It’s been said a prudent investor should limit the value of one stock to a maximum of 10% of their total portfolio. Usually it’s advised that one is even more diversified, especially if that stock is a small cap. I haven’t found advice about private companies because at that point wealth managers are generally advising angel investors with over $1 Million in networth to their name already. It’s really hard to find good advice for startup employees trying to figure out what to do with ISOs (incentive stock options.)
ISOs are a type of employee stock option that can be granted only to employees and confer a “US tax benefit.” They are also called Qualified Stock Options by the IRS. Tax benefits provided by the IRS are typically designed to encourage regular folk like myself to take minor risks in order to obtain higher value down the line. For example, the IRS allows the average joe to put pre-tax money (up to $17,500 a year) into his 401k, which, theoretically, is taxed at a lower rate during retirement.
For ISOs, the benefit can be huge if and only if the employee takes the risk to exercise early via an 83(b) election and the company does extremely well. The problem is that the risk that the employee is required to take is much, much larger than that of someone investing in a 401k. When you invest in a 401k for $17,500 per year you usually have an array of mutual funds that you can select so you have a diversified investment. If one company goes under, your investment will take a hit, but you won’t be down to $0.
Now, with ISOs, it’s a different story. If you join a company as an early employee you’re often sold the dream of the company hitting it out of the park, and those stock options being worth much more than they’re worth today. That’s how startups entice talented folks to leave big corporations to work for less money and much longer hours. Sure, there’s the flexibility, the excitement of building something new, et al, but if stock options weren’t a key part of that recruitment package they wouldn’t exist in the first place.
Some people do strike it rich on options. But the matter of fact is, 9 out of 10 startups fail. It isn’t clear how many of those 9 startups go to $0 and how many of those 1 in 10 actually return anything significant to common shareholders (i.e., the employees.) I know for a fact that a certain $1 billion acquisition returned around $1 per share to common shareholders, while an acquisition of just a few million over what was raised returned $3 a share to common shareholders. The numbers never make clear sense.
With ISOs, you’re provided the benefit of early exercising. I’ve written a bit about this before, but basically, early exercising means you “get” (benefit) to BUY your shares right away. Why would you want to do this? Well, say you have the option to buy 10 shares for 1 penny each today, even though you don’t actually own any of them until one year down the line because you have 4-year vesting with a one year cliff, standard terms for founders and early employees. This means that whether you buy your options or not, you don’t actually have the right to any of them until one year of service. If you quit before that time, so long options.
But it gets more complicated. After the one year of service, every month you vest a percentage of those options, until year four. The company may or may not be sold or go public during this time. Companies, even successful ones, usually take much longer to go anywhere. Many of them have ups and downs and ups and downs on the way. The ups are great. The downs sometimes include investors coming in to give more money to keep the company afloat while washing away any potential gains of common shareholders. That’s one reason why successful companies may still not even provide expected returns to employees who have worked long and hard for their reward.
So why exercise early? Exercising is actually a taxable exercise. Companies gain value, albeit paper value, as they grow. So if you received 10 options for 1 cents a share in 2013, you can buy them in 2013 for 10 cents a share and pay no tax on these options. Say in 2015 your company is supposedly worth $1 per share. If you want to exercise them at that point, you have to pay tax on 99 cent gain per share. That’s not much. But if you own hundreds of thousands of shares, and the difference between the exercise price and the current value is much greater, you’re looking at a sizable tax bill for assets that are entirely illiquid and may be for the foreseeable future. Long story short, if you want to get any of the potential value out of your stock options, you probably should exercise early if your company lets you. Exercise early and pray.
Now, you’re thinking, why not just wait until a long time in the future when the company sells to exercise my options vs taking the risk today? You can certainly do that. The only problem – and it’s a biggie – is that makes you stuck if you want to leave the company or if you are forced out. You have 3 months (count ’em, 90 days) to exercise your options, or you give them up. At that point, even though the company may be doing well, you are looking at a taxable event if you want any of those options you negotiated so hard for and earned during your tenure at the company. You’re stuck with a psychological battle here — do you buy the options, pay tax on them, because they were part of your compensation package, accepting that they very well will be worth nothing after you’ve paid a heap of tax on them – or do you let them go and accept that one day they might be worth a lot and you won’t see a penny of it?
Yes, that’s the problem with ISOs. Worse yet, when you join a company early on, you don’t have to exercise your options, but when you’re a small team — unless it’s clear you just cannot afford to exercise those options today — people you work with like to see your skin in the game. If you’ve exercised your options, you’re an investor in the company. Yes, your fancy benefit for working for a startup is that you get to pay to invest in a company that has a 90% chance of failing.
The later you join a startup, the chances of failing might go down ever-so slightly, but the cost to exercise the options go up. No matter what, it’s a crapshoot. Like in Las Vegas where the Casino always wins, in startups, the investors always win, even if they lose. Founders have a slightly higher chance of walking away with a piece of the pie, even in a failed outcome, because they have so many shares the investors often want to buy them back from the founder so they can control the company. Founder gets a few million for selling their shares back, leaves on his merry way. Early employees are pretty much fucked.
That’s just the way it is. Few people understand this, or the odds. I joined an early-stage startup and paid $20,000 to exercise my options. Yes, this was a huge risk. Our CEO would rattle off numbers of our shares one day being worth something between $35 and $65 a share in company meetings. He got us all excited because that was his job and at the time we all had to be a bit delusional to grow the company from nothing to something. But I fell for it. I wanted to. I wanted to buy the startup lottery ticket and, while I knew the $65 per share was a long shot, I dreamed of walking away with enough for a down payment on a house. Couldn’t my 100,000 shares turn into $200,000? The fantasy was always $1M, but I kept myself grounded in reality, worked hard, hoped that maybe all my hard work would result in $2 per share. Just $2 per share.
Today, everything has changed. We have a new leadership. There’s no CEO standing up and talking about employee share price anymore. I’m pretty sure that’s one conversation the executive team wants to avoid. And I’m just an early employee who put 10% of her networth into one very early-stage company. If someone came along and asked me to invest $20,000 into a Series A startup today, and if I was legally allowed to, I don’t think I would because the risk is too high.
Angel investors (and VCs for that matter) would never invest in just one risky company and call it a day. For more seasoned executives, buying a chunk of a small company to exercise their stock options may be a much smaller percentage of their portfolio, so that’s a different story and a different risk allocation – what’s 10% of my portfolio could easily be 2% of an executive’s portfolio who has a lot more money and assets saved up.
That said, I encourage everyone thinking of exercising their options to be realistic about the risk involved. It’s not like buying an expensive lottery ticket exactly, or putting it all on roulette red, but there are risks involved, and yes, you can and very well may lose all or some of your investment. Venture Capitalists do not care about employees or their cute little stock. They care about not losing money and making money. If you’re working for a company that is going to raise a lot of money and wants to grow fast (once you take any VC money this is kind of a given) your stock is most likely going to be worth very little to worthless. Unless you happen to hit the jackpot.