The Price of Liquidity

11 min read
June 30, 2020

The Price of Liquidity

10 MIN READ

A liquidity premium is a term that describes the amount of money you get paid to lock your money up for a period of time. If you are giving up liquidity, or your ability to sell your investment for cash, you should be compensated. And this makes sense - because by locking up your money, you are exposing yourself to market risks and/or opportunity costs that wouldn’t exist if your money was readily available.

The analysis of liquidity was a big part of my work as a risk manager in the hedge fund world. We had clients who had expectations that we would be able to return their money upon their demand within one quarter’s time. This meant that the portfolio we managed needed to have a large portion that was liquid enough to meet that expectation. At the same time, it was our job to make as much money as we could, given a certain level of risk. Many times these were competing goals, so we had to pick and choose which liquidity premiums were really worth it. If we selected an investment that had great performance despite the illiquidity, our clients had no issue, because they didn’t ask for their money back. However, if we selected an investment with lesser performance, our client would redeem, at which point we wouldn’t actually be able to return their money which would lead to a much bigger mess. Understanding the risks to be compensated for that liquidity premium was very important. 

Institutions think about liquidity premiums often because there are clients who rely upon their liquidity needs being met. This construct requires process and so each portfolio typically has an investment policy statement and decisions are made by an investment committee. While it would be amazing if individuals were as disciplined as institutions, it’s not reasonably practical to assume that all decisions we make in our lives are based on committee agreement. That said, there are lessons we can learn from our institutional counterparts.

In our lives, there are major financial decisions where considering the liquidity premium could serve you well. In this blog we’ll give you three examples of decisions you might face and walk you through our thought process in how we think about choosing your liquidity premiums wisely.  

Earning Stock in a Private Company

As an employee of a private company, you might receive stock as a portion of your compensation - and you may not have a choice. Typically stock is granted on a specific date and then vests over a period of 3-4 years. The vesting date is the day that you officially start to own the stock and as a result of your additional compensation received, there may be tax consequences. The issue with private stock is that even though you are receiving shares that have value, you can’t actually do anything with those shares to prove their value. Private stock is inherently illiquid, which means that until a time presents itself that you can sell, you have to foot the tax bill personally. Because of this mismatch of cash available versus cash due to the IRS, understanding the liquidity premium you are receiving as part of this transaction is important. We highlight the main points in time where you will be able to make decisions around liquidity. 

The first is an 83(b) election. When you are granted stock compensation, you have 30 days to submit an election that front loads the taxes you pay on the stock you were granted. This strategy requires that you pay the tax on your full stock grant in the year of the election, rather than gradually as you receive your stock. If the stock price goes up over your vesting period, you will have saved ordinary income taxes along the way. However, if the stock price goes down over your vesting period, you will have paid ordinary income tax at the higher valuation - and unfortunately, you will not be able to recoup these taxes paid. Similarly, if you were to quit your job or get fired, you would most likely lose your unvested shares and not be able to recoup the tax consequences. 

Questions to consider:

  1. Can I afford the tax payment out of my ordinary income?

  2. How would this impact my financial situation if my shares went to zero?

  3. What are my expectations for the stock price over the vesting period?

  4. What are opportunities in the future to sell my stock? 

Once your stock is vested, it belongs to you. The tricky part is that your private stock is governed by legal documents that may restrict you from selling or transferring without agreement from the decision makers of the company. However, as private companies grow, oftentimes growth is funded by raising capital. When this happens, you may receive a second chance to think about liquidity:  a Tender Offer

Tender Offers are a way for early employees to receive cash for their stock at a predetermined value, to provide liquidity to the company and to employees without diluting existing investors (through issuing new shares). A fair market value will be assigned and you will be able to sell some or all of your shares to investors at that price. 

 Questions to consider:

  • How much of my net worth is tied up in company stock?

  • If I continue to work here, how much of my net worth will be tied up in company stock upon full vesting?

  • If I were given a cash bonus equal to the fair market value of the tender offer, would I buy my company stock with it? 

  • What are the terms of your stock agreement and how would your benefits and tax obligations differ if you waited for an IPO? 

Presuming you held onto your company’s stock through the tender offers, your next opportunity for liquidity is after the IPO. It’s important to understand the ramifications of an IPO before you go into it. Every company is different and the terms of your stock depend specifically on the terms of the legal agreements in place. This is a unique time period that liquidity becomes a real attribute, while at the same time you have to balance your tax consequences with a decision around liquidity. Most companies withhold a certain percentage of stock to help you proactively cover the taxes you owe, but depending on that percentage versus your tax bracket that year, you may still owe additional taxes.  The statutory rate is 22% for federal tax, so if you fall into the 37% tax bracket there is a big gap to fill. For companies with ‘double trigger’ provisions that postpone your vesting and taxation until two events occur: 1) time and 2) performance like a change in control or IPO, this can be a significant dollar amount. Company insiders and employees are usually subject to a 180 day lockup period following the IPO. If the IPO occurs in the same tax year as the lockup expires, you’ll have an opportunity to sell your stock to meet your tax needs. Once the stock hits the public markets, the market will set its price. If the price goes up, this will certainly benefit you, but if the price goes down, you may have to sell at a level you didn’t expect. We recommend developing a plan in advance, with the help of a financial professional who has experience in stock compensation and taxation. 

Questions to consider:

  • How much of my net worth is tied up in company stock?

  • What will be the expected tax consequence of an IPO? How will I pay for this?

Earning stock in a private company is a great way to build wealth if liquidity presents itself, but comes at the risk that it may never happen. Build an understanding of exactly what you are receiving, how it is taxed, and the opportunities you will have to convert that stock into cash. Liquidity doesn’t come often in private companies, but doing your research in advance of these opportunities will provide you with greater flexibility when they come. 

Investing in Real Estate

While earning stock may not be a choice, buying real estate is oftentimes one of the biggest financial purchases an individual chooses to make. As a primary residence buyer, you’re purchasing a place to live. To qualify as a primary residence, you have to live there for most of the year and it needs to be a convenient distance from your employer. (Sorry to all those Californians looking for primary residence in Nevada or Arizona - it very likely will not qualify). Rental real estate has similarly stringent rules. In order to classify a property as a rental real estate property, you may use this property personally for no more than the greater of 14 days per year, or 10% of the total days rented to others at a fair market value. Anything in between is considered a residence for tax purposes (but not a primary residence), and loses many of the tax benefits that come with other types of real estate. 

Your first evaluation of the liquidity premium relates to your down payment. In order to buy real estate without having to buy additional insurance, you’re typically required to put down 20% of your home's value for a primary residence, or 25% down for a rental real estate property. This can be a significant dollar amount, but also can have tremendous benefits. 

Questions to consider:

  • What percent of your total savings are you putting towards this downpayment? 

  • If a 20% down payment depletes your savings, what is the cost of insurance of a lower down payment? What homes could you afford with a lesser down payment? 

  • If you saved for 1-2 more years, how would this change your long term experience of owning property?

  • What will the total annual cost of owning property be including property taxes, homeowners and other related property and casualty insurance, repairs, utilities, HOA and other costs?

The remaining balance will be financed through a mortgage, which can range in term (5-30 years) and structure (fixed vs floating rate). Primary residence buyers are typically deciding between a 15 year versus 30 year mortgage. 15 year mortgages can offer lower rates of interest, but require a higher monthly payment since you are paying off the same principal value of the loan twice as fast. Rental real estate can have unique terms depending on your level of experience and sophistication in the current market.

Questions to consider:

  • What will my monthly cost be over different mortgage terms? 

  • What percent of my monthly take home income will be allocated to covering this mortgage?

  • If I am deciding between a primary residence and rental property, will I be relying upon the income from the property to cover the cost of the mortgage? How will a delay or absence of renters impact my financial situation? 

  • If I invested the total annual cost elsewhere, how would this compare to the income and home equity that I earn in my home? (Don’t forget the tax benefits). 

Owning real estate gives you a real asset that provides diversification to your stock and bond portfolio, as well as protection against rising inflation, since you have a fixed monthly payment.  The primary risk is not being able to make your payment, so being clear on the affordability of the monthly payment - even if a life emergency were to happen - is incredibly important. The opportunity cost is unique for everyone, but we encourage you to think about what your life looks like over the next 5-10 years. Investing in real estate has a high upfront cost due to fees, inspections, decorating and very likely some renovations and repairs. We always recommend having extra cash on hand to account for these unknowns.  

Spending Versus Saving

 Our last two examples were investment-related -- private stock & real estate, both quite illiquid investments. So why are we talking about spending vs. saving? 

Cash is liquidity. 

We’re not saying you should keep mounds of cash sitting around without purpose -- this is actually bad for your net worth, but your decisions around how you spend and save are extremely important when it comes to making decisions around liquidity in other areas of your life. Every month as you get your paycheck, you have the option to spend or save. For many individuals, seeing a balance in their checking account means they can spend it. We encourage our clients to set up automatic transfers to their savings and investment accounts to help facilitate the saving process. By creating the automatic transfer, establishing savings to cover emergencies and any near term cash needs and investing the rest in a taxable brokerage account, you are giving yourself the flexibility to take the risk of illiquidity elsewhere. 

If you were to save an extra 10% or 20% of your take home pay each month, what would this enable you to do in the next 5 years? 10 years? Could you pay down your mortgage faster to save on interest payments and have more equity in your home? Could you cover the tax burden of your stock compensation to stay invested in a company you are confident will continue to grow? Could you do both? Your options are endless when you have liquidity. 

Thinking holistically, weigh the pros and cons.

As a tech employee you will almost certainly face all three of these decisions in your life. But with the rise of stock compensation and private equity in the United States, it’s likely that many of you in and outside of tech will have these same considerations. We encourage you to think through each of them like an institution. 

What are the risks?

  1. What happens if we go into a recession, housing crisis, you lose your job or your company goes under? Do you have enough cash on hand to support you in a time of stress? 

  2. Are you overly concentrated in a single asset or investment? Will a change in this asset’s value materially impact your ability to achieve your most important goals? 

  3. If you forego the opportunity for liquidity when it presents itself, is it possible that this time will be the last? 

What are the opportunity costs?

  1. If you were given a bonus of $X of cash today (actually assign a dollar amount), what would you do with it? What would you want out of it? 

  2. What other obligations or goals do I have where this money could be used instead?

What are the benefits?

  1. How will choosing these investments serve your biggest goals?

  2. If given the choice, how do the returns of these investments (net of tax) compare to the returns of a similar investment with better liquidity? 

When you’re in the mix of making big financial decisions, it’s common to have an emotional connection to your potential new home or to the company where you’ve worked for so long. But sometimes reframing these decisions by thinking about cash - including the time it takes to work towards saving a specific amount - and the many possibilities that cash can provide you and your future, can be a good place to start. Illiquidity is not a bad thing, but it’s a more permanent thing, so get compensated for it.

Stephanie BuckoAbout the Author
Stephanie Bucko is a fee-only financial planner based in Los Angeles, California and is the Chief Investment Officer of Mana Financial Life Design. Mana Financial Life Design provides comprehensive financial planning and investment management services to help clients organize, grow and protect their wealth throughout life’s journey. Mana specializes in advising professionals in the tech industry, as well as women who work in institutional investing, through financial planning and investment management. As a fee-only fiduciary and independent financial advisor, Stephanie never receives commission of any kind. She is legally bound by her certification to provide unbiased and trustworthy financial advice.

 

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