One Way to Think About Equity Hedging
What happens after you sell your company to a publicly traded one and, in the deal, you take stock in the acquirer? You just invested in the acquirer! The details make all the difference. Here are a few of the key elements seen in these transactions:
- Your stock is restricted for a period of time, meaning you cannot sell for a specific period.
- You may have more stock that will vest at some future point in time.
- You may also have restrictions against doing certain things to hedge your risk in that position.
Hypothetical situation
In a hypothetical scenario, your business is Gold Standard Programming, a SaaS company that builds software for construction fleet management. You just sold it to Dark Iron, another SaaS business with a suite of services for large and mid-size construction companies.
Gold Standard has a superior product to the internal Dark Iron solution. They just made you a fantastic offer to sell, merge Gold Standard and become their vice president of fleet management. The deal is for $28M with $6M up front in cash, $15M in Dark Iron stock up front, $5M in Dark Iron stock that vests in one year (if you meet certain targets) and $2M paid over the next year as an employment agreement.
The Dark Iron stock has been an average performer against peers for the past few years. It has an experienced management team, so you feel comfortable taking a stock-heavy deal and getting a higher total purchase price for Gold Standard. You do not know what you want to do next, and you are happy to work for a year to make sure the transition goes well for your existing team and clients. Working for a year also ensures that your product gets into the Dark Iron ecosystem effectively. The targets should be a layup to complete, and you feel good about capturing the full value of the deal over the next year.
Risks
The kicker to all this is one thing you cannot control - how Dark Iron stock will perform over the next year. Your shares have a restriction that you cannot sell them for a year from the deal date and not for another year for the $5M in stock (contingent on targets). You will have a total of $20M of wealth tied up in a single stock for the next year and $5M tied up for two years.
Here are a few of the top risks that you now face for that period of time:
- General market downturn
- Industry market downturn
- Company specific performance
- Company merger or acquisition event
- Litigation against the company
Protection strategies
So how do you go about protecting yourself and ensuring you get the full value for Gold Standard? Again, it will depend on the terms of the specific deal you have, but there are some strategies you can use. Group the above risks into two categories (those that only apply to Dark Iron and those that pertain to a group of peers or the market as a whole). Start with the bottom three, as they only apply to Dark Iron.
Some deals place restrictions against hedging your company-specific risks with derivatives, and some do not. In simple terms, a derivative is a financial instrument based on another financial asset. In this case, we are talking about using stock options to hedge the risk that Dark Iron stock may decline significantly in value over the next one-to-two years.
An option is a contract you purchase for a price. Think of it, in this case, as an insurance contract. You pay a premium for the right to sell the stock to someone else at a specific price at a future date. In this case, you would decide how much you are willing to let the Dark Iron stock decline in value, and lock that price in.
For the sake of simplicity, let us say that Dark Iron is trading at $100 per share at the time of your transaction. You are willing to let it fall a maximum of 30% from that point, and you have no interest in holding the shares longer than the required holding period in the deal. In this case, let us say that you can buy put options that allow you to sell the $15M of Dark Iron stock in one year for $80 per share for a premium of $2 per share. You can also buy options that allow you to sell the remaining $5M of Dark Iron stock for $80 per share in two years, but those have a premium of $7 per share.
Here is the range of outcomes that can happen once you put this in place:
- The stock goes up in value and you sell at a higher price than your transaction.
- If Dark Iron is trading at $108 when you sell, your proceeds are $106 per share on the first $15M and $101 per share on the second $5M.
- The stock goes down in value but less than 20%. You sell at a lower price than your transaction, but you stay above your desired $80 per share.
- If Dark Iron is trading at $90 per share when you sell, your proceeds are $88 and $83 per share, respectively.
- The stock goes down in value by more than 20%, and you exercise your options to sell at $80 per share.
- If Dark Iron is trading at $50 per share, your proceeds are $78 and $73 per share, respectively.
What you are trying to do with the use of these option contracts is avoid a worst-case scenario, where the value of the stock declines past the point that the deal works for you. You pay for insurance with the put option contracts and hope that they expire as worthless.
Restrictions and risks
What if, in this hypothetical scenario, you are restricted from using derivatives to hedge the risk present? This is where it would get quite a bit tricky. If you are trying to hedge company specific risks, there will likely be some that you just cannot hedge completely.
Depending on the specific risks present, you could choose to purchase derivatives tied to Dark Iron’s closest competitors, using call options so that you benefit if the stock price of those competitors increases. The idea is that if something damages Dark Iron, their competitors will gain in relative value. This is an imperfect hedging strategy, because the stock price of one company is not perfectly tied to the stock price of another.
As we look at risks to the industry, we can start to look at hedging using options tied to a specific market index that represents the performance of the companies in that index. For general market risk, you can also use broad-market index hedging strategies which allow you to cap your downside risk due to overall economic conditions.
Whenever you are taking equity in an acquiring company and do not have the ability to immediately sell that equity, you are taking on a new risk that should be accounted for and managed. The worst outcome is that you take a stock-heavy deal, and by the time you can use that capital, it has declined past the point where you can do the things you want to do (like starting your next venture, purchasing real estate or making large philanthropic donations). Whatever your vision for the exit is, the capital needs to create the outcomes you are seeking, and managing your stock specific risk is part of that process.
If you have a question or simply want to talk through your financial planning, we are here to help.
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DISCLOSURE: Jarrod Musick is an officer of Destiny Capital and Entrepreneur Aligned, a DBA of Destiny Capital. This article is for informational purposes only and should not be relied upon as a basis for your investment, business, or personal financial decisions. We recommend consulting with your wealth advisor, CPA/tax advisor and/or attorney, as applicable to your situation, prior to implementing any new tax, legal, or investment strategy. Advisory services provided by Destiny Capital Corporation, a Registered Investment Adviser.
ABOUT JARROD
Jarrod was born into financial planning and solving financial problems. With his financial advisor father Steve telling stories about finance around the dinner table from an early age, the idea that everyone has a different financial situation was always there. After an early professional career spent in nonprofit and government, Jarrod came back to his roots helping people plan and invest in 2011. Since then, he has worked with individual clients, led internal teams and ultimately became partner and the CEO of Destiny Capital in 2017. With a passion for helping entrepreneurs change the world, Jarrod ultimately oversaw the creation of Entrepreneur Aligned in 2020. With both Destiny Capital and Entrepreneur Aligned, Jarrod leads teams that help people live lives of abundance where money is simply a tool to let everyone be a positive force for the world around them. When he isn’t working with the talented teams for EA and DC you can find him chasing his twins, wily trout or a podium spot at an OCR race.