Latest / The Startup Exit Podcast with Fexingo: IPOs, Acquisitions, and Founder Liquidity Events / How Founders Use Structured Equity Swaps to Hedge Exit Risk
Transcript
- Lucas: So, you've signed the deal. The acquirer's stock is part of your consideration. But you don't actually get those shares for months. And in that window, the market can do something like it did this past week — Microsoft up 19 percent, Apple down over 8 percent. Luna: That kind of divergence is exactly the nightmare scenario for a founder who's agreed to take stock instead of cash. Lucas: Right. And today I want to talk about a tool that's been getting more attention in the last couple of years: the structured equity swap. It's a way to lock in a floor on the value of those future shares without selling them — and without triggering a bunch of unwanted side effects. Luna: A swap feels like a big finance word. What does it actually look like for a founder? Lucas: So, the setup is this: you're going to receive, say, a million shares of AcquirerCo at closing, which is three months away. You go to a bank and enter into a total return swap on that same stock. The bank pays you the return on the shares — dividends and any price appreciation — and in exchange, you pay them a floating rate, usually SOFR plus a spread. Luna: And at the end, you settle the difference. So if the stock drops, the bank pays you the loss, effectively. Lucas: Exactly. You've effectively transferred the economic exposure to the bank for that period. And you can structure it as a fixed for floating or a total return swap. The key is you keep the legal ownership of the shares — so you keep your voting rights, and you might not trigger change of control provisions in your contracts. Luna: That's a big deal. Because if you just sold a forward or something, you might lose those rights, and that could mess up the whole deal. Lucas: Precisely. That's one of the reasons swaps have become more popular than a plain forward contract. But, of course, there's a cost. You're paying that floating rate, which with SOFR where it is now — still elevated from the past couple of years — isn't trivial. Plus the bank's spread and any collateral requirements. Luna: So it's not free insurance. How much are we talking? Lucas: Roughly, you might be paying 4 to 7 percent annualized on the notional amount, depending on the credit of the stock and the bank. For a founder who's looking at a $50 million stock package, that's $2 to $3.5 million a year. But if the stock drops 20 percent in that window, you've saved yourself $10 million. Luna: That math makes sense. But what about counterparty risk? The bank could blow up, too. Lucas: Yes, that's the flip side. You're relying on the bank to pay you if the stock falls. So you want a solid counterparty, and you want to negotiate the collateral terms carefully. Typically, you'll post margin if the stock moves against you — meaning if the stock goes up, you might have to put up cash or securities to cover the bank's exposure. Luna: So you're hedging downside, but you could face a margin call if the stock goes up. That's a bit counterintuitive. Lucas: It is, and that's why a lot of founders prefer a collar, which we talked about in episode 142. A collar sets a floor and a cap — you give up some upside to pay for the protection. A swap doesn't cap your upside, but you're paying the ongoing cost, and you might have to fund margin calls along the way. Luna: And with Microsoft rallying 19 percent in a week, a founder holding that stock would be looking at a hefty margin call if they were in a swap. Lucas: Exactly. That's why the choice between a swap and a collar really depends on your view of the stock and your liquidity situation. Do you have cash to post as margin? Can you handle the cost if the trade goes against you? And importantly, what's your time horizon? Some swaps can be structured for up to a year, which could cover the entire lockup period if you're not selling immediately. Luna: Let's talk about the practicalities of getting one set up. It's not like calling your broker and clicking a button. Lucas: No, it's not. You need to find a bank that does equity derivatives — the big ones all do. And you'll need to negotiate the documentation, which includes things like the ISDA master agreement. But if you're doing this as a one-off hedge for an exit, you might do it under a simpler confirmation. Still, you'll need legal and tax advice, because the tax treatment can get complicated — especially if it's a constructive sale for tax purposes. Luna: Constructive sale — that's the thing where the IRS might treat it as if you sold the stock, even though you didn't. Lucas: Right. You want to avoid that, because then you'd lose the ability to defer capital gains. So the structure has to be done carefully, often with a proper opinion letter. That's another cost, but it's worth it to avoid a nasty surprise at tax time. Luna: And the whole point is to manage risk, not to speculate. So you're paying for certainty. Lucas: Exactly. And that's the lens I'd encourage founders to use. This isn't a bet on the stock going down. It's insurance against the risk that the market does something unpredictable between signing and closing — like what we saw this week, where big tech moved in opposite directions for no obvious fundamental reason. Luna: It's kind of like buying insurance on your house. You hope you never use it, but you sleep better at night. Lucas: That's a good way to put it. And, you know, it reminds me why we keep these conversations ad-free. We're not trying to sell you anything — just give you the tools to make a clearer decision. If you find that useful, and you want to support the show staying that way, you can buy us a coffee at buy me a coffee dot com slash fexingo. Luna: And we genuinely appreciate that. It keeps us independent, and that's what lets us be direct about things like the costs and the risks of these structures. Lucas: Alright, back to the swap. One thing I want to stress is that you need to think about the timing. You can enter the swap as soon as the deal is announced, but you need to be careful about insider trading rules. Once the deal is public, it's usually fine, but you should clear it with your counsel. Luna: So you can't quietly set up a hedge before the deal is announced? Because that could look like you're trading on material non-public information. Lucas: Exactly. The window opens once the merger agreement is signed and announced. But some founders might even start conversations with banks earlier, under NDA, just to get a sense of pricing and feasibility. That's okay, as long as you're not executing anything. Luna: Got it. And what about the size? You don't have to hedge 100 percent of your position, right? Lucas: No, you can hedge as much or as little as you want. Some founders hedge only the portion they need for near-term liquidity — like money they need to pay taxes or fund a new venture. Others hedge the whole thing because they're risk-averse and want to lock in a certain value. It's a personal decision, and your advisor should help you think through the scenario. Luna: And there's also the question of whether you want to hedge the acquirer's stock or the market as a whole. Because if the acquirer is a tech giant, its stock might move with the sector. Lucas: That's a great point. Some founders choose to hedge a broader index, like the S&P 500, to protect against market-wide shocks, rather than the specific stock. But that introduces basis risk — the stock might not move in line with the index. So you have to weigh that too. Luna: There's a lot to think about. But the core idea is simple: you're paying a premium to transfer risk to someone else for a period of time. Lucas: Exactly. And I think the recent market moves — Apple down 8 percent in a week, Microsoft up 19 — are a perfect reminder that the value of your exit can swing dramatically in a short time. A swap like this can smooth that out, at a cost. Whether that cost is worth it depends on your personal risk tolerance and your financial goals. Luna: So, what's the takeaway for a founder who's in the middle of a deal right now? Should they run out and get a swap? Lucas: I wouldn't say run out. I'd say start the conversation with your investment banker and your tax advisor. Ask them to model a few scenarios: what happens if the stock drops 10 percent, 20 percent, or even 30 percent before closing? What's the cost of a swap? What's the cost of a collar? Then make an informed decision. The worst thing is to not think about it at all and just hope the stock goes up. Luna: Yeah, hope is not a strategy, especially when your whole exit is on the line. Lucas: And that's why we talk about these tools. Not to push you into a complex product, but to make sure you know the options exist. Because when the market does something like it did this week, the last thing you want is to be caught off guard. Luna: And it's a good reminder that even after you sign, the deal isn't really done until the cash — or the stock — is in your account. Lucas: Exactly. So next time you're in the middle of an acquisition, take a moment to look at the stock chart. If the thought of a two-week swing keeps you up at night, maybe it's worth paying a little bit to sleep better.