The rise of startup equity compensation and private equity stakes among investors has become a centerpiece of wealth creation and management for executives, founders, and early employees. In these scenarios, it is key for investors to use “listed options” where they can overlay a hedge onto illiquid positions that make up the downside profile of startup equity compensation and private equity stakes. These listed options can protect the value of these positions during uncertain market periods.
The illiquid options we previously mentioned result in traders having no easy way to reduce their risks until there is a buyout, a secondary sale, or an IPO. This is why traders must take advantage of listed options, which serve as a public-market overlay for private holdings. Our guide will cover everything you need to know about using the listed options as a guide to increasing the upside and decreasing the downside in private equity and startup stock grants.
Understanding the Challenge of Startup & Private Equity Exposure
There are considerable risks of holding private equity and startup stock. It’s by understanding the challenges of startup and private equity exposure that traders can begin to know the boundaries of using listed options as a strategy. Unlike publicly traded shares, private and startup equity have three unique risks:
- Concentration: There are many employees in the markets who have anywhere from 80-100% of their net worth tied up in a single startup.
- Illiquidity: They come with long lock-up periods where shares are locked up until a liquidity event happens. Low liquidity and the lack of daily pricing are two of the biggest risks for investors when it comes to start-ups and private equity.
- Valuation Volatility: Each fundraising round can bring with it paper valuations that swing wildly. This event can leave some holders completely exposed. High valuation uncertainty and the volatility surrounding it can present one of the biggest risks for traders.
For investors and employees alike, hedging startup stock is about protecting against macro downturns and sector-specific crashes—risks that can erase millions in paper wealth overnight.
Why Listed Options are a Powerful Hedging Tool
Using listed options for hedging can offer a degree of flexibility that private markets simply don’t offer. You can enjoy the liquidity and accessibility of exchange-traded options for accomplishing this goal, mimicking exposure to correlated public companies. See exactly why listed options and ETFs can be a great combo for hedging:
- Customizability: Traders or investors can size options positions to ensure a better match in terms of values for the holdings they have in private equity.
- Scalability: Listed options offer a scalable overlay, and this could apply to something as small as a $200k investment or upwards of $20 million in founder shares.
- Liquidity: Price updates can occur in real-time with deep markets. This applies to indices as well as ETFs.
- Serves as a Proxy Hedge: Listed options can smooth the volatility of otherwise liquid positions, serving as a sound and reliable proxy hedge. In other words, traders can use listed options as public market hedges for private equity.
Correlation as the Bridge—Mapping Private to Public
The trick of mapping public to private equity through listed options is to find a correlated proxy that does not own the same security. Finding a publicly traded proxy can be done by focusing on sector ETFs, competitors, or indices. We’ve outlined a few examples below to give you an idea of how you can use correlation as a bridge to go from the private to the public.
Examples
- Fintech startup equity → hedge with options on SQ (Block) or FINX ETF.
- Biotech fund stake → hedge with XBI or IBB biotech ETFs.
- SaaS startup → hedge with QQQ or IGV software ETF.
- Consumer-tech startup → hedge with XLY consumer discretionary ETF.
There’s something called “basis risk” that comes into play, and this is due to correlation never being perfect. It might pose some challenges for traders, but many investors can have a correlation that’s close enough, and this can provide a stable hedge protection if there’s a downturn in the market. It doesn’t have to be perfect or seamless to be completely effective.
Practical Hedging Strategies with Listed Options
Let’s take a look at a few of the practical strategies that options traders can use when hedging using listed options. To give you a good idea upfront, these tactics include protective puts for hedging, a collar strategy for private equity, and options hedges for illiquid equity. We’ll go over these in greater detail to see how you can realistically use the listed options for strong hedging purposes.
- Protective Puts: Using this strategy can offer good downside insurance through sector/index puts. Traders must buy sector or index puts to cap downside risk, with a good example being a trader who buys QQQ puts while holding SaaS startup equity.
- Covered Calls: Another good method for hedging with listed options is by using a covered call, where you can generate yield while offsetting private equity risk exposure. This is done by writing calls against correlated ETFs, and it can help to offset private equity risk by producing steady income for the investor.
- Collars: Defining a band of expected outcomes for private-equity-linked exposure is another way for traders to hedge through the power of listed options. They can create a hedge that is cost-effective by combining puts with covered calls. This tactic is popular for locking in a valuation brand.
- Calendar & Diagonal Spreads: This strategy can be useful when a liquidity event is expected, such as an IPO or an acquisition. Calendar spreads, or diagonal spreads, can be aligned with option expirations or anticipated timelines associated with the companies involved.
Case Studies & Scenarios
If you’re curious about how listed options can be used to hedge private equity or startup equity, we’ve outlined a few examples of hedging startup stock with options that can illustrate a few key concepts.
- Example 1: Early employee with $2M paper gains in a pre-IPO SaaS startup → hedges with QQQ puts. Jane holds $2M in paper gains from her SaaS startup. To hedge, she buys out-of-the-money QQQ puts, protecting her net worth if tech markets go before IPO.
- Example 2: Biotech private equity investor with PE stake in biotech fund uses XBI collar to mitigate downside, basically hedging sector-wide downturns while awaiting exits.
- Example 3: Angel investor with multiple consumer-tech startups → basket hedge via consumer discretionary ETF (XLY). By hedging with XLY ETF options, the investor offsets exposure across multiple consumer-tech startups in one trade.
Limitations and Pitfalls to Watch
Options aren’t a foolproof, guaranteed path for investors to profit 100% of the time when hedging private equity or startup equity. There are some risks of hedging startup stocks as well as some pitfalls of hedging private equity. Let’s run through a few of the common limitations of using listed options in these circumstances.
- Basis Risk: The ETF or index may not perfectly track private equity performance. This imperfect correlation can present some smaller risks for investors, but the good thing is that the correlation doesn’t have to be exactly perfect for traders to achieve a good hedge.
- Hedge Costs: Options premiums can be expensive, especially for long-dated contracts. There’s also the issue of the traders over-hedging when they sell the upside too cheaply, which can present some profitability risks.
- Roll Risk: Lock-ups can last years, requiring frequent hedge adjustments. These rollovers during long lock-up periods can create active management for the trader, which can eat into their time for doing other productive activities.
- Tax Implications: Derivatives trading may create taxable events, even if private equity shares remain illiquid.
Advanced Approaches & Institutional Techniques
Institutional hedging strategies for private equity require a more advanced and sophisticated approach from traders. Beyond basic hedges, institutional players like hedge funds or PE firms use overlay strategies in the following ways:
- Structured Products: These are a bit complex, but they’re extremely efficient for large portfolios. These structured products include combinations like total return swaps and options.
- Basket Hedges: Building a portfolio of option hedges across multiple ETFs to better approximate exposure.
- Professional Advisory: There is a time and place to consider professional help, be it from family offices or experienced advisors. Family offices and hedge funds employ structured derivatives desks to build tailored overlays.
Options as a Bridge Between Illiquidity & Flexibility
Hedging startup stock with options or hedging private equity with options doesn’t always eliminate the associated risk; however, traders can create a firm bridge between illiquid positions and flexibility. Investors using listed options can smooth volatility and reduce the downside risk associated with overlaying sectors, indices, or single-stock options. All in all, the listed options provide flexibility, liquidity, and risk control.
For founders, employees, and investors alike, listed options may be the missing link in protecting concentrated startup equity. While hedging isn’t perfect, it can smooth volatility until an IPO or liquidity event to protect paper wealth. We’d encourage you to continue exploring sector/index option strategies and consult professionals!
Frequently Asked Questions
What have our customers and readers been asking about hedging private equity and startup equity? Let’s take a look at the frequently asked questions we have received on the subject. If you haven’t read through the entire guide, this might be a good place to get the key highlights of what we’re talking about.
Can I Hedge My Pre-ipo Stock with Listed Options?
Not directly. You hedge by finding a correlated public proxy—like an ETF or competitor’s stock—and using listed options on those. The reason you have to do this is that you don’t yet own the underlying shares, which are necessary for options trading. You might be restricted by a lock-up agreement if you have recently gone public or by the company itself before the IPO.
What ETFs Are Best for Hedging Startup Stock?
It depends on the sector: QQQ (tech), XBI/IBB (biotech), XLY (consumer discretionary), IGV (software), etc.
• Hedge fund replication ETFs attempt to mimic the investment strategies of hedge funds, and they typically involve a mix of asset classes and long-short positions.
• ETFs aim to minimize exposure to overall market movements through balancing long and short positions within different assets.
• Inverse EFTs (bear ETFs) are good for inverse performance to a specific index.
• Tail risk hedging ETFs offer protection against extreme market downturns by using put options to profit when the market falls significantly.
What’s the Cheapest Way to Hedge Private Equity Exposure?
Collars (buying a put + selling a call) can significantly reduce cost versus protective puts. ETFs are another solid way to go, offering a cost-effective method for getting exposure to a broad range of PE-related investments or to hedge against downturns in the general market.
How Do Protective Puts Work for Illiquid Assets?
They act as insurance: if the sector/index falls, your put increases in value, offsetting losses in your startup or PE stake. Since you own the underlying asset, you can purchase a put option on that same asset, which gives you the right to sell at the strike price by a certain expiration date.
What Are the Risks of Hedging with Options?
The main risks are hedge costs, imperfect correlation, and the need to roll positions during long lock-ups.
