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Equity Guide for Employees at Fast-growing Companies

Compound is a financial manager for startup founders and employees.

Conventional wisdom says that startup equity is worthless. While most startups fail, there’s a chance your equity will become a life-changing pot of money. This guide explains how to make the most of your equity.

Let’s start with an example.

Suppose you join a Series A startup as the fifteenth employee. A few months in, and you’re feeling incredibly optimistic. Customer demand is skyrocketing; you can’t seem to build quickly enough to meet their needs. The startup has added six new employees since you joined and is frantically recruiting more—you’re already a “senior employee!”

You’ve been offered the opportunity to “early exercise” all of the stock options you’ve been granted. This will cost you $40,000.

It sounds expensive (and it is!) but say that, two years from now, your company reaches a billion dollar valuation—it’ll then cost you upwards of $400,000 to exercise this same tranche of stock options and cover all of the tax obligations.

Silicon Valley is full of stories where startup employees miss out on material tax savings, on the order of hundreds of thousands, sometimes millions of dollars, because they ignored their equity compensation until it was too late. This guide helps you strategically maximize your upside as an early startup employee at a fast-growing company.

Equity 101

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If you are familiar with startup equity, or have read one of our other guides, feel free to skip (5 min read).

Deciding to exercise

Exercising your stock options represents a high-risk, potentially high-reward investment in your company. At a high level, here are the pros and cons of making such an investment:

Pros

With the 409A rising, you’re incentivized to exercise sooner rather than later. Furthermore, your options do expire eventually, so you can’t put off exercising them indefinitely. This will kickstart the long-term capital gains clock and break your golden handcuffs. The term golden handcuffs refers to compensation incentives that discourage you from leaving your company. While your equity may pose a large reward, if you cannot afford to exercise it, you’re monetarily encouraged to stay at your company until at least the IPO.

Cons

Investing capital into stock directly tied to your single source of income greatly increases your overall concentration in a risky, illiquid asset.

To answer the question of whether or not you should exercise, consider the following:

1. Your liquidity constraints

Your liquidity constraints will limit the number of options that you are able to exercise. To determine these constraints, audit your personal finances. Consider metrics such as your current liquidity, movable assets, near-term liabilities, and financial goals.

Cash flow timing plays an important role, as startups often take 5-10 years to exit (if ever). Investing in your startup therefore comes with a significant opportunity cost: you could deploy this same capital into other opportunities (e.g., public stocks or real estate) that could generate steady, dependable returns over the course of those 5-10 years. You’re really looking to come up with a projected, probabilistic return on investment for exercising your stock options (and compare that to your broader financial picture).

2. Your view of the company

In deciding how much of stock to purchase, you are essentially quantifying your level of optimism in your company. While you’re unlikely to have access to every line-item on your company’s income statement, you do likely have access to key figures (e.g., revenue trends) to inform your analysis. In the end, you need to form your personal investment thesis—Why will your company win? What will prevent you from succeeding? What’s the best case scenario?

At the same time, keep in mind that even startups with the most seemingly promising trajectories can stumble. WeWork is an obvious example: in early 2019, it was valued at $47 billion and was filing for an IPO. By the end of the year, its valuation had dropped to $8 billion. Pebble went from a $740 million valuation in 2015 to $40 million by 2016. Juul went from $38 billion in 2018 to $12 billion in 2020. Employees who exercised their options at the higher valuations fell out of the money (and overpaid in taxes).

Deciding

To quantify this decision, let’s explore another example.

  • You have 100,000 options, with a strike price of $1
  • The current 409A valuation is $1.20
  • The 409A in 3 years will be $20
  • In 5 years, your company will IPO, and each share will be worth $100

Here are the various strategies you can try:

  1. Early exercise everything now
  2. Exercise all options in 3 years
  3. Wait until the IPO to exercise

The table below estimates the hypothetical costs of exercising now, in 3 years, and in 5 years.

Early-exercise all now
409A at exercise: $1.2
Exercise all in 3 years
409A at exercise: $20
Exercise all at IPO
409A at exercise: $100
Cost at exercise
$100K
Stays under AMT limit
-$775K
With AMT tax
-$5.42M
With AMT tax
Net tax obligation
-$3.65M
-$4.49M
-$5.32M
Net outcome if IPO
$6.25M
$5.56M
$4.58M
Net outcome if fail
-$100K
-$775K
$0
You can scroll right on the table above →

Importantly, these projections assume a successful outcome for your company and don’t account for relevant factors such as dilution, timing, and liquidation preferences. Early exercising performs worse than doing nothing in the event your startup fails. Exercising your stock options is making an investment in your company. You are betting on its future performance and if it fails, you will lose your principal investment. Consult your financial and tax advisers to make the right decision.

Liquidity

Deciding when to exercise is also a matter of timing. How soon do you need liquidity? It’s often possible to sell some of your equity before your company goes public (or gets acquired).

Tender offers

From time to time, your company may hold what’s called a tender offer. In a tender offer, some cohort of shareholders are given the opportunity to sell their shares for a set price per share. Most companies irregularly hold tender offers (once every couple of years), and generally restrict them to current employees who’ve reached some level of tenure. Deciding whether or not to opt-in the tender offer has trade-offs—every share you sell is potentially worth more (or less) in the future.

Secondary markets

A number of secondary markets make it possible to sell shares to independent investors. There are also funds and brokerages designed to help you get financing to exercise your options. It’s not guaranteed that you’ll be able to participate in either of these vehicles; it depends on factors such as transfer restrictions, timing, and demand from investors.

Conclusion

No matter what, early-stage startups are inherently risky. You could end up with a life-changing pot of money in five years, or your equity could end up being worthless. Furthermore, along the way, funding rounds and 409A re-evaluations can occur and change your financial situation at any time without warning. In light of this risk and uncertainty, it’s crucial that you take an active role in managing your equity strategically from the start.

Disclosure
This material presented on Compound’s Resources blog is for informational purposes only and
should not be construed as legal, tax, accounting or investment advice. Under no circumstances
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does not constitute, and may not be used in connection with, an offer or solicitation by anyone in
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Any analysis or discussion of financial planning matters, investments, sectors or the market
generally are based on current information, including from public sources, that we consider
reliable, but we do not represent that any research or the information provided is accurate or
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Compound provides wealth management for startup founders and employees.

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