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Why startup equity can feel like a scam—and how companies can fix it

14th Oct 2021 | 11:00am

Startup compensation packages include equity—in the form of stock options—to give employees ownership in the company they’re building. It also creates an incentive to reward all for their hard work and align company growth objectives. If all goes well, the company thrives and employees experience a life-changing financial windfall as a result. 

But it’s not that simple and, unfortunately, startup employees don’t often reap the benefits they deserve. We believe companies have a responsibility to step up and educate their employees to help their team avoid common equity pitfalls. 

Equity gets more expensive over time

Employees join a startup out of their personal drive to build anew and make great impact through their work. In many cases, they take a salary cut in favor of receiving stock options in the form of company equity—an exciting moment with huge potential. But, in reality, they lean in, put in the hours, work hard, and lose sight of the fact that they need to take action regarding their equity. In other words, they need to “exercise their options.” This means they need to come out of pocket to buy their stock options. 

In the early days with low strike prices and company valuations, it may not make a huge financial dent. But many wait to exercise their options for two reasons: One, they don’t understand the economics behind how stock options work in that there are significant tax advantages that make stock options cheaper to exercise in the beginning, and two, they are not yet ready to bear the associated risks and costs with an early-stage company. 

Over time, the plot thickens. The company is growing, and its growth is being recognized through higher 409A valuations. There may even be talk about a future exit in the form of an IPO, acquisition, direct listing, or SPAC. And that prompts many questions from employees regarding the value and cost of their stock options. 

This is where the frustration for many startup employees really sets in. The more successful and valuable the company becomes, the more expensive it is to exercise options because of taxation. The taxes are determined by the difference of the strike price (the cost to exercise one stock option) and the 409A valuation (the appraisal of the value of a single company share) at the time of exercising. 

In 2020 alone, startup employees left behind $4.9 billion by not exercising their options before an IPO. The number one reason was because they couldn’t afford them. The cost to exercise is, on average, twice the annual income of an average employee at a late-stage startup. And it’s mostly due to taxes. In fact, 85% of exercise costs are taxes.

Many employees lose their equity when they leave the company

Employees decide to leave their job for many reasons—a new opportunity, a change in career paths, or even moving to a new location. But many are surprised to learn they have 90 days to exercise any vested options when they leave.

If they are still bullish on their company—which many leaving employees are—they suddenly find themselves scrambling to get as much cash as they can to take ownership of their shares. But there are many that, as hard as they try, will just never be able to come up with tens or hundreds of thousands of dollars in 90 days.

Some also decide the short-term pain isn’t worth the long-term reward. Maybe they’re about to put a down payment on a house or are worried about losing all of their emergency savings. So, they let them expire and hope it wasn’t a mistake. At Snowflake, one of the most successful IPOs in recent years, more than $1.2 billion worth of stock options went unexercised. 

Some startups are combatting this latter issue with longer exercising windows. Instead of 90 days, employees can have 5, 7, or even 10 years to exercise. In a recent episode of the Founder’s Field Guide podcast, Spenser Skates, CEO of Amplitude, discussed how he personally got involved to extend their window to 10 years. 

But this workaround still comes with a 90-day deadline. That’s because, legally, incentive stock options (ISOs) automatically convert to nonqualified stock options (NSOs) after 90 days of leaving the company. Most employees are granted ISOs, which have a more favorable tax treatment than NSOs. So while it’s fantastic that more startups are extending the window, employees who take it will likely end up paying even more to exercise their options. 

Companies need to provide more equity education

 All this talk about cost, taxes, and planning illustrates just how complicated equity is. Most employees are left feeling lost and are not sure where, or to whom, to turn. The first place employees will likely go when they do have a question is their employer. In fact, 82% of employees want their company to help them understand their equity. 

Founders and executives do want employees to value their stock options. Many just don’t know how to help. Legally, companies can’t offer financial advice to employees, but they can offer helpful tools and resources. Being more proactive about educating and helping their employees with equity would also benefit the company.

First, it would foster a culture of transparency and openness. Culture is a big part of any successful company. Proactive communication about stock options can contribute to a positive culture. And that can help with any number of things, from recruiting and retainment to just overall employee satisfaction. It’s no secret that happy employees are often productive. 

Second, going public is not easy. It’s why companies bring in equity teams to help—it’s a lot of work. Getting ahead of employee questions can streamline that process so the executive team can focus on going public. Having a successful IPO will benefit everyone. The same goes for an acquisition. Getting ahead of employee concerns removes unnecessary work in the process.

Going public is something to celebrate, but financial conversations are not easy to have. So, most people don’t have them, especially at work. Even for the most seasoned CPA, stock options can be complex territory. Yet employees are being asked to figure out one of the biggest financial decisions of their lives on their own. 

If more startups can help provide the tools and resources for employees to make an informed decision about their equity, it can create much more value for everyone in the company. Quite literally.

Frederik Mijnhardt is the CEO of Secfi, a pre-wealth management platform helping startup employees navigate financial decisions from offer to IPO.