Disclaimer: This post, or anything else on this blog, is not financial / legal / investing / tax advice, just some pointers for you to research. Each person's situation is different and what works well for one person may not be applicable for another.
So you IPO'ed or got an exit?
Now, many people also want to use this liquidity to buy a home. This is especially true in the Bay Area where the real estate market is crazy, with the median home price in SF being around $1.2m as of today, and your typical jumbo loan requiring a 20-30% downpayment, i.e. $240k to $360k of cash on hand. I personally never had anything even close to this much cash, so I never thought buying a home was an option for me, even though I could technically afford the monthly mortgage payments (see this great rent-vs-buy calculator to run the maths for you, you might be surprised).
I've seen a lot of people sell off a big chunk of their shares, or even sometimes all of it, to buy a home or even just make a downpayment. They were then hit with a huge tax bill and, sometimes, the regret of having cashed out too soon and not having captured some of the upside of their stock.
There is a lot of research that shows that IPOs typically underperform the market in the short term (1-2 years), and that investors buying at post-IPO prices typically underperform the market in the long term (3-6 years) as well. Wealthfront has a nice blog post comparing the different selling strategies across a few different scenarios.
But if your strategy of choice is to diversify over the course of the next 3-5 years, as opposed to cashing out as quickly as possible, then that makes it much harder to get access to the cash to buy a home, unless you're willing to take a big tax hit.
Borrowing cash against assets
Margin loan 101
Let’s take a concrete example. You open a margin account and transfer in $2000 worth of XYZ stock. Your account now looks like this:
|Market Value (MV)||= $2000|
|Debit (DB)||= $0||(you haven’t borrowed anything yet)|
|Equity (EQ)||= $2000||(you own all the stock you put in)|
There are two margin requirements: the “initial” margin requirement, required to open new positions (e.g. buy stock), and the “maintenance” margin requirement, needed to keep your account in good standing. With IB the initial margin requirement (IM) is 50% and maintenance margin (MM) is 25% (for accounts funded with long positions that meet certain conditions of liquidity, which most mid/large-cap stocks do).
The difference between your equity and your initial margin requirement is the Special Memorandum Account (SMA), it’s like a credit line you can use.
SMA = EQ - IM = $2000 - $1000 = $1000.
(Detail: SMA is actually a high watermark, so it can end up being greater than EQ - IM if your stocks go up and then down).
This $1000 you could withdraw in cash (a bit like taking a HELOC against the part of your house that you own) or you could invest it with leverage (maybe 2x, 3x leverage, sometimes more).
So let’s say you decide to withdraw the entire amount in cash (again, like taking an HELOC). You now have:
|DB||= 1000||(you owe the broker $1000)|
|EQ||= 1000||(you now only really own half of the stock, since you borrowed against the other half)|
|SMA||= 0||(you depleted your credit line)|
|MM||= 500||(25% of MV: how much equity you need to be in good standing)|
Now your equity is $1000, which is greater than your maintenance margin of $500, so you’re good. Let’s see what happens if XYZ starts to tank. For example let’s say it drops 25%.
|MV||= 1500||(lost 25% of value)|
|DB||= 1000||(the amount you owe to the broker obviously didn’t change)|
|EQ||= 500||(difference between MV and DB)|
|SMA||= 0||(still no credit left)|
|MM||= 375||(25% of MV)|
In this case the account is still in good standing because you still have $500 of equity in the account and the maintenance margin is $375.
Now if the stock dips further, let’s say your account value drops to $1350, we have:
Now you’re running close to the wire but you’re still good as EQ >= MM. But if the account value was to drop a bit further, to $1332, you’d be in the red and get a margin call:
Now EQ < MM, you’re equity is short of $1 to meet the maintenance margin. The broker will liquidate your XYZ shares until EQ == MM again (and perhaps even a bit more to give you a bit of a cushion).
Bottom line: if you withdraw your entire SMA and don’t open any positions, you can only absorb a 33% drop in market value before you get a margin call for maintenance margin violation. Obviously if you don’t use the entire SMA, you then have more breathing room.
Obviously this whole thing is super safe for the broker, if they start to liquidate you automatically and aggressively when you go in margin violation (like IB would do), there is almost no way they can’t recover the money they loaned out to you, unless something absolutely dramatic happens such as your position becoming illiquid and them becoming stuck while trying to liquidate you (which is why they have requirements such as minimum daily trading volume, minimum market cap, minimum share price, which, if not met, result in increased margin requirements – IPO shares are also typically subject to 100% margin requirement, so you typically have wait if you're just about to IPO, but it's not clear to me how long exactly – might be able to get some liquidity before the hold up period expire?).
You have to run the numbers, based on the assets you have, how much would they need to tank given the amount you borrow, before you get a margin call. Based on that and your assessment of the likelihood that such a scenario would unfold, you can gauge what amount of risk you're taking, what's a reasonable balance to maintain vs not.