What is a Liquidity Event?
By charlie
What is a liquidity event? To understand what a liquidity event means, it’s important to first understand which category of assets venture capital investments fall in. VC investments are considered illiquid capital. In other words, you cannot convert them into cash immediately.
A liquidity event unfolds during the lifecycle of a VC fund. This is when investors get to convert their investments into liquid capital. This capital could be much more than their initial investment if the fund performs well. Liquid assets don’t always have to be in the form of cash. They can take the form of publicly traded shares as well. Liquidity events typically unfold in three main forms:
Acquisitions
Aside from high-profile public listings, acquisitions are another common way for VCs to enter a liquidation event. Compared to public listings, VC acquisition deals are typically smaller in size. However, there are certain exceptions including: PayPal’s $4 billion acquisition deal with the shopping platform Honey, and Square’s $29 billion deal with Afterpay, which is a buy now pay later platform.
When a Startup Goes Public
When does a startup go public? The answer: when its shares enter the public stock exchange such as the NYSE or NASDAQ. A startup can go public in many ways but the most common is taking the IPO road. Portfolio companies funded via VC funds like Coinbase and Roblox went public through a direct listing (where no new shares are created and only outstanding shares are sold). Other companies like SoFi stuck to the Special Purpose Acquisition (SPAC) route.
Once a startup goes public, limited partners usually enter what is called a “lockup period.” During this period, they cannot sell their shares for a period of 3 months to a year.
Transactions in the Secondary Market
Secondary market transactions appear as instances when certain limited partners have the right to sell all or a part of their stocks to an existing or a new investor. This transaction doesn’t necessarily cause a startup to experience a change of control.
When Do Liquidity Events Happen?
Venture capital funds have a lifecycle of 10 years. The initial investment period usually takes place during the first 3-5 years. Given these factors, most LPs expect a liquidity event to occur within the fund’s next 5-10 years. According to data, the median time span between the initial VC fund setup and a portfolio company going public is 5.7 years. This period, however, depends on which industry the startup operates in, the type of exit liquidity, and the current market conditions.
The same data, for instance, notes that an acquisition deal most commonly occurs during the earlier stages. Most acquisitions in the year 2021 unfolded directly after the Seed or Series A stage. Most startups, however, go public only after their Series C stage.
What Investors Need to Know About Liquidity Events
Sure, the main motivation for most investors deploying capital in VC funds lies in startup liquidity events. However, there are certain elements LPs must be aware of. These include:
Startup Founders May Not Share the Same Beliefs
Founders and investors often have different incentives when it comes to liquidity events. For instance, some founders choose to stay with an acquiring company for two main reasons: receiving earnouts and effectively running the product line.
Other LPs May Have a Different Viewpoint on When a Liquidity Event Must Occur
When it comes to VC investors, some may want a faster exit, whereas others may choose to wait longer until they hit a massive IPO. Some factors influencing the viewpoints of different investors on the right liquidity event include: the terms of a specific deal, the fund’s lifecycle, the performance of the portfolio company, and more.
Consider Liquidation Preferences, Drag Along Rights, Seniority, and Protective Provisions
When it comes to investing in a VC fund, it is critical for investors to properly negotiate three things: liquidation preferences, drag along rights, seniority of each investor, and protective provisions.
A Liquidity Event May Depend Heavily on the Broader Market Sentiment
Several market elements such as low-interest rates, increasing corporate valuations, and investor enthusiasm for specific industries can directly impact the results a liquidity event brings. For instance, VC liquidity events were valued at $289 billion in 2020. However, this figure nearly tripled in 2021, amounting to a whopping $774 billion.
The Regulatory Landscape Must Be Considered
Every liquidity event is subject to regulatory risks. For instance, the merger between Plaid and Visa (valued at $5.3 billion) was called off when the Department of Justice filed an antitrust suit against the merger. An antitrust bill can also halt any merger that exceeds a value of $100 billion. Every acquisition-based liquidity event must deeply consider the regulatory risks to ensure a merger goes smoothly.
Liquid Capital: Meaning and Examples
What’s liquid money or liquid capital?
Liquid capital is the money an investor has on hand. In other words, liquid capital refers to assets or cash that is readily available to the investor.
This capital is not money you use to pay the bills or spend on your personal expenses. Rather, it is money that can be invested in potential ventures while still being able to afford a daily life. Liquid capital is also referred to as quick assets, fluid capital, realizable assets, liquid assets, and cash required. Let’s look at some examples of liquid capital:
· Mutual Funds. Mutual Funds unlock a way to invest in a diverse portfolio such as bonds, stocks, and other securities. Investors can sell their shares any time they need and receive quick payouts. This makes mutual funds a great source of liquid capital.
· Saving Accounts. Savings accounts are a great way to store money in a low-risk, low-return place. This money can be acquired for any financial decision including investments, planned purchases, or emergencies. It is generally easy to withdraw money from a savings account, making it a convenient form of liquid capital.
· Stocks and Other Securities. Assets that are purchased and sold in a public market – like a stock exchange – are considered marketable securities. Treasury bills, bonds, certificates of deposits, exchange-traded funds (EFTs), and commercial paper are other forms of marketable securities. These shares can be sold quickly without losing much of their value (regardless of the market fluctuations), making them a good source of liquid capital.
· Money Market Funds. These funds are a form of mutual fund that is often invested in securities with lower risks. Some examples of money market funds include certificates of deposit, commercial paper, and treasury bills. Money market funds are considered as liquid capital because investors can sell their shares in exchange for cash within just a few days.
Exit Liquidity
An investor can tap into the power of exit liquidity when they have assets or securities that can be:
· Sold quickly
· At a fair market value
The main factor that impacts exit liquidity is the size and depth of the market an investor invests in. Bigger liquid markets allow investors to sell their assets at a decent market value. Why? Because large markets include a higher number of potential buyers and sellers, making way for a solid pricing mechanism.
The level of information asymmetry is another factor that affects exit liquidity. An investor would hesitate to invest in a venture when the information asymmetry is high. This is because they are often uncertain about the true outcome. High information asymmetry can lower the demand for security and stunt an investor’s ability to sell their assets quickly and at a good price.
Finally, exit liquidity depends on the terms of a VC fund agreement. For instance, if an LP is in a lock-up phase, they may not be able to sell their shares for a long time. This may hinder their chances of exiting the investment quickly.
How Everybody Wins
Investing in a VC fund involves entering a high-risk, high-reward world. Before making any investment decision, general partners and limited partners must consider the fund’s exit liquidity and understand the terms and conditions of the investment to make informed decisions. The goal here is to minimize risk and maximize returns by acquiring gains quickly and at a fair market value. At Dispensary-Growth Capital, we help investors support and gain substantial profits by investing in cannabis companies with a high growth potential. Reach out to us today to understand how our process unfolds!