A couple years ago, this one 28 year old woman I knew left a Series B funded company after two years for a higher salary at a large financial institution. She decided not to buy a single one of the many options she had spent two years accruing. At the time, I thought she was crazy because her startup was clearly going places.
Well, I’ve finally come to realize that perhaps she wasn’t crazy. Maybe she really also believed in the trajectory of her startup, but simply didn’t have enough money to buy her own shares.
TO BUY OR NOT TO BUY YOUR OPTIONS
After a year of consulting at one firm, I was fortunate enough to be granted some options after asking the CEO whether that was a possibility. He said “yes,” and just like that, an option package was created that granted a certain amount of options to me for every month I worked plus a one time grant for the year that I had just completed.
I basically had to cut multiple checks that added up to a little under $9,000 to buy my options within 90 days after I separated from the company. I did so because I believe in the company’s valuation trajectory. In the grand scheme of things, $9,000 isn’t a lot of money. But remember, I was a contractor who worked part-time.
Imagine how many more options full-time employees get after a similar duration of work? In order to buy their options, they’d probably have to pay $20,000 – $60,000 on average!
When I sent my envelope with the signed documents for each grant and checks totaling almost $9,000, I also e-mailed the recipient asking her to inform me when she planned on depositing the checks. I never have more than $1,000 sitting in my checking account at any given moment in order to maximize interest returns and control my spending habits.
In other words, even though I have a healthy income, $9,000 is still a meaningful amount for me to pay. Now imagine if you were only making $60,000 – $150,000, like the majority of startup employees do, with student loan debt, and a desire to save as much as possible to buy a house one day? Writing a $20,000 – $60,000 check to buy your options sounds like a difficult task!
ARGUMENTS TO BUY YOUR OPTIONS
- Holistic View. If you were willing to give up at least a year of your life making a below market salary, then you should absolutely be willing to buy your options when you leave. Options are an integral part of any startup employee’s pay package. You don’t want to lose out on making less salary and not have options be worth something meaningful in the future.
- FOMO. What if you passed on buying your options, and the options then turned out to be a 10 bagger? You would probably never forgive yourself for making such a bad financial move. It would be like passing to work at Facebook when the firm still had less than 1,000 employees. You might literally cry yourself to sleep every night!
- Diversified Portfolio. If you are moving to another firm, you’ve already secured another income stream. If you’re already methodically investing your savings, why not buy your options to create a more diversified portfolio? After 10 years, you might be able to build a portfolio of 2-10 positions in startups much like a Venture Capitalist would. Add your private positions with your public positions, and you’ll have an overall portfolio many people would be proud of.
- Reasonable Percent Of Your Portfolio. If you have a $100,000 investment portfolio, exercising $10,000 worth of options is within a reasonable range. But if you’ve got to exercise $50,000 of your options, perhaps your risk is too skewed. Unless you really believe the company is a slam dunk, you don’t want to have greater than a 1/3rd position in your options.
- High Certainty Of Growth. Startups are usually loss making. But if there is a high certainty of growth with a proven business model that will allow the company to eventually make a profit, then it’s probably a good idea to buy your options. You should know better than most how well your company is doing.
- An Increasing Amount Of Acquisitions. If you see competitors getting gobbled up by larger companies, your company might be next if its in healthy operating condition. I promise you that big fish are always analyzing whether to acquire smaller fish or grow from within.
- The High Chance Of An IPO. It’s pretty obvious that companies like Uber and AirBnB will eventually go public. Companies of this size usually give RSUs vs. options. RSUs are basically stock grants given to you at various anniversary dates. Hence, you don’t have to buy your options. But for other smaller companies that are showing similar funding and growth trajectories, it’s better to buy your options, even if the final IPO valuation might be lower than previous private funding.
- Low Liquidity Needs. If you’ve got strong cash flow, or a high level of liquid savings, then it’s better to buy your options for all the reasons stated above. You may have to wait for 1-10 years for your options to become liquid, if at all.
- You Can Pay Fewer Taxes. You must consider three tax rates: The federal AMT rate at 28%, the ordinary income tax rate that can go up to 39.6% if you make over $400,000, and the long term capital gains tax rate of 0% for the 10%–15% brackets; 15% for the 25%–35% brackets; and 20% for the 39.6% bracket. If you are early in the company, can afford to exercise, believe in your company, and hold on for at least one year, then you can pay the lower LT capital gains tax rate.
REASONS NOT TO EXERCISE YOUR OPTIONS
The reasons against buying your options are basically the opposite of all the above. But the main two reasons for not buying are as follows:
- You Can’t Afford To. You generally have 90 days once you leave the company to buy your options. If the choice is between buying an option lottery ticket or paying your rent or your student debt, then you probably will have to pass on buying your options unless you can get a nice loan from your parents.
- The Company Is Failing. There’s no use throwing good money after bad. If you’re leaving your company, chances are that you no longer believe in the company anymore. Perhaps growth rates are slowing precipitously, or management has extended its breakeven forecast one too many times, or perhaps it’s become clear that larger, better-funded competitors will eat your lunch. After all, most startups never have a good exit.
OPTIONS ARE ALWAYS A LOTTERY TICKET
The ~$9,000 position at this startup will be catalogued under my private equity investments portfolio. My hope is that the $9,000 will turn into a realistic ~$30,000 in three years. It’s not a significant amount of money, but if I look at the position as a part of a larger portfolio, it’s better than a poke in the eye.
I cannot emphasize enough that for a large majority of people, joining a startup won’t make you as wealthy as joining an established firm due to the significant base salary differentials. Established firms often pay 30% – 100% more than startups, while also providing year end cash bonuses as well. Therefore, my bias is for employees to buy their options if it’s clear their company isn’t going in reverse.
According to Glassdoor, the median pay at Netflix, a public company, is $132,220. The median pay at Uber is only $102,000. A 25%+ differential is significant, as that equals $125,000+ over 5 years. Meanwhile, Netflix stock is liquid and Uber stock is not. There are many more examples where the difference in median salaries is even larger e.g. finance firms vs. startups.
The general rule of only having 90 days in order to buy your options seems quite restrictive. It’s good to see some companies like Pinterest have a longer time period for departing employees to purchase. No wonder why so many employees stay at firms longer than they want to, because as long as they are with the firm, they don’t have to pay for any of their options.
I like the idea of building a diversified portfolio of private company stock just like a VC. All it takes is one to do really well. But overall, I’d keep your private investments as a percent of your total investable assets to no more than 10%. For the rest of your investment portfolio, follow my stock and bond allocation by age. Over the long run, you’ll be glad you went for singles and doubles instead of lottery tickets.
Recommendation For Leaving A Job
If you want to leave a job you no longer enjoy, I negotiating a severance instead of quitting. If you negotiate a severance like I did back in 2012, you not only get a severance check, but potentially subsidized healthcare, deferred compensation, and worker training. Since you got laid off, you’re also eligible for up to 27 weeks of unemployment benefits. Having a financial runway is huge during your transition period.
Conversely, if you quit your job you get nothing. Check out, How To Engineer Your Layoff: Make A Small Fortune By Saying Goodbye, on how to negotiate a severance. I first published the book in 2012 and have since expanded it to 180 pages from 100 pages in the 3rd edition thanks to tremendous reader feedback and successful case studies.
Recommendation To Build Wealth
Manage Your Finances In One Place: One of the best way to become financially independent and protect yourself is to get a handle on your finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize your money.
Before Personal Capital, I had to log into eight different systems to track 25+ difference accounts (brokerage, multiple banks, 401K, etc) to manage my finances on an Excel spreadsheet. Now, I can just log into Personal Capital to see how all my accounts are doing, including my net worth. I can also see how much I’m spending and saving every month through their cash flow tool.
The best feature is their Portfolio Fee Analyzer, which runs your investment portfolio(s) through its software in a click of a button to see what you are paying. I found out I was paying $1,700 a year in portfolio fees I had no idea I was hemorrhaging! There is no better financial tool online that has helped me more to achieve financial freedom. It only takes a minute to sign up.
Updated for 2020 and beyond.