company.
A direct acquisition is usually done to consolidate market share, gain access to new technology or products, or enter into a new market. In an M&A, the shareholders of the company being acquired will sell their shares to the acquirer in exchange for cash or stock in the acquirer.
Selling shares on a secondary market
A secondary market is a market where investors trade preferred stock to other willing buyers.
A company can sell shares on a secondary market to raise money without going public or getting acquired, and an investor can sell a portion (or all) of their stock on a secondary market if they are in need of cash. This is usually done by venture capital firms that want to cash out on their investment without waiting for an IPO or M&A.
When do liquidity events typically occur?
Most fund have a ten-year investment lifecycle, and they view investments as long-term bets. As a general rule, investor expect to exit their positions (either through a liquidity event or the company going out of business) between 5-7 years.
According to Statista, the median time to exit for a venture-backed startup is 5.7 years.
What else should investors know about liquidity events?
The liquidation preferences and seniority of each investor can significantly influence their view on prospective liquidity events.
People will always act in their own best self-interest, and investors are no different. Giving up too much voting power and and economics gives investors power to vote their way on any controversial liquidation events.
Whoever has a majority stake controls the voting power.
Liquidity events depend largely on the macro economy.
Businesses are more hesitant to pursue an IPO or large M&A transactions when investor sentiment is down.
In a recession, investors can expect less liquidity events to occur, so it is important for them to coach portfolio companies to consider liquidation options before the money dries up.
If previous investment rounds were ultra-dilutive or had unfavorable liquidation preferences, a liquidity event can leave employees with nothing.
If a liquidity event happens at a flat valuation to the last round and prior investors have more protective clauses, it can result in employees’ equity being worthless.
Liquidity events are an important part of the private investing process. They provide a way for investors to cash out on their positions and allow companies to raise money quickly.
The most common types of liquidity events are an IPO (initial public offering), M&A, or selling shares on a secondary market. Most funds have a ten-year investment lifecycle, and they view investments as long-term bets.
As a general rule, investors expect to exit their positions (either through a liquidity event or the company going out of business) between 5-7 years. Investor sentiment can significantly influence how many liquidity events occur in a year. Employees should be aware of the potential consequences a liquidity event could have on them if they hold common stock.
A term sheet is a document commonly used in venture capital and private equity investing to outline the terms of an investment agreement between a company, investor, or syndicate of investors. It typically includes various financial and legal considerations that govern the relationship between the parties and serves as a blueprint for the more detailed investment documents that eventually need to be drafted.
Management fees in venture capital are fees charged to the limited partners by the venture capital firm to cover its operating expenses. These fees are typically calculated as a percentage of the total committed capital to the venture fund.