Recent news of Fab's fire sale and Aereo's bankruptcy filing sent a jolt through the startup world. For employees of these companies, the news surely has a major adverse impact on their finances. Startup shareholders--employees and founders alike--should take heed as they ride the startup rollercoaster.

Meteoric Rise, Precipitous Fall

Fab.com, nee Fabulis, was founded in 2010 as a social network for the gay community. On the brink of shut down, the founders decided to pivot in 2011, capitalizing on their passion--design--to form a home decor flash sales business based on co-founder Bradford Shellhammer's design eye. Within a year, Fab had over 1 million members and a $50 million run rate. Things peaked a short 2.5 years or so after the pivot, when Fab raised $150 million at a $1 billion valuation in June 2013. It has since been a downhill ride, punctuated by Shellhammer's departure in late 2013, followed by a wave of layoffs as the company realized that flash sales do not a sustainable e-commerce company make. Finally, on November 21, 2014, it was announced that Fab would be sold to PCH International for $15-50 million, meaning that its current value may be as low as 1.5% of its peak value.

Aereo has had a similar rise, founded in 2012 with total fundraising reaching $97 million by January 2014. The company reached a reported $800 million valuation, with 350,000 subscribers in 11 US markets. On November 21, 2014, Aereo announced that it had filed for bankruptcy. Aereo's story is a bit different from Fab's in that it was a classic, all-or-none venture capital wager. The company captured over-the-air television signals via antennae, and rented the antennae to customers, who could then stream and record programming. The cable companies sued, alleging that the signal capture was illegal, and the fight went all the way to the Supreme Court, with Aereo losing the case. With no Plan B, the next chapter for Aereo is Chapter 11.

That Old Saying About Eggs and Baskets...

In both instances common stockholders have likely suffered a big economic hit. Fab and Aereo should serve as cautionary tales to employees, and all common shareholders, at startups, that the fall can be as quick as the rise and it's important to take some protective actions.

Today's context makes things a bit more complicated for startup employees. Startup employees (and founders for that matter) are paid significantly in company stock. While lucrative, this stock is illiquid--it can't be quickly converted to cash to pay for real life needs or to de-risk or diversify one's holdings. Further, as the company's fortunes rise, so do those of the employees; but remember, an employee's net worth is becoming increasingly concentrated in illiquid stock. At the same time, tech companies are staying private longer. They are deferring exit via IPO (according to the National Venture Capital Association, the median time to IPO exit for venture-backed companies was 3.1 years since first funding in 2000, and 7.4 years in 2013), which means delaying the all important liquidity event for the employees. The implications are of this clear: employees are left holding illiquid stock longer, making it harder to meet ordinary course financial obligations and increasing the concentration of their net worth in risky, illiquid stock.

The falls of Fab and Aereo underscore the importance of taking some liquidity along the way if you can. It's good common sense to not have your net worth concentrated in a single, risky, illiquid investment. And while selling some stock can facilitate paying off school debt or preparing for the birth of a child, liquidity doesn't need to result in only cash. Diversification is a core tenet of modern portfolio theory, and it applies even to a startup employee. In addition to meeting personal financial needs, liquidity can serve as a vehicle for diversification: take some chips off the table and re-invest elsewhere. At the end of the day, it's not prudent to have your net worth tied to the performance of a single company whose stock cannot be quickly sold.

To be sure, selling private tech company stock is not as simple as selling NYSE-listed stock. However, these channels are starting to open up. It has been estimated that the secondary market for shares of private tech companies exceeds $1 billion for 2014. Had a shareholder in Aereo or Fab taken advantage of a liquidity opportunity before the recent news, she may be breathing a sigh of relief, if not sitting on a nice return.

This is Part I of a two-part series. Part II tackles the news from the investor's perspective. I'm co-authoring this series with my colleague, Shri Bhashyam. Stay tuned.

Published on: Dec 4, 2014