Selling your startup equity used to be the only option for startup employees to get cash prior to IPO. But as the number of unicorns has ballooned and startups stay private for longer, a new option has emerged. Startup employees can finance their options. No money is owed until the startup goes public or is acquired. We discuss the tax treatment of options, the tradeoffs of financing, selling, or waiting, and the growing number of lenders employees can engage.
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Hey friends -
Last week's letter looked at the thriving secondary market for startup equity and how early employees can get cash before IPO. The letter built on a previous discussion of startup equity more generally - how to value equity as an early employee, tradeoffs among equity compensation structures, and the key tax considerations.
This week we're looking at how to get cash using startup equity without selling.
In this week's letter:
Total read time: 11 minutes, 47 seconds.
Selling equity means that you give up the potential upside.
That may be the right choice for some founders, investors, and employees. Perhaps the startup equity makes up 90%+ of their net worth and they want to diversify.
Selling is also the least complex arrangement. While the sale process may be lengthy and there will be substantial paperwork, the sale is ultimately a one-time event. Once the cash is delivered to the seller and shares delivered to the buyer, the relationship is over. All of the other structures we're going to explore establish long-term relationships between the current equity holder and the capital provider. While the relationships can be mutually beneficial, they also pose novel risks. They're not for everyone.
The major benefit of not selling is clear - you retain upside if the value of the equity continues to appreciate. For many equity holders, that benefit more than offsets the risks.
The most common reason early employees want cash isn't for living expenses - it's to actually own equity. Most startup employees receive options to purchase equity. They do not receive equity outright. It takes cash - and often a lot of it - to buy the equity.
Option holders have to outlay cash to exercise the options and pay the associated taxes. Options for employees come in two forms - Incentive Stock Options (ISOs) and Non-Qualifying Stock Options (NSOs). In both cases, the option owner will pay to exercise the option and take ownership of the associated shares. Tax treatment differs between the two.
Employees can vest up to $100,000 worth of ISOs per year. Any amount above that is treated as an NSO. Startups can also choose to only issue NSOs.
ISOs are not taxed at vesting or exercise unless the alternative minimum tax is tripped. The alternative minimum tax is what it sounds like - an alternative way to calculate income taxes owed. Employees that exercise ISOs must calculate the gain at the time of exercise, namely the difference between the current value per share and the option strike price (the price you pay per share) multiplied by the number of options exercised. If the gain is large enough relative to ordinary income, then the alternative minimum tax rate is used to calculate taxes owed. Those taxes owed will include the gain. There are helpful tools available so you can make an estimate.
NSOs are also not taxed at vesting but they are taxed at exercise. The gain at the time of exercise is taxed as ordinary income.
This is just a rapid flyby of a complex subject. The earlier letter goes much deeper, including covering topics like cashless exercising.
The tax obligations can get surprisingly large very quickly. Take Fireblocks for instance. The startup kicked off 2021 at a $700 million valuation. The company just raised more money at an $8 billion valuation just twelve months later. Hypothetical employee Sally joined in 2021 just after the company raised capital a $700 million valuation:
It's a lot of money. And this is far from a contrived example.1 One startup that helps employees with options estimates that taxes accounted for 73% of their clients' options exercise costs. That doesn't even include the estimated $11 billion in avoidable taxes paid by startup employees in 2021 who delayed exercising their options.
The tax burden on early employees can spiral out of control quickly. By law, startup options must expire within 10 years of issuance, a problem when the average startup takes 12 years to go public. Standard company policy for departing employees is even worse - typically 90 days to exercise options or they're forfeited. That turns options into unintentional golden handcuffs for early employees. And the tax burden grows as the startup gets more valuable.
Remember - even though the equity values are large, it's not cash. You can't pay your taxes in shares. Cash must come from elsewhere.
It's where options financing comes in.
Most options financing is structured as non-recourse loans collateralized by the startup equity. The cash goes towards paying for the options.
The key attributes of the loans are as follows:
It's an inherently attractive structure for both the borrowers and the specialized lenders. The value of the loan is entirely dependent on the startup, not the options owner. That means the personal creditworthiness of the borrower isn't a relevant input into the risk model.
The lender only has to evaluate the likelihood of a liquidity event, the time horizon over which it will happen, and the price. Once they are comfortable with the risk profile of a startup, they can lend to all of the employees at the startup without needing to tweak the model. That's the makings of a scalable business.
Loan fees and rates are expensive in absolute terms, but typically far less than the alternatives that incur large immediate tax bills or risk the options expiring. There are typically three key components:
The origination fee and interest charge establish an attractive rate of return for investors. The incentive fee has an uncapped upside - it gets bigger as the startup gets more valuable. The potential profits materially offset the risks that the loan isn't paid back at all. The order-of-magnitude incentive fee range reflects the differing risks across startups - some may have already announced their intent to go public while others may be years away if ever.
Similar loan structures don't just work for options, but also for startup equity.
Loans against startup equity can be issued standalone or in conjunction with a loan to exercise options. The only material difference among the various loans is what the borrower will do with the cash.
As long as the equity remains illiquid and the only recourse is to the equity itself, the lenders will remain conservative about just how much they lend. Loan-to-value ratios of 30% are not uncommon, meaning that you can only borrow up to 30% of the current equity value. Quid, one of the main lenders, caps loan-to-value ratios at 35% and lends no more than $30 million per startup.
Such arrangements are well outside the realm of traditional banking. Regulators force banks to hold significant capital against illiquid assets, which makes them comparatively more expensive for both borrowers and lenders. Except for one-off cases involving founders and investors borrowing against tens of millions of dollars of startup equity, banks tend not to participate in this market.
Non-bank lenders are better equipped to make competitive loans. And they're doing it at scale.
There are at least five main lenders and one lending marketplace. Each of the lenders has raised hundreds of millions of dollars.
ESO Fund is the oldest. Since its founding in 2012, the company has lent over $1 billion to startup employees, founders, and investors at over 500 companies. Their model is similar to most other private fund structures:
It's a well-proven model, not just for lending with startup employees but more generally. It's proven effective here as well, which has inevitably led to competition:
I expect many other private funds to enter the market in due course. Startups are staying private for longer and more startups are reaching multi-billion dollar valuations before they go public. Not only is this a growing market of potential borrowers, more startups mean more data to create better lending models. It's a flywheel that'll continue to accelerate.
EquityBee sees a similar future - many more lenders competing to underwrite loans against startup equity. Rather than compete, the startup raised $75 million in two rounds to build a marketplace that connects over 12,000 potential lenders to 1000 borrowers and counting.
EquityBee allows any accredited investor to lend on the platform starting at $10,000 loans. The company charges a 5% platform fee to the lender and an additional 5% incentive fee on profits when a liquidity event happens.
It's an attractive business that will allow EquityBee to facilitate financing for a broader range of startups than the other lenders. Options owners at less risky startups that will soon go public can force lenders to compete to lower their rates. Owners at higher-risk startups that won't go public for years to come can likely find individual lenders with high-risk tolerances and longer time horizons than the big lenders who have to pay back their funders. While EquityBee will likely collect less on each loan, their business is a compelling bet on growing the size of the market.
With many options2, the question remains - should you finance your options?
The answer, as always, is maybe. I can nonetheless leave you with a summary list of considerations so you can make the decision.
If you own options for startup shares, you have three choices to generate cash today:
The fourth option is always to do nothing. While sitting on ISOs or NSOs won't generate cash, it also won't trigger any tax bills. The options can of course expire if you don't exercise them.
Out of pocket is likely only a viable choice when the startup is young and not yet that valuable. Exercising early will avoid large potential tax bills, but the likelihood that the startup fails and your equity is worth nothing is high. You won't get back the cash you spent to exercise the options.
Selling options in the secondary market will continue to be highly restricted by startups (see earlier letter). Even if it is allowed, the tax bill from the sale will be large - assume you need to sell at least $1.30 of options to take home $1.00 after taxes. The upside of a sale is that you get cash immediately with no further exposure to the startup potentially becoming worthless. That's also the major downside - you won't share in any future value appreciation.
Financing generally doesn't require startup approval - you still own the equity. But it is a loan with a fixed rate. If you finance the options exercise when the startup is at a lofty valuation and the startup later goes public at a lower valuation, you may have to sell most of your equity to pay back the loan. The amount will never exceed the total value of the equity, but it may nonetheless be more than you would have paid in taxes had you never financed. Furthermore, financing is only available for equity at those few startups that lenders think will go public or be acquired soon.
Selling and financing are essentially taking opposite bets. When you sell, you get cash immediately and forfeit the potential upside of the startup growing in value. When you finance, you get much less cash but keep much of the upside potential. The upside potential is tempered by the risks of the liquidity event happening at a low price.
The right choice depends on you.
How badly do you need cash?
What do you expect the startup's future to hold?
Are you willing to give up part of that upside to get cash today?
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Dusting of Nutmeg
Pineapple Wedge
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Reality will be somewhat different. Her strike price is likely to be below the market price because she receives common equity rather than preferred like investors. The company will also get diluted during the capital raise so while the overall company value will increase 11.4x, the price per share will increase somewhat less. The calculations are nonetheless directionally accurate and the conclusions remain the same.
Pun intended.
