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.
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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.
Liquidity events typically can only occur three ways:
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.
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.
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.
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.
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.
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.
ESOPs are common stock, and common stock is paid last.
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.
To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.