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Prepaid Forward

A contract to sell securities in the future in which payment is immediate and the actual number of shares that will be delivered varies according to the share price. These transactions entail a private sale of securities to a broker at a fixed price, which typically is not closed until two to four years after the contract is entered into. The broker counterparty pays the seller (or deposits the purchase price in escrow) at the time of entering into the contract. The seller's shares are typically pledged to the broker to secure his or her delivery obligation upon ultimate settlement of the contract. The transaction allows holders of concentrated stock positions to maintain their equity positions while monetizing their hedged securities to defer any tax consequences until an actual transfer of stock.

Example: An investor owns $10 million in stock now at $100 per share and wants to reduce the downside risk, maintain partial upside potential, and take money out of the stock position without a sale. He may get $86 per share (discount from market price) for a forward contract, obligating him to deliver shares two years in the future. The transaction, structured by a securities firm, may also include a downside protection threshold price, perhaps at $100, and an appreciation threshold price, perhaps at $120, which limits the profit and protects against loss. The range of these contract limits will affect the initial premium (i.e. discount) received.
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