A Framework For Thinking About Exercising Your Stock Options
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Investing your time and money
Careers require investments of time. Tech careers can also require investments of money. You invest your time by choosing where to work. You invest your money by choosing whether or not to purchase shares in the startup you work for (through a motion known as exercising your stock options). This article covers a framework to decide if and when it makes sense to invest in your employer.
Venture capital firms are professional startup investors. Their backers give them money to invest in startups. Unlike full-time investors, you—the startup employee—don’t have the luxury of diversification (nor do you have access to an army of analysts combing through performance data). Nonetheless, if you were given stock options in your startup, you too must make an investment decision: you must decide whether to exercise your options.
Doing nothing is itself a decision and one that can have material consequences on the future of your net worth. So how should you go about deciding? What’s the formula?
In some ways, executing options is just another investment decision.
There’s a not-so-scientific approach to determining whether or not you can invest in any new opportunity. It looks something like this:
First, determine how much money you need to maintain your current lifestyle. The simple approach is to login to your bank, click on “checking account” and look at how much money you have.
However, I’d suggest taking a more holistic look at your finances by looking at your complete balance sheet. Add all of your cash, public market investments, private market investments, and any other assets. Then, subtract out liabilities such as credit card debt, student loans, or a mortgage. The result is your net worth.
Finally, to figure out how much money you can invest, set aside expenses that are due in the short-term in cash. This can include an emergency fund (generally 3-6 months of living expenses), taxes for next year, and general spending (house payment, wedding, etc.). The amount of money you have remaining is the amount you can invest.
(Of course, there are many people who don’t have enough money to set aside an emergency fund, let alone excess funds to invest. This article assumes that you’ve been able to save some of your salary for a while such that you have liquidity to invest.)
Now you probably don’t want to necessarily invest all of your money into risky, illiquid startups (as my compliance officer Slacked me: “YOU MOST CERTAINLY DO NOT WANT TO DO THIS AND I AM IN NO WAY RECOMMENDING YOU DO THIS”). So that money you have—your investment budget—should be allocated in risk-stratified ways according to your risk preferences, financial goals, and time horizons.
To help determine your allocations, you must first figure out your financial goals. (In finance terms, you’d call these “future liabilities” or “future expenses” since they’re things you’ll want to pay for in the future. What purchases do you want to make? How much wealth do you need to maintain the lifestyle you want? What is your risk tolerance? Will these purchases be investments or merely consumables?)
Investors create fancy forecasting models to help them analyze their investments. While I’m not recommending you spend hours in Excel trying to do a 5 year forecast model, map out dozens of line item expenses in order to roll up to the 2027 adjusted EBITDA, a little work can go a long way, and there are simple tools to help.
To estimate the value of your startup investment over an X-year time horizon, try to answer: “what do you think you could sell this investment for in the future?” A simple way to do this is by either looking at how similar companies performed or applying an annual growth rate to your company’s revenue (Compound can help with this :) ).
You can then compare this return on investment with your opportunity cost (i.e. where else could you put this money—cash, crypto, index funds, real estate, etc.). Of course, this comparison isn’t quite apples-to-apples due to the different risk profiles, liquidity, day-to-day cognitive anxiety, etc. but for most purposes, it’s close enough.
In other ways, executing options is special
While executing options is a lot like any other investment decision, in some ways it’s unique. Here’s why:
- Startup equity has a power-law distribution – most go to zero while a few return life-changing sums of money. If you invest in a winner, you’ll first feel really behind in terms of liquid wealth for a long time as your peers have higher cash salaries. Then, all at once, you’ll feel very ahead financially.
- Your startup equity is illiquid, and you don’t really know when it will become liquid.
- Taxes around startup equity are, annoyingly, uniquely complicated.
- There’s not a lot of transparency in Startup Equity World (i.e. companies, even your employer, don’t typically share a ton of information with you because they cannot advise you on your finances).
- The investment is tied to your single source of income, so investing in it would mean a material concentration of risk. You already are dependent on your employer for income. Now, you'd be dependent on them as an investor.
- You can influence the outcome. If you’re talented, investing in the company you work for is betting on yourself.
Yes, this is a complicated decision. And yes—seeing tax terms in the #personal-finance employee Slack channel sending you notifications and causing anxiety is also not fun. I have to admit, I work in tech now, but in a former life, I worked in finance and EVEN STILL I get anxiety over my personal finances, especially when I’m sent Investopedia articles (please stop sending me Investopedia articles).
It’s also not something you talk to your peers or colleagues about. “So Jenny, how many options did you get?” It’s awkward. And besides, it always feels like everyone else knows their stuff (narrator: “they don’t”).
So what do you do?
You have two options: exercise your options now, or wait until there’s more certainty. (Okay there’s a lot of grey area too where you can exercise some options… but we’re tryna write an article here).
Given all of this complexity, I can promise you one thing for certain: there’s no right answer. I don’t know if your startup will be successful. You don’t know if your startup will be successful. Anyone who says otherwise is trying to influence you (your founders might mean well, but even they don’t know for sure). The majority of startups fail, and you have to be very good and very lucky to succeed.
But I am confident that you should:
- Make sure you’re happy with your time investment (working at the company) agnostic to the financial outcome of your stock options
- Chart out the tradeoffs with this decision so you have full visibility into the pros and cons
Most startups have one of two outcomes: success or failure. Success typically looks like an IPO or an acquisition, and failure is when you have to shut down the company (or get acquired for pennies on the dollar). Of course there are some in-between options such as a medium-sized acquisition or if the company finds a way to continue on without a liquidity event. At some later-stage companies there’s also the possibility of selling your shares on a secondary market.
But for now, let’s focus on your options strategy given your company falls into one of the two “success” or “failure” categories.
If your startup fails…
If you do nothing with your options and your startup goes to zero, congrats! Well not because you’ll have to find a new job and didn’t create a big business, but from an options perspective you likely just saved some cash. If your company goes to zero and you never invested in your options, you didn’t lose any money. Instead, you invested your cash somewhere else (that hopefully has given you a positive return).
If you exercise your options and your company goes to zero, you’ll lose the money you invested in your company (in addition to still being out of a job and not having created a big business). Additionally, if you paid taxes when you exercised your options, you’ll also lose that money. Yeah, this sucks. You might be able to claim capital losses as a tax benefit going forward, but that’s the only silver lining.
You can treat this as a good learning opportunity though – always be careful with concentrated startup bets (especially when they correlate with your single source of income).
If your startup succeeds…
If you do nothing with your options and your startup has a successful outcome (perhaps getting acquired or going public), there are a few things that can happen.
First, you’ll likely have to pay more taxes upon exercising your options. You’re taxed on the difference between your strike (or “exercise”) price and the latest 409A price, and so if the 409A price increases, your taxes will likely increase too. This number, depending on your tax bracket, could be a 10-20%+ difference in the ultimate value you take home. (Here’s a deeper dive on startup equity taxes).
This situation becomes especially challenging if you’re trying to leave your startup (or you get fired), and your options are expiring and the cost of exercising is sooo high that you can’t afford to do it, and the alternatives to finance your options are ridiculously expensive, and... well, it’s overwhelming.
It’s also a frustrating problem because the more money you stand to make, the more taxes you’ll have to pay. It’s a double-edged sword.
Here at Compound we see this problem a lot! Many companies only have a 90-day post-termination exercise window (meaning your options expire 90 days after you leave) but you should double-check that. You can generally find the answer in your offer letter. Some companies will also use tools like Pulley’s offer letter generator to educate their employees on the terms and potential value of their option grant.
Secondly, it’ll be harder to get preferential tax treatment (long-term capital gains) at the time you sell your shares in the future. When you sell (either at an IPO or acquisition), you’ll need to wait a year between the exercise and sale date if you want to qualify for long-term capital gains (reminder: this can be 10-20%+ better than short-term capital gains). Otherwise, your profits will be taxed at short term capital gains, which is equivalent to the ordinary income rate. (And in other cases, such as certain types of acquisitions, you simply won’t have a choice since you’re mandated to sell right away by the acquirer.)
If you exercise your options and your company succeeds, well, you’ve hit the jackpot.
- First, you’ll have a lower, taxable bargain element at the time of exercise. This means you’ll pay the lowest amount of taxes upon exercise (sometimes zero).
- Next, you’ll start the long-term capital gains clock. This is awesome, again, because if you sell after holding for at least two years, you’ll save 15% or more on car insurance taxes.
- Finally, if you own your shares and they are vested, you’ll have the flexibility to leave whenever you want because, well, you already own your shares. You aren’t tied to the company for fear of losing your options.
As a reminder, if you exercise your options, you’ll need the liquidity to do so. Typically this comes from other parts of your personal balance sheet – either cash (bank accounts) or public investments (brokerage accounts). I’ve said it once and will say it again: buying private company equity is a risky, illiquid, concentrated investment. It can also potentially one day be worth a life-changing sum of money. You should scrutinize this until you feel confident in your decision. (My compliance officer gave me a pat on the back for this paragraph.)
I even tell my friends to block off a full day to really understand their equity options, the potential outcome, and the pros and cons of each choice. You can be heads down building your startup but it’s very important to pause and take time to think about your financial future (even if it’s intimidating).
Keep in mind that exercising is not a binary decision (you can exercise some now, some later, etc.). But you certainly shouldn’t make this investment today if you can’t afford to do so.
 Short-term capital gain taxes are the taxes you pay upon the sale of an asset that you’ve owned for less than a year (generally). This tax rate is the same as your ordinary-income rate and can be as high as 37%. Long-term capital gains taxes are the taxes you pay when you sell an asset that you’ve owned for longer than a year (generally). The long-term capital gains rate is between 0% - 20%. Of course, always consult a qualified tax professional for personal tax advice.
How do you decide?
First of all, investing is a profession that very smart and hard working people spend their entire lives doing – and a lot of times even they get it wrong! So don’t be so hard on yourself as an employee trying to underwrite your startup as a part-time gig.
But instead of becoming a full-time investor to learn the best methodologies (or giving up due to the complexity of the problem), there are a few things that you likely already have a good grasp on that you can use to figure out if your company will have a “successful outcome.”
Instead of investing in companies, think about investing in people. You might not be fluid in benchmarking unit economics for companies in your sector, but if you’re an engineer you probably know what a good engineer looks like. You’ve met plenty of people in your life and a good proxy is to bet on the people you work with – if they are capable, relentless and have high integrity, consider betting on them. (And a not-so-secret fact is that a lot of VCs do this too!)
Another thing you can do is analyze your own company. While there are plenty of ways to math your way to different answers, I actually wouldn’t index too heavily on the math. Instead, try to answer a few basic questions. What’s the founder like? Do you believe in them? What’s the revenue to date and growth rate? Does the company have product-market fit? What do customers think about your product relative to your competitors?
These are just a few ways to answer how to think about the decision to exercise your options. Whatever you decide to do—and full transparency I work for a company that specializes in helping you with these decisions —I’d suggest writing a memo to yourself documenting why you’re choosing to or not to exercise your stock options, but writing it down will help minimize your personal regret.