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Understanding Illiquidity Discounts: A Guide for Employees with Equity Compensation

When you receive equity compensation in a private company, one crucial concept that affects the value of your shares is the illiquidity discount. This guide explains what illiquidity discounts are, how they're calculated, and their impact on your equity's value.

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What is an Illiquidity Discount?

An illiquidity discount is a reduction in the value of an asset because it cannot be easily converted to cash. For private company shares, this discount reflects:

Why Illiquidity Discounts Matter

Understanding illiquidity discounts is crucial because they:

  • Affect the real value of your equity compensation
  • Impact tax calculations and planning
  • Influence investment decisions
  • Factor into negotiation strategies for secondary sales
How Illiquidity Discounts Are Calculated

Several methodologies are used to calculate illiquidity discounts:

Restricted Stock Studies Approach: This method compares the prices of restricted shares to their publicly traded counterparts. Historical studies show discounts typically ranging from 30-35%.

Example:

  • Public company stock trading at $100/share
  • Restricted shares of same company might trade at $70/share
  • Resulting illiquidity discount: 30%

Option Pricing Model: This approach uses the cost of a put option to estimate the discount.

Example calculation:

  • Stock price: $50/share
  • Cost of 2-year put option: $15/share
  • Illiquidity discount = Put option cost / Stock price
  • Discount = $15/$50 = 30%

IPO Studies Approach: Comparing pre-IPO transaction prices to post-IPO prices.

Example:

  • Private shares sold at $40/share one year before IPO
  • Same shares trading at $60/share after IPO
  • Implied discount: 33%
Real-World Examples

Example 1: Secondary Sale Transaction

Consider a software engineer at a late-stage startup:

  • Company's latest funding round: $100/share
  • Secondary sale opportunity arrives
  • Buyer offers $75/share
  • Implied illiquidity discount: 25%

Analysis:

  • Market conditions suggest 25-30% typical discount range
  • Offer falls within reasonable range
  • Engineer should consider company's growth trajectory and time to potential IPO

Example 2: 409A Valuation Impact

Scenario:

  • Preferred shares priced at $40 in recent round
  • 409A valuation needed for common stock
  • Company applies 35% illiquidity discount
  • Resulting common share price: $26

Impact on employee options:

  • Lower strike price for new option grants
  • Potentially lower tax burden for early exercises
  • More favorable entry point for new hires
Factors Affecting Discount Size

Company-Specific Factors

Stage of Development

  • Early-stage: Higher discounts (40-50%)
  • Growth stage: Moderate discounts (30-40%)
  • Pre-IPO: Lower discounts (20-30%)

Financial Performance

  • Strong growth: Lower discounts
  • Uncertain prospects: Higher discounts
  • Profitability status

Industry Dynamics

  • Hot sectors: Lower discounts
  • Declining industries: Higher discounts
  • Market volatility impact
Market Conditions

Overall Economy

  • Bull market: Lower discounts
  • Bear market: Higher discounts
  • Interest rate environment

IPO Market

Holding Period Considerations

Typical discount ranges by expected holding period:

  • 1-2 years: 20-30%
  • 2-4 years: 30-40%

  • 5+ years: 40-50%

Impact on Employee Decision-Making

Early Exercise Decisions: Consider this scenario:

Decision factors:

  • Cash required for exercise
  • Tax implications
  • Risk tolerance
  • Belief in company's growth

Secondary Sale Opportunities: Evaluation framework:

  • Compare offered discount to market norms
  • Consider company's growth trajectory
  • Assess personal financial needs
  • Calculate tax implications
Tax Considerations

409A Valuations: Lower valuations due to illiquidity discounts can reduce:

Example:

  • 409A value without discount: $50/share
  • 35% illiquidity discount applied
  • Final 409A value: $32.50/share
  • Potential tax savings on 10,000 share exercise: $52,500 (at 30% tax rate)

Secondary Sales: Discounted sales may affect:

  • Capital gains calculations
  • Holding period requirements
  • Future basis calculations
Strategic Considerations

Timing Strategies

Early Exercise

  • Lower valuation = lower upfront cost
  • Potential tax advantages
  • Start capital gains holding period

Secondary Sales

  • Balance discount against growth potential
  • Consider multiple smaller sales
  • Time sales with company milestones
Portfolio Management

Diversification

  • Use discounted valuations strategically
  • Balance concentration risk
  • Create selling strategies

Risk Management

  • Consider collar strategies
  • Evaluate insurance options
  • Plan exit scenarios
Common Mistakes to Avoid

Ignoring the Discount

  • Don't assume private shares = public value
  • Factor discount into financial planning
  • Consider impact on net worth calculations

Overvaluing Immediacy

  • Don't accept excessive discounts for quick liquidity
  • Compare opportunities across time
  • Consider structured selling approaches

Poor Tax Planning

  • Failure to consider AMT implications
  • Missing holding period requirements
  • Ignoring state tax impacts
Action Items for Employees

Documentation

  • Keep records of all valuations
  • Track exercise prices and dates
  • Document discount calculations

Regular Review

  • Monitor company progress
  • Assess market conditions
  • Update personal financial plans

Professional Consultation

  • Tax advisor coordination
  • Legal review of sales agreements
  • Financial planning integration

Understanding illiquidity discounts is crucial for making informed decisions about your equity compensation. While discounts can significantly impact the current value of your shares, they also create opportunities for tax planning and strategic decision-making. Regular review of your equity position, combined with professional advice, will help you maximize the value of your equity compensation while managing associated risks.