Monetization and Hedging Strategies for Restricted Stock and Other Concentrated
Owners of Rule 144 or Rule 145 stock, unregistered stock, or other unsalable stock positions often seek liquidity, diversification, and tax minimization in preserving their wealth. Such holdings are often acquired in connection with the founding of a new company, from venture capital partnership distributions, as consideration in connection with mergers, acquisitions, buyouts, and compensation to executives. Tax or regulatory constraints may make it difficult to diversify such concentrated or restricted equity positions. Traditional methods of locking in gains or diversification may also be unavailable. Usually owners of these securities have only two choices: sell under restricted conditions or hold.
Restricted stock positions are difficult to liquidate by traditional means and often represent a significant portion of an individual's net worth. But a number of structured product strategies that have become popular among certain groups of investors are available that offer holders of concentrated equity positions ways to protect their assets:
The monetization and hedging strategies available to investors depend on whether they meet certain levels of suitability. Although certain strategies may be pursued for persons affiliated with the company and whose stock is involved in a proposed transaction (i.e., officers, directors, or other control persons, such as shareholders of greater than 5 percent of the company's outstanding common stock), many of these strategies relate only to nonaffiliates (i.e., individuals who are not officers, directors, or other control persons). The proposed counterparty to each strategy is assumed to be a brokerdealer or other financial organization that legally engages in structuring concentrated equity transactions. Such private transactions usually arise through introductions made by investment executives or other sales personnel to financial engineers. Restricted stock and concentrated equity transactions typically provide higher broker commissions than other, less complex types of securities transactions.
The main types of strategies and transactions available to investors for monetizing restricted stock, other concentrated equity positions, and customizing solutions to meet particular investment needs are summarized as follows:
Discounted Private Equity Sales. Discounted private sale by investor of restricted stock to counterparty who holds stock until it is freely tradable or otherwise further monetizes it or sells it pursuant to an exemption from registration; investor loses all control and equity ownership in the stock, receives less than 100 percent of the current market value of the stock, but has no economic risk in the position going forward.
Monetizing Equity Swap. Investor exchanges cash flow obligations with a counterparty relating to investor's restricted stock or concentrated equity position in exchange for the returns of another asset or diversified index; transaction generates temporary cash proceeds to the investor who retains stock ownership and voting rights but is still exposed to market price risk
Sale of Deep-in-the-Money Call Options. Investor partially monetizes and hedges restricted or clean stock position, retains control of stock and avoids taxation; investor's downside price protection is limited to amount of premium received; no investor participation in upside appreciation beyond value of premium received; at expiration investor must pay counterparty any per-share amount above the strike; investor's upside price exposure mitigated by eventual salability of stock position; moderate risk to investor.
Sale of Out-of-the-Money Call Options. Costless yield enhancement strategy to investor; investor sells the option, receives cash, retains control of stock, and avoids taxation; price protection to investor up to the strike and downside protection equal only to the value of the premium received; investor suffers loss if the stock price declines below the value of the premium received; investor's upside price exposure mitigated by eventual salability of stock position; investor retains downside stock price risk.
Purchase of Put Options. Investor obtains downside price protection on equity position by purchasing a put option; investor retains control over stock and all appreciation potential.
Zero-Cost Collar Transactions. Costless trade to investor seeking hedge protection of equity position without incurring any out-of-pocket costs (e.g., also referred to as "costless" or "cash settled" collars); investor retains control of stock and avoids taxation; investor achieves price protection by selling a call and buying a put, therefore locking in gains between put and call strikes; investor's upside price exposure through the sale of the call option is offset by the ability to sell the actual stock position; minimal risk to investor.
Monetizing Collar. A zero-cost collar transaction (see above) combined with a margin loan; proceeds to investor are typically greater than a conventional margin loan.
Short against the Box. Investor fully monetizes restricted or clean stock, locks in price, has use of cash proceeds during the term of the position, and retains control of stock; investor runs the risk of borrowed stock being called away, but risk is mitigated by deliverability of stock held as collateral; presently not a taxable event but currently being reviewed and subject to change by the Internal Revenue Service.
Trust Structures. Legal "containers" into which restricted stock can be deposited or pledged and resold as units to other investors; investor retains voting rights, partially monetizes a concentrated equity position, hedges price risk, and defers potential tax payments during the life of the trust.
Sale of Stock Through a Structured Equity Program. Provides public corporations, affiliates, and shareholders with a means to sell large amounts of stock over time in a cost-effective, consistent, and "quiet" manner; outright sale of stock through an SEC shelf registration.
Many of the strategies to be discussed involve a high degree of risk and, as such, the client will be required to have the appropriate sophistication to understand the relevant risks of the transaction and the financial ability to satisfy any payments that might be required to be made. Clients should be advised to conduct an independent review, consult their investment advisors, and reach their own conclusion regarding the legal, tax, and accounting aspects of a proposed transaction as it relates to their asset, liability, or other risk management objectives. Investors should also be aware that, as a private OTC transaction, there is no established secondary trading market for the positions established in most of the strategies to be discussed. Therefore, secondary trading liquidity for the position, if any, will be provided by the counterparty to the transaction, thus creating additional risks for the investor.
The strategies discussed in this chapter are divided between monetization and hedging. Private equity sales, the sale of deep-in-the-money and out-of-the-money call options, monetizing collars, monetizing swaps, trust structures, and stock sales from equity shelf programs produce varying amounts of cash proceeds, depending on the investor's circumstances and status vis--vis the corporation from which the underlying stock was issued. The purchase of OTC put options, zero-cost collars, and shorting against the box offer investor's price protection from market risk to their restricted or other stock holdings.
A careful marketing strategy must be developed when offering monetization and hedging strategies. A significant number of legal, tax, trading, hedging, and customer suitability issues have to be explored when engineering financial solutions to restricted stock problems. It is important that the sales personnel involved in introducing potential clients to the structuring team that handles these types of transactions be extremely familiar with the basic structures mentioned herein, among others. The experience level of clientele involved in restricted and concentrated stock trades typically includes the most sophisticated of investors who are inclined to use those firms with demonstrated expertise in structuring financial solutions to their particular circumstances. Developing restricted stock strategies is an intensive and time-consuming business. Only a small percentage of transactions that are proposed are usually consummated.
Chapter 14 discusses a number of examples of capital-raising alternatives available to corporations using structured financial products.
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