Wednesday, March 25, 2015

Quitting with Employee Stock Options

Many startup companies still use Restricted Stock Options to make up for a below-market compensation, or as an incentive to stay with the company for a longer period of time. This leaves employees with a dilemma when they decide to leave the company.

Should you spend tens of thousands of dollars to exercise their options? Or should you just save your cash and leave the equity along with the job? The options probably expire a few months after leaving the company if you don't exercise them — that’s part of the restrictions on most options.

What if the stock never goes public, or never experiences a “liquidity event”? What if the stock doesn't perform as well as the S&P 500? $X0,000 is a lot of money to put on a single bet. Your money would be forever stuck in a useless stock.

What if you decide to abandon your options and the company has a massive IPO eight months after your departure? You'd probably be really jealous of your former coworkers who are all buying Teslas and getting fitted for Gold Apple Watches.

I’m facing this dilemma right now. I have options that will expire in a few months, and they will cost a big chunk of change to exercise.

What if I can participate in the potential high upside of the private stock while removing the risk of losing the money?

There are some options. The ESO Fund has an interesting offer: they will give you money to exercise your options. What do they want? According to Quora they want a liquidation preference and a percentage of the upside.

This would mean that if the stock turns to money, they will get some small multiple of the money they gave you to exercise the options. In addition, they get a percentage of the remaining proceeds. If they gave you $10 to exercise an option and then the company goes public and you sell the share for $40, you might owe them $20 for a 2X liquidation preference, and then an additional $5 for a 25% split of the remaining money (these are completely made-up numbers).

What if it’s the same $10 to exercise, but the stock sells for $20? Then you pay them $20 for the liquidation preference and get no money out of the deal. What if it’s $10 to exercise and the stock sells for only $5? Then you pay them the entire $5, and they eat the loss for the additional $5 they paid in to exercise. The exact way it works depends on the agreement you negotiate with the fund.

A 1X liquidation preference is completely fair. This simply means that the ESO Fund gets back whatever was left of their investment -- and you've lost no upside.

A higher liquidation preference means that in certain scenarios you won’t share in the appreciation over the strike price. From the Quora question, it sounds like you can trade liquidation preference for a less favorable split of the remaining capital. I suggest making a spreadsheet or writing a program to evaluate the possible scenarios.

Based on what I know so far, the ESO Fund seems like a great way to protect your wealth if you are willing to share your upside. There is a significant opportunity cost to turning your cash into illiquid private equity. Do you really want to sink your hard-earned cash into an equity you can’t readily sell or control? The ESO Fund offers a nice way to solve that dilemma.

Another interesting option that might help you turn stock options into cash is EquityZen. Unlike the ESO Fund, EquityZen is a place to sell — or pledge to sell — your equity. It appears that EquityZen may even help you work around “Rights of First Refusal”, and other clauses that private companies use to exercise control over their employee’s equity. You might be able to use this service to sell enough shares to exercise all of your shares.

One possible sticking point of EquityZen is that their minimum transaction size is $100,000. They allow you to bring in another stock holder into the transaction to reach that minimum, but that sounds potentially tricky.