Cashing Out Shares in a Private Company: A Comprehensive Guide

Shares in a private company often remain illiquid until there is an exit event, making it challenging for early shareholders to cash out their shares. However, understanding the process and key considerations can help navigate these challenges. This article provides a detailed look into the capitalization and liquidity of shares in a private company.

Understanding the Illiquidity

Shares in a private company tend to have little or no market until there is an exit event, such as a merger, acquisition, or initial public offering (IPO). This is particularly true for early-stage startups, which may not generate profits or have high levels of liquidity. The valuation process can be complex and often requires specialized knowledge and networks within the industry.

The Exit Event: A Significant Milestone

An exit event is one of the most critical moments for early shareholders looking to cash out their shares. It can occur through a merger, acquisition, or IPO, and often involves a premium paid to the controlling shareholders. In this article, we explore the different stages and dynamics of cashing out shares in a private company, highlighting the experiences of an early-stage startup.

The Experience of Early Investors

Bootstrapping Phase (Year 1-3): Prior to the company reaching profitability, there was very little liquidity for early shares. Investors had to rely on the cash flow generated by the company and did not have spare cash to buy back shares. Shares were issued at a very low price, ranging from one penny to twenty-five pence per ordinary share.

Restructuring and Pivot (Year 3): During Year 3, the company began to pivot and restructure, leading to the buyback of some shares by the Founders at cost. This was both to accommodate early investors who wished to exit and to make room for new investors and a Management share option pool. The share price here was around 30 pence per ordinary share.

Increase in Stake (Year 5): In Year 5, after the company reported its first profit, early investors saw the business as less risky and wanted to increase their stakes. They bought shares from other early investors, with the price ranging from one to one pound per share.

Increasing Liquidity (Years 6-12): Between Years 6 and 11, the internal share price increased from one pound to 2.50 pounds due to the growing company profits and the presence of annual dividends. Sellers had to wait up to two years for buyers, but the accumulation of dividends made the shares more attractive.

Private Equity Acquisition (Year 12): By Year 12, a private equity company acquired a significant minority shareholding at 3.50 pounds per share, after a backlog of early investor exits had built up. This event provided a critical liquidity opportunity for early shareholders.

Substantial Growth and Dividends (Years 13-17): Between Years 13 and 17, the company's profits grew substantially, leading to annual dividends paid to all shareholders. The internal share price increased from 3.50 pounds to 6.00 pounds. Dividends paid in total surpassed the original investment cost, making the shares a more attractive investment.

Final Exit Event (Year 18): In the final year, all shareholders participated in an exit event, with shares valued at 10.50 pounds each, including a control premium for the strategic purchaser.

Key Considerations for Cashing Out Shares

Timing of Sales: Successful exits often require strategic timing, with many early shareholders waiting up to two years for a buyer to appear. Valuation: Exit events, particularly those involving strategic buyers, often come with a control premium. This premium reflects the value of the company as a whole and the specific value of owning a controlling stake. Dividends and Growth Trajectory: The trajectory of company growth, individual shareholder dividends received, and the overall market dynamics can significantly impact the value and liquidity of shares. Market Conditions: The larger market conditions and the industry-specific trends can also affect the ease of exiting shares. Regulatory Compliance: Ensuring compliance with all relevant regulations and legal requirements is crucial for a smooth exit process.

Conclusion

Cashing out shares in a private company is a complex and often challenging process. Understanding the unique dynamics of private company shares, the impact of exit events, and the key considerations involved can help early investors plan and navigate their exit strategies more effectively.