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?
Good for you, your shares are now convertible to real $$. The generally accepted strategy is to sell your stock and buy a low-cost diversified portfolio to avoid the risk of keeping all your eggs in the same basket. You can either do it yourself by buying Vanguard funds, or use a service like Wealthfront (disclaimer: referral link) to do it for you.
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.
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
Enter the wonderfully dangerous world of lines of credits you can get against your (now-liquid) assets. I didn't even know this was a thing until a couple months ago, but there is a plethora of financial products to get liquidity by borrowing against your stocks. SBLOC (Securities-Backed Lines of Credit), PAL / LAL (Pledged / Liquidity Asset Line), pledged-asset mortgage, etc. And margin loans. They all come with slightly different trade-offs but the basic idea is essentially the same: it's a bit like taking an HELOC (Home Equity Line of Credit) against your assets. If don't know what that means, don't worry, keep reading.
I'm going to focus on margin loans because that's what I've researched the most, the easiest to access and most flexible, and the best deal I've found in my case, with Interactive Brokers (IB) offering interest rates currently around 2% (indexed on overnight Fed rate).
Your brokerage account typically starts as a cash account – i.e. you put cash in (or you get cash by selling shares) and you can use cash to buy stocks. You can upgrade your account to a margin account in order to be able to increase your buying power, so that your broker will lend you money and use the shares you buy as a collateral. But that's not what we're interested here, we already have shares and we want to get cash.
Margin loan 101
I found it rather hard in the beginning to grok how this worked, so after being confused for a couple weeks I spent a bunch of time reading select chapters of a couple books that prepare students taking the “Series 7 Examination” to certify stockbrokers, and the explanations there were much clearer than anything else I could find online. It’s all very simple at the end and makes a lot of sense. As I mentioned earlier, this works mostly like a HELOC but with investment leverage.
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:
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:
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%.
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, your 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.
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:
| MV | = 2000 | |
| 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:
| MV | = 1350 |
| DB | = 1000 |
| EQ | = 350 |
| MM | = 337.5 |
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:
| MV | = 1332 |
| DB | = 1000 |
| EQ | = 332 |
| MM | = 333 |
Now EQ < MM, your 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.
Negotiating margin terms
I very recently figured out that while Interactive Brokers seems the only one with such low interest rates (around 2% when everybody else charges 5-8%), with the exception perhaps of Wealthfront's Portfolio Line of Credit clocking in at around 3-5%, you can actually negotiate the published rates. I've read various stories online of people getting good deals with the broker of their choice, and usually the negotiation involves transferring your assets to IB and coming back to your broker saying "this is what I get with IB, but if you are willing to earn my business back, we can talk".
I did this with E*TRADE recently, they not only matched but beat slightly IB's rate, and made it a flat rate (as opposed to IB's rate being a blended rate, which would only beat my negotiated rate for really large balances) along with a cash incentive and a couple months of free trading (I'm not an active trader anyways but I thought I'd just mention it here). Morgan Stanley was also willing to give me a similar deal. I'm not a big fan of E*TRADE (to say the least) but there is some value in keeping things together with my company stock plan, and I also appreciate their efforts to win me back.
Buying a home
So once you have access to liquidity via the margin loan, the cool thing is that you don't pay anything until you start withdrawing money from the account. And then you'll be paying interest monthly on whatever balance you have (beware that the rate is often based on daily Fed / LIBOR rate, so keep an eye on how that changes over time). Actually, you don't even have to pay interest, it'll just get debited from your balance — not that I would recommend this, but let's just say the terms of this type of loan are incredibly flexible.
You can then either do a traditional mortgage, where the downpayment comes in part or in full from the margin loan – generally speaking lenders don't want the downpayment to be borrowed money, but since the margin loan is secured by your assets, that's often fine by them (I've had only one lender, SoFi, ironically, turn me down due to this, other banks where fine with it), or if you have enough assets (more than 2x the value of the property) borrow the entire amount in cash, make a cash offer (unfortunately a common occurrence in the Bay Area), and then get a mortgage within 90 days of closing the deal. This is called delayed financing, and it works exactly like a mortgage, except it kicks in after you closed on the property with cash. This way you pay yourself back 70-80% of the amount, enjoy mortgage interest deduction (while it lasts) and the security of having a fixed rate locked for 30 years.
I know at least two people that are also considering using this trick to do expensive home remodels, where it's not clear just how expensive exactly the work will be, and having the flexibility of getting access to large amounts of cash fast, without selling stocks / incurring taxable events at inconvenient times, is a great plus.
This whole contraption allows you to decouple your spending from the sale of your assets. Or you may decide to pay the loan back in other ways than by selling assets (e.g. monthly payments using your regular income), thereby preserving your portfolio and saving a lot in taxes. Basically a bit like having your cake and eating it too.
So you IPO'ed or got an exit? Not even in my dreams...
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