Stock Option Lending: The Fastest Growing Market in the Private Company Liquidity Toolbox

October 15, 2019 Shareworks Marketing

At this point, it has been incredibly well documented how private companies are taking longer to make the leap and launch into the public arena. Despite the recent run of IPOs that resulted in many of the biggest names becoming public companies, the number of unicorn companies has grown to over 400 worldwide.

Even more impressive than the number of unicorn companies may be the amount of revenue they are generating. Things have evolved significantly from 1999-2001, when companies were going public with little to no revenue.

Today, companies often don’t even consider launching an IPO process before they have hit $100 million in annual recurring revenue (ARR). With plenty of capital available in the private market, they can afford to pick when they want to go public. With nine-figure raises in the private market becoming a daily occurrence, the dynamic that led companies to IPO as a way to access capital has changed.

While staying private longer has a lot of advantages for companies, it is not always an ideal position for employees that have received equity as part of their compensation. When well-known companies delayed their IPO timelines after the recession, their employees found themselves wealthy on paper, but with no way to monetize it.

This dilemma gave rise to the first iteration of the secondary market, as cash-poor shareholders in high-flying tech companies began to search out investors to buy their stock. With marketplaces proliferating to connect shareholders and interested investors, companies began to take control of the situation by offering certain shareholders—mainly employees—a chance to sell their stock through company- sponsored tender offers.

Although tender offers have now become a major release valve that private companies use to provide liquidity, they can be expensive and tend to have significant impacts on a company’s 409A. While many employees will still seek out secondary markets, several companies discourage or outright block sales. Even if an employee can sell, they are often more focused on tax planning and would prefer to exercise and hold at least part of their option grant, assuming they had the cash to do so. Enter the option lending market.

Like the secondary market before it, option lending has evolved rapidly over the past several years. The market gained momentum from 2012 to 2016, with lenders providing capital to employees that were leaving their current company and who had a limited amount of time to exercise their options and pay any taxes associated with the exercise. These shareholders often didn’t have any time to arrange a sale before their options expired, so taking out a loan to cover the costs of exercising their stock became an attractive alternative for shareholders that had no other viable way to capture the value of their equity.

As the lending market picked up steam on the back of these expiring option grants, ever-increasing valuations opened up an opportunity for those same lenders to help shareholders that were getting high-priced options in these newly minted unicorns. While it was great for these employees to have options to buy stock that was worth $250,000 or more on paper, many holders were forced to just sit on those options because they weren’t in a position to afford the $100,000 or more it would cost to purchase the stock. As those holders began to look around for ways to exercise their stock and kick off the capital gains clock, the emerging lending market started to become an attractive option.

Unlike shareholders in public companies who can go to almost any bank and receive a loan for their stock, holders of private stock and options have far fewer opportunities. Currently, there are two distinct and growing groups of banks and funds that are willing to lend against your private company stock.

The first group of more traditional bank lenders typically charge a fixed interest rate on a loan and use your stock as collateral. While this is generally the cheapest choice in terms of cost, the loan is also secured by what is commonly known as “personal recourse.” That means if your stock goes to zero, you and your remaining assets are still on the hook for the loan.

The second tranche of lenders are typically structured as funds, and they offer loans that combine fixed interest and upside. In these structures, you are required to pay back the interest and hand over a certain percentage of your stock (or proceeds from the stock) at the time you gain liquidity (e.g. M&A, IPO or tender offer.) These structures tend to vary and every fund has their own preferred methodology, but one similarity across all the funds is that they remove the personal recourse requirement. This usually means that the shareholder is only putting up their stock as collateral and not their other assets. Despite the relatively high sticker price of the “loan plus upside model,” the ability to take advantage of tax planning strategies (e.g. achieving capital gains treatment) often helps to reduce the impact on the shareholder and increase the attractiveness of this option.

While the lending market continues to grow rapidly thanks to recent market conditions, shareholders should still be thoughtful about deciding to take out a loan against their stock. Most companies expressly prohibit taking a loan out against your shares, commonly referred to as “hypothecating,” without board consent, so you should talk to your stock administration team about which methods they approve. Many companies are open to the conversation and several have relationships with specific funds or banks to provide lending solutions to their employees, which will help ensure that you don’t run afoul of your company’s bylaws.

In addition to making sure to adhere to your company’s preferred procedures, you should keep in mind that taking out a loan against your stock is not a simple endeavor. The terms of the loan can be complex, and if personal recourse is involved, you must be thoughtful about the size of the loan and what type of risk you are willing to bear if the stock declines. If you have questions, you should seek out legal advice and fully understand the risks before signing on the dotted line. This could be the largest financial transaction you have ever completed, so it pays to be thoughtful and weigh all the possible outcomes before diving in headfirst.

As the private market continues to evolve, more options will become available to help shareholders gain liquidity. Every private company shareholder should think through the implications of exercising, selling or lending against their stock to make sure they pick the best path for their personal success. For private companies that need help navigating the complex landscape of equity management, the Shareworks by Morgan Stanley team is excited to continue serving as a resource.


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