For anyone who holds equity in a private company, a liquidity event is the moment everything has been building toward. It’s when that equity becomes real. Whether it’s an acquisition, an IPO, or some other transaction, it’s when your shares on paper are finally converted into money in the bank.
However, the gap between what many employees expect to receive in a liquidity event and what they actually end up getting can be significant due to the mechanics of how proceeds are distributed. This can cause uncertainty and confusion in the moment. Here’s a quick look at what to expect.
What Qualifies as a Liquidity Event?
For most private-company equity, value on paper is not money you can use. Your shares or options represent a potential future value that becomes real only when a specific kind of transaction occurs. There are a few main forms.
Acquisition: An acquisition is when another company buys yours, either for cash, for stock in the acquiring company, or some combination of the two.
Initial Public Offering (IPO): An IPO is the process of taking the company public, which converts your equity into shares that trade on the public markets.
Secondary Sale or Tender Offer: These types of transactions can create liquidity before a formal exit by allowing existing shareholders to sell some of their shares to investors or the company to buy back shares from employees at a set price.
Until one of these events happens, though, your equity is illiquid. An equity grant that looks impressive on paper, in a company where everyone is confident it will succeed, is still not really money until there is a mechanism to sell that value to someone else.
What Happens to Your Equity in an Acquisition
In an acquisition, your outcome depends on the merger agreement, your company’s equity plan, and your individual grant documents. Vested shares are typically exchanged for cash, stock in the acquiring company, or a mix of both. For vested options, one of two outcomes is most likely: cashed out for the difference between the deal price and your exercise price or converted into options in the acquiring company.
Unvested equity is usually just converted into equity in the acquiring company while maintaining the original vesting schedule. Some lucky employees have acceleration provisions that speed up vesting in an acquisition. Single-trigger acceleration vests some or all unvested equity when the deal closes. Double-trigger acceleration adds a second event requirement such as a separation or control change. This is another crucial fact to uncover well before a liquidity event arises.
What Happens to Your Equity in an IPO
An IPO converts your equity into publicly traded shares, but not the type that you can sell right away. That’s because almost every IPO includes a lock-up period, which is typically 180 days following the offering, during which insiders and employees are restricted from selling. This protects the newly-public stock from being flooded with sell orders the moment it begins trading.
Accounting for the Liquidation Waterfall
Not all equity is equal. When a company is acquired, the proceeds are not simply divided by ownership percentage. They are paid in the “liquidation waterfall” order. Debt and deal costs come first, then preferred shareholders, and then common shareholders.
This is because most venture-backed companies have raised money from investors who hold preferred shares. Those shares usually come with a contractual right to get their investment back, sometimes a multiple of it, before common shareholders receive anything.
In an exit where the sale price far exceeds the capital raised, preferences may not matter. But in an exit where the sale price is close to or below the total raised, preferences can absorb most or all of the proceeds, leaving employees with little or nothing. (Some investors hold “participating” preferred, which lets them collect their preference and share in what remains, reducing common payouts even in good outcomes). In an IPO, preferred shares generally convert to common, so the waterfall usually doesn’t apply.
A Word on Taxes
Much like the old saying, “where there’s smoke, there’s fire,” where there’s liquidity, there’s tax. Not always, but almost. What you owe depends on what you hold, when you acquired it, and how the deal is structured.
Incentive stock options (ISOs): If you exercise and then hold the shares more than one year after exercise and two years after grant, your gain may be taxed at long-term capital gains rates. Exercising can trigger the alternative minimum tax (AMT), so the timing needs planning.
Non-qualified stock options (NSOs): The difference between your exercise price and the share value at exercise is taxed as ordinary income. Growth beyond the point of exercise is capital gains.
Restricted stock units (RSUs): At many private companies, RSUs don’t pay out until an IPO or sale. But regardless of when paid out, the full value is taxed as ordinary income when vested.
Qualified Small Business Stock (QSBS): If your shares qualify, you may be able to exclude much or all of your gain from federal tax. Eligibility depends on the company’s size when the shares were issued, its business activities over time, and how long you’ve held the shares. For options, that clock starts at exercise. Some states, including California, don’t recognize the exclusion.
Options in an acquisition: Options cashed out in a deal are generally taxed as ordinary income, so the opportunity to improve your outcome usually comes well before the deal.
These are not decisions to make in the days surrounding a transaction. They benefit from advance planning, ideally with an advisor who understands both your equity structure and your broader financial picture.
Before the Liquidity Event Arrives
The common thread across acquisitions, IPOs, and secondary sales is that those who fare best are the ones who understood their position on the cap table before the event forced the question.
That means knowing what you hold and on what terms. Knowing your place in the liquidation waterfall. Knowing whether your unvested equity accelerates. Understanding the tax treatment of your specific shares. And, when a significant event is on the horizon, consulting a financial advisor, an accountant, and when appropriate, an attorney, who can help you make decisions with clarity rather than under pressure.
For many equity holders, a liquidity event is the single largest financial moment of their lives, and it deserves the same preparation you would bring to any decision of that magnitude. The time to understand what your equity will do for you is well before the day it finally does it.
Composition Wealth, LLC (“Composition Wealth”) is a registered investment adviser. Advisory services are offered only to clients or prospective clients where Composition Wealth and its representatives are properly licensed or exempt from licensure. The content is for educational purposes only and should not be considered investment, financial, tax, or legal advice. It should not be treated as a solicitation to buy or sell securities and does not consider individual investment objectives, strategies, tax status, or horizon. Please consult your own tax, legal and accounting advisors before making any related decisions.
Composition Wealth and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.