The Case for Selling (Some of) Your Startup Equity
Look, the case is pretty simple:
You probably under-appreciate the value of diversification.
You probably have too little liquidity.
You may have just put all your remaining liquidity towards buying a house.
You may be unaware of the degree to which liquidity in the macroeconomy will be tighter going forward (which will make it harder for your startup to raise its next round).
Quick Finance 101: There are two types of assets: liquid and illiquid. Liquid assets, such as money, can easily move around and be used in transactions. Illiquid assets, like startup equity, are tied in complex structures that are hard to move around, making them hard to turn into cash when you need to. If everyone tries to turn their illiquid assets into cash at once, the price tends to drop way down.
The conventional wisdom that employees go down with the ship doesn’t have to be true.
Here’s the deal.
When a startup takes an investment, it’s making a trade: cash for equity. The other people in the trade — the angels, the VCs, the cross-over investors — have protections you (probably) do not.
First, they buy protection from you in the form of a liquidation preference, aka, they get paid back first if you sell or are acquired.
Then, they generally create additional protection through portfolio diversification.
Finally, they are much more able (and willing) to hedge their risk in public equity markets. In other words, they have positions which tend to make money when the value of your company goes down.
They know winter comes in cycles, and they invest in protection.
To be clear, investors aren’t doing this out of some sort of moral failing or malice. They are protecting their bottom line because that’s their job.
People give them money to play with, in exchange they have to be good stewards of capital.
Which is kind of like being Steward of Gondor, but you don’t get access to a Palantir.
Well, unless you, you know, invested in Palantir.
Also instead of protecting the realm of men, they are protecting Timmy’s college fund. So there’s that.
Anyway, the next time an investor tries to make it hard for employees to sell their stock, ask them if that’s consistent with their advice as a professional. If they tell you, as an investor, that it’s a good idea to have 90% of your wealth tied up in an illiquid, undiversifiable asset (and they believe it), you probably don’t want them on your board to begin with.
Here’s the thing people miss about liquidity. Liquidity is optionality. Yes, your startup can go up another 10 or 100x in value, and wouldn’t that be great. But it’s also great to have money today, that you can do stuff with. By de-risking yourself, just a little bit, you get access to a world of possibilities that come with more options and greater protection.
The solution to this is actually pretty simple. It’s called a market.
The reason that no one is talking about diversification is because there is no structure or incentives in place to facilitate it.
On the contrary, most of the structures in place in the unicorn economy prioritize opacity and illiquidity over what you would expect in a functioning market.
Markets facilitate transparency and that transparency begets liquidity.
You don’t just deserve a market, you need one.
DISCLAIMER: I am biased. After researching #TheUnicornEconomy for months, last year I started an investment firm which enables people to hedge the very exposures I write about here. This means I have a conflict of interest.
Notes:
- There is a movement afoot to make fundamental changes to the way startups are created to avoid some of these problems. Sam Altman has some totally reasonable ideas here. Unfortunately, it is probably a little too late in this cycle for these changes to take effect in ways that help the people reading this.
#theUnicornEconomy #liquidity #theCreditCycle
