The Liquidity Dilemma With Startups

What is liquidity and why is it important

Liquidity refers to how quickly and easily an asset can be converted into cash.

Liquidity matters when holding any kind of asset because it gives the owners comfort to know that there’s an easy way to convert their holdings into cash should there be a need to (let’s say they have a sudden family emergency or need to put a down payment on a home, for example). Some assets are considered easily tradeable (i.e. liquid) if there’s an investor base readily available to buy them on the spot (such as equities listed on public exchanges), whereas other types of assets are considered not so easily tradeable (i.e. illiquid) if there isn’t an investor base readily available to buy them (such as a piece of land).

The difference in liquidity between private and public companies 

When startups raise capital, they often look to the private markets and exchange equity for capital from investors. This happens systematically through “rounds” at predetermined, forward-looking valuations that determine the exchange rate of equity to capital.

The investors (whether individuals, institutions, venture capital funds, or other) that invest at each round essentially become shareholders in the company, each with a specific share class and associated rights based on the round at which they entered.

Unlike shares in companies listed on a public stock exchange (where you have a large number of buyers and sellers, information symmetry, and automation that results in easy conversion of shares into cash), private company shares are not liquid. This is due to a variety of factors including (but not limited to) a smaller number of buyers and sellers, information asymmetry, lack of price discovery mechanisms, as well as administrative and legal hurdles.

Lack of liquidity is a risk factor for startups 

Usually, a startup’s stakeholders (e.g. investors, founders, and team members) hold onto their equity in the company until it’s acquired or goes public. Often, they have no control over when this happens. Access to liquidity could also sometimes be achieved in parallel to a fundraising round; although, again, this is buyer-driven and happens at specific times in a company’s lifecycle, if at all. Therefore, they have limited control in the liquidity of their equity, which makes the private markets rather inefficient.

Irrespective of the business risk at the various stages of a startup’s lifecycle (risks are always higher in the early days, before product-market fit and scalability are proven), the liquidity risk exists so long as the company is privately held. Investing at the later stages comparably reduces the risk of your capital being illiquid for as long as it would have been had you invested earlier.

The MENA regional average to achieve liquidity in venture-backed companies was historically around 7 years according to Magnitt, with their latest Emerging Ventures Market Report showing record exists in 2022, a large percentage of which was achieved by companies founded within 5 years or less. The trends however are continuously changing and are driven in part by macroeconomic trends and investor sentiment. This means that if you are an investor or a startup employee that holds equity, you’re likely not able to access cash for years during certain periods of time. This is particularly true for investors and team members who come in at the very early days of a startup, such as friends & family investors and angels). 

'Liquidity as a service’ to startups and the wider ecosystem

To be clear, private markets are private for a reason and young companies benefit from a stable long-term shareholder base and limited volatility in their valuation between rounds. To extend these benefits, it is therefore critical that access to liquidity does not negatively impact the company, and instead, brings positive impact, transparency, and better engagement across stakeholders. 

With the above in mind and looking at recent trends in this ever-evolving investor landscape, controlled liquidity in the private markets can help drive growth within the startup ecosystem as a whole. That is because millions (or even billions) of capital will no longer be locked up for as long anymore. With this freed-up capital, investors can re-invest into other new startups, further enabling the recycling of capital for a young and vibrant ecosystem of startups to thrive. Additionally, founders and startup employees who own equity can focus on achieving long-term growth for their startups, as opposed to focusing on locking in the first exit opportunity that comes through the door, just to bring in liquidity.

Bringing liquidity to private markets

Zest is bringing controlled liquidity to startups, aligning different stakeholder interests to create positive impact across the venture ecosystem. Our platform allows for existing stakeholders (investors, founders, and employees) of later-stage private companies to benefit from liquidity (crystallize paper gains) through our platform’s secondary marketplace in a pre-approved and transparent manner. 

What does this mean in practice?

Zest looks at the underlying company as the ultimate client. We work with companies to determine liquidity needs based on their priorities and requirements. Are your employees happy? Do you have issues with retention? Do you have early investors that have certain liquidity requirements? How can liquidity help keep you focused on sustainable growth - and not necessarily, an exit at all costs? 

Whether you're an investor, founder, or employee, Zest is building the infrastructure to allow for private market liquidity, join us here.