I’ve previously written case studies about successful exits, such as the multibillion-dollar IPOs of Snowflake and Doordash. As a startup employee myself, I love to study success stories, and admittedly picture myself on the day of Secfi’s IPO.
That said, the harsh reality is that most startups don’t become the next Snowflake or Doordash. Most startups fail.
So what happens to employee stock options when a startup doesn’t reach a successful exit? If you work at a startup, it’s vitally important to build a plan for your stock options — no matter whether your startup succeeds or fails.
Note here at the top: Building a startup is hard. For that reason, this isn’t a company-specific case study. The numbers here are real, but rounded and anonymized to respect those who worked so hard to build their dreams.
Understanding how a company exits
Before jumping into numbers, let’s define an “exit.”
Generally speaking, when you’re granted employee stock options in a startup, you’re given the ability to buy shares in the startup at a set price. The good news is that the price-per-share is comparatively low, because the startup is still growing. The bad news is that there aren’t a lot of places where you can sell your shares until the company exits — either by being acquired or going public.
The majority of startups don’t exit. And of those that do, the majority don’t go public — they’re acquired. And while acquisitions are much more common, they don’t always result in good outcomes for employee stock option holders.
Why company valuation matters for employee equity
Valuing a publicly traded company is easy: shareholders use the information available to them to collectively decide on the company’s value every day. Valuing a private startup is much harder: companies are growing quickly, and their value is heavily dependent on the prices that investors are willing to pay at each round of funding.
Every time an investor puts money into a startup, they acquire what’s known as preferred stock — a special class of shares that come with certain rights that common stockholders don’t have.
Valuations are a hot topic right now, and we’ll save the subject for a future deep dive. But for now, it’s important to note that a startup’s valuation matters, because it determines what the company is currently worth and, ultimately, how much employees will pay in taxes to exercise their shares.
There’s a commonly understood norm in the startup world that it’s far harder to grow your company from $0 to $1 billion than it is to grow your company from $1 billion to $10 billion. And while unicorn startups are increasingly common, growing a company to a $1 billion valuation is a major milestone, and usually the start of when a company starts considering an IPO.
What happens to employee stock when a startup fails
Unfortunately, most companies won’t get to that $1 billion valuation that so many dream about. Bankruptcy is a much more common outcome than getting to unicorn status.
So what happens to your equity when your company goes bankrupt? We’ll look at Susan, a fictional startup employee, and get a better understanding based on her equity and financial situation.
Susan is single, lives in California, and earns $200,000 per year as an engineer at a promising startup. She’s granted 200,000 incentive stock options (ISOs) at a $1.50 strike price. When she decides to exercise her stock options, they’re carrying a 409A valuation (also known as fair market value) of $3 per share.
Susan pays her company $300,000 to exercise her shares (200,000 shares x $1.50 per share). Those 200,000 shares are, on paper, worth $600,000 (200,000 shares x $3 per share, per the 409A valuation), meaning that she has to record an assumed gain of $300,000 to the IRS ($300,000 cost - $600,000 assumed value).
For Susan, that triggers the federal alternative minimum tax (AMT), and that year, she pays an additional $100,000 in combined state and federal taxes. Susan has now spent $400,000 to exercise her stock options, in hopes of earning far more in a successful exit sometime in the future.
Unfortunately, the company’s performance and growth stalls. Investors are unwilling to provide more capital, and the company eventually becomes insolvent.
All common shares (which Susan holds) are now worth $0 and deemed worthless. Susan can’t recover the $300,000 she paid to the company. However, she may be entitled to some tax benefits.
The $300,000 that Susan paid is the “basis” of her stock, and she’s now able to record a capital loss of $300,000, which she can use to offset future capital gains, like the sale of other stock or real estate, to reduce future tax bills. The downside is that it might take years for Susan to see $300,000 in capital gains from other sales.
What about the roughly $100,000 in taxes that Susan paid? Because she paid the alternative minimum tax, she’s now entitled to a $100,000 AMT credit, which she’s able to take in future years as a dollar-for-dollar reduction in taxes.
Like her capital losses, there are limitations to the AMT credit, as Susan is limited to a certain amount of AMT credit per year. The AMT is complicated, so I won’t dive into the math behind it, but what that means is that Susan is stuck with only taking a small portion of the AMT credit per year. In theory, it might take her 10 years or more to recover the $100,000.
This sounds brutal, and it is. An employee paid taxes for an investment, lost money on it, and may not recover the taxes she paid for a long time — if ever. In fact, this was the exact outcome for many people during the dot-com bust. The problem was so severe that Congress had to enact temporary laws to allow former employees to recover those taxes.
Why not all acquisitions are good for employee stock
We hear about successful acquisitions, where a startup gets bought by a larger company and employees get a nice cashout on their equity. And while people often use the terms “acquisition” and “exit” interchangeably, not all acquisitions are built the same. Acquisitions can also result in bad outcomes for equity-holding employees.
Back to the preferred stock that we discussed earlier. The most important right that preferred stockholders get is that in a liquidity event — like an acquisition — they get paid back their money (and sometimes more) first.
For example, let’s say that a venture capitalist invested $100 million in a startup at a $1 billion valuation. If the company later gets sold for $200 million, the investor has rights to the first $100 million (because they hold preferred shares), while the remaining $100 million would get split among the remaining common shareholders.
The existence of preferred shareholder rights has a big impact on employees.
Returning to our example with Susan, let’s assume that Susan’s startup took $400 million from investors, who paid $10 per share for preferred stock in the startup at a $2 billion valuation. Susan paid $1.50 per share for her common shares (plus some taxes). Overall, it seems like a pretty good deal for the employee.
Susan’s company eventually gets acquired for $500 million. Employees are excited about the exit — but not so fast. Due to preferred stock rights, the investors first get their $400 million back, leaving only $100 million to be split among the common shareholders. And while this is better than losing everything, common shareholders like Susan may only recover a fraction of the price they paid for their stock.
For example, this remaining $100 million could mean that common shareholders only get 50 cents per share. In this case, Susan paid $300,000 to exercise her stock options, and another $100,000 in taxes, but only received $100,000 back when her startup was acquired.
This happened to employees at a company we were working with. Publicly, reporters congratulated the people who had built the company to a solid, $500 million exit. But in fact, employees barely received anything for their exercised stock options.
The moral of the story
We all join startups with the hope that one day our equity may be worth a lot, but we can never predict the future.
Employees need to weigh the pros and cons, to determine if they want to exercise their stock options. Planning ahead will allow you to make the best decision for yourself and your financial future.
So startup employees: be aware of the benefits and risks of your startup equity. Stock options and taxes are complicated, and startup valuations and exits are uncertain. If you are unsure about what to do, find help from a CPA or licensed financial professional, who will be able to help you understand your options.
If you’d like to better understand the cost to exercise your stock options, visit Secfi’s Stock Option Tax Calculator, or reach out to us to explore non-recourse financing.