Latest / The Startup Exit Podcast with Fexingo: IPOs, Acquisitions, and Founder Liquidity Events / How Founders Use Lockup Derivatives to Hedge IPO Windfalls
Transcript
- Lucas: If you're a founder who just took your company public, you're likely sitting on a concentrated stock position worth tens or even hundreds of millions of dollars — but you can't sell a single share for six months. That's the IPO lockup period, and it's one of the most stressful windows in a founder's financial life. Luna: And we've talked about lockup expirations before — how they create that big selling window. But what about during the lockup itself? Founders are just supposed to sit and watch the stock move? Lucas: That's exactly the question. And increasingly, sophisticated founders aren't just sitting. They're using a set of financial instruments called lockup derivatives — essentially contracts that let them hedge their exposure during the lockup period without technically selling shares. It's not new, but it's becoming more common and more creative. Luna: So let's define the main tools. What are we talking about — collars, prepaid forwards, something else? Lucas: Two primary structures. The first is a collar — you buy a put option to set a floor on your stock price, and you sell a call option to cap the upside. That gives you protection on the downside, but you give up some of the gains if the stock moons. The second is a prepaid variable forward — basically you sell your shares today at a discount, get cash upfront, and deliver the shares when the lockup ends. Luna: And these are all done through investment banks, right? Goldman, Morgan Stanley, the usual suspects. Lucas: Exactly. The banks act as counterparties. They structure the derivative, they take on the risk, and they often hedge their own exposure by shorting the stock in the market. That last part is what gets controversial — because when a bank shorts stock to hedge a founder's collar, it can put downward pressure on the share price. Luna: And retail investors usually have no idea that's happening. They see the stock drifting lower and wonder why, while a founder is quietly protected. Lucas: Right. And the disclosure requirements are minimal. Founders have to report these transactions in SEC filings, but they're buried in footnotes. The average investor isn't parsing a 13D or a Form 4 looking for derivative language. Luna: Let's talk about a recent example that makes this real. Palantir went public in 2020, and its stock has been volatile — it's down about 6 percent in the last five days, trading around 128 dollars. Did its founders use these hedges? Lucas: Palantir is a great case. Co-founder Alex Karp has been vocal about his long-term conviction, but the company's lockup structure was unusual — they used a direct listing, so there was no traditional lockup for existing shareholders. But many early employees and investors did have contractual restrictions. And we've seen filings where insiders entered into collars and prepaid forwards ahead of the direct listing. Luna: So let's zoom in on the mechanics. Say a founder has 10 million shares worth, at today's price, about 1.3 billion dollars. They enter into a collar with a put at, say, 20 percent below current price and a call at 20 percent above. What happens to them day to day? Lucas: During the lockup, nothing. The derivatives are just contracts. But if the stock drops below the put strike, the bank pays the founder the difference. If the stock rises above the call strike, the founder pays the bank the excess. So the founder's net position is locked into that band — they won't lose more than 20 percent, but they won't gain more than 20 percent either. Luna: And the prepaid forward — that's more like an outright sale, just deferred? Lucas: Pretty much. The founder gets cash today — usually 70 to 80 percent of the current stock value — and promises to deliver shares when the lockup lifts. The bank then holds those shares as collateral. It's effectively a loan against the stock, but structured as a derivative so it's not a margin loan. Luna: And that matters because... Lucas: Because margin loans have different regulatory treatment and can trigger margin calls. A prepaid forward doesn't — the founder already got their cash. The bank takes the price risk. Luna: So if a founder does this, what signal does it send to the market? Isn't it basically saying 'I'm not confident the stock will go up'? Lucas: That used to be the conventional wisdom. But the thinking has evolved. Ten years ago, if a CEO hedged, investors would hammer the stock. Today, institutional investors often expect it. They see it as prudent risk management. A founder with 90 percent of their net worth in one stock is taking enormous personal risk. Hedging doesn't mean they think the company will fail — it means they're being responsible with their family's finances. Luna: Still, there's a perception problem. When retail investors see a founder hedging, they feel like the insiders are getting out while they're left holding the bag. Lucas: And that's a real tension. The SEC is actually looking at whether these derivatives should be disclosed more prominently. There's been discussion about requiring a plain-English summary in proxy statements. But for now, it's still an opaque corner of the market. Luna: Let's talk about the tax side. Do these structures have tax advantages? Lucas: Absolutely. If a founder sells shares outright, they trigger a taxable event immediately — capital gains. With a collar or a prepaid forward, they can defer that tax until the shares are actually delivered, which could be years later. And if they structure it as a 'variable delivery' contract, they might even qualify for long-term capital gains treatment on the entire gain. Luna: So it's a triple win: protection during lockup, cash now, tax deferral. Why doesn't every founder do this? Lucas: Cost and complexity. Banks charge fees — typically 1 to 3 percent of the notional value. The legal and accounting work is significant. And there's reputational risk. If you're a high-profile founder like Elon Musk or Mark Zuckerberg, any hedging move gets scrutinized by the press. Also, if the stock jumps dramatically, you've capped your upside. Some founders would rather ride the volatility. Luna: Quick honest thing — this kind of deep analysis takes time to research and produce, and we keep this show free of ads because of listeners who support us. A handful of people chip in monthly through buy me a coffee dot com slash fexingo, and that literally funds making this many episodes. So if you're finding these conversations useful for what you're building or running, that's the valve that keeps it going. Lucas: Yeah, it's a small community that makes a big difference. And we don't have to chase sponsors or compromise on topics. Back to the lockup derivatives — one emerging trend I'm watching is the use of these instruments by employees, not just founders. Luna: Oh interesting. So rank and file employees with options are starting to hedge too? Lucas: Indirectly. There are now platforms that aggregate employee shares and allow them to enter into derivative contracts collectively. Companies like EquityBee and Forge Global are creating secondary markets where employees can get liquidity before the lockup ends. It's like a mini ipo for employee shares. Luna: And the SEC is okay with that? Lucas: It's in a gray area. Rule 144 still applies — you can't sell restricted securities without registration or an exemption. But these platforms structure the transactions as derivatives or loans, so technically no sale occurs. The SEC has issued no-action letters for some of these structures, but it's not universal. Luna: So what's the bottom line for a founder listening today? Should they consider this? Lucas: If you're going public and you have a concentrated position, you should at least have the conversation with your wealth advisor and your bank. The decision depends on your risk tolerance, your tax situation, and your conviction in the stock. But the tools exist, and they're being used more every year. The key is to understand the trade-offs — protection comes at a cost, and that cost is often future upside. Luna: And to be transparent with your board and your investors. Because if they find out you hedged through a footnote, that's worse than disclosing it upfront. Lucas: Exactly. The most sophisticated founders are pre-communicating their hedging plans. They say, 'I'm putting on a collar to manage personal risk, but I remain fully committed as CEO.' And the market has largely accepted that. It's a sign of maturity in the ecosystem. Luna: One last question — does this apply only to IPOs, or are we seeing it in SPACs and direct listings too? Lucas: All of the above. SPACs have their own lockup periods, usually six months to a year, and we're seeing founders and sponsors hedge those as well. Direct listings often have no lockup, but early investors may have contractual restrictions. So wherever there's a restriction on selling, the derivatives follow. Luna: It's almost like the financial industry has built a parallel universe where shares can move without technically moving. Lucas: That's exactly what it is. And as long as lockups exist, that parallel universe will keep expanding. The question is whether regulators will eventually pull back the curtain and make it more visible.