🤔 How do you know if your startup is “good”?

I hope you all had a great July 4 as all of us Secfiers took a bit of time off to celebrate with your friends and family and recharge for summer. Which has been much needed because things have been very busy for Chris, Vieje, myself, and the rest of the team. Which is great news! We’ve been speaking to a lot more people and bringing on new clients at a rapid pace.

One reason is that many in our community are seeing a light at the end of the tunnel. Yes, layoffs are still happening, and yes the IPO window is still shut. But there are glimmers of light — IPO rumors for later this year into early next year are running rampant — and we’re even in a new bull market, which I covered in our last issue.

But in good times, or bad, the constant question we always get is: “how do I know if exercising my stock options is worth it?” Really, what they’re asking is if their company is good.

One factor that is different right now is that we are coming off of peak valuations. According to one study at Carta, 45% of Series D 409A valuations declined in Q1 of 2023. We’ve seen this continue in Q2 with our clients and others we’ve spoken with. So wondering if now is a good time to exercise stock options is a valid question. Plus, we already covered this year that one main barrier to IPOs returning is valuation mismatch between startups and investors.

It’s often the key question for our clients, and exactly where we like to start: figuring out their equity. Since Chris, as our lead financial advisor, often spearheads the discussion about this, I asked him to contribute some guidance.

Before I pass it over I’ll note that exercising options always carries risks. And sometimes, it’s not a good financial decision! So do you evaluate if it is, and minimize the risks? We’ve already helped clients retain hundreds of thousands of additional value, learn more about our advisory services here.

🏃 Step back and understand the decision

Exercising stock options is an investment decision. When you exercise your options, you’re buying stock in the company you work for. The money you put up is at risk — it can lose value. So how do you evaluate the soundness of your potential investment? How do you get to a better understanding of the risks you are taking?

Let’s start with the first principles: stock is fractional ownership in a company. That means, as a shareholder, you have a proportional claim to the profits that company generates. This is why stock prices are driven by earnings in the long run.

So the fundamental questions you need to answer are:

• Will my company be profitable?
• How profitable?
• How long will it take?
• And, how much am I paying for that potential profitability?

The more clear the profitability path becomes, the more investors are willing to pay for the shares.

To state the obvious, Profits = Revenue - Expenses. Revenues are simply the volume of sales multiplied by the price per sale. Finally, expenses are all the inputs it takes to make those sales. Some expenses are variable, like the cost of the materials to produce a product. And some are fixed: you have to pay the rent on the office building no matter how much you sell or don’t sell.

With this simple framework and understanding of what drives profits, you can more clearly think about the viability and potential value of your company shares.

🚦 What signals to pay attention to

If you’re uncertain about your exercise decision, it’s likely that you’re concerned about the downside. So let’s talk through some potentially negative signals that you should consider when exercising stock in an individual company.

1. Unsustainable unit economics

You can’t sell a dollar for $0.50 and make up for it with volume. Unit economics is about the sales price of your product minus the variable cost of producing/selling that product. If it’s costing you an incremental dollar to generate an incremental $0.50 of revenue, you may have a problem unless you can increase the revenue per sale or decrease the variable costs.

In short, unit economics is about understanding how much it costs your company to generate new revenue, and how much it will cost in the future.

Over the past two years, the market has shifted from a historically low interest rate environment — where growth was rewarded with little regard for the costs incurred to generate that growth — to now, where investors are rewarding capital efficient companies who demonstrate their business model can produce profits. By nature, many venture-backed startups are not profitable starting out, so if you’re at an early-stage company, it’s likely the company is unprofitable. That’s okay and normal! It’s why startups are often called “venture-backed.”

That does mean the risks of exercising options at a young company are higher, however. But the total costs are also significantly lower than mature companies due to a lower valuation for the company (and to taxes owed). If you’re optimistic about your company and are comfortable risking some of your money on your company’s future, exercising a portion of your option grant could make sense.

If you’re at a late-stage (Series C and beyond) company, and for every $1 of new revenue your company generates, the variable costs are > $1, this is a signal that your company may have a difficult time increasing their valuation going forward and could be a reason to hold off on exercising your options.

2. Missed revenue targets and customer attrition for consecutive quarters

In the current market environment, many businesses have taken a closer look at where they are spending money and are seeking opportunities to reduce expenses and become more capital efficient. “Nice to have” products are being eliminated as companies determine they are non-essentials for operating their business. As a result, a lot of companies that sell B2B solutions have seen this trend reflected in their revenue over recent quarters.

One of the most reliable methods to tell if your product is truly indispensable is if customers continue renewing their contract despite being forced to reduce spend across the business. A quarterly revenue miss is not fatal, nor a reason to give up on your stock options. However, you should be aware that if your company has missed revenue targets or has experienced higher than normal customer attrition, it is unlikely that the business valuation will be increasing until these trends are reversed.

3. Employee and leadership turnover, or talent fleeing to a competitor

There are a variety of reasons for why someone chooses to leave a company. We’ve seen many individuals involuntarily leave as many companies have reduced headcount to lower their burn rate to preserve runway. I have also spoken to many employees who have voluntarily left their company due to burnout, cultural shifts, or stifled personal and business growth over the past year.

An exodus of talent takes a toll on any business and can erode value creation, especially if top performers are leaving to join a competitor that they believe is better positioned to capture market share. If you notice this trend at your company, it could be a cautionary signal to hang tight on exercising your options until you are able to evaluate how these changes are impacting the business.

4. Your options are "underwater"

The term “underwater” means that your strike price > current 409A (aka FMV). In this situation, exercising options would not be favorable because you are paying a higher price than the current value to acquire your company’s stock. Unless you’re extremely confident that your company’s valuation will rebound or you’re on a tight deadline to exercise your options, it’s better to not exercise underwater stock options.

If you find yourself in this situation, I would recommend that you inquire with your company about reissuing your option grant based on the current fair market value.

For example, if you were granted 20,000 ISOs at a $1 strike price and your company’s current 409a is $0.80, the same economic value would now be 25,000 options. If you’re optimistic about your company’s future prospects and want to financially participate in any upside created from this point on, it’s in your best interest to request that your options grant to be reissued.

📏 Remember, nothing is black-or-white 

Ultimately, these red flags could mean the company may have a hard time increasing the valuation of the business going forward but it's not a cut-and-dry rule. Also look at the current environment — nearly every company is cutting valuations and has done layoffs. Even the good ones!

That’s why, in some situations, it might still make sense to exercise options in the presence of these red flags. Even if you’re uncertain about your company’s ability to increase the business valuation going forward, if you have a wide “margin of safety” between your strike price and the company’s current FMV, now may be a great opportunity to consider exercising your options.

For example, if your strike price (i.e. price you pay to acquire one share in your company) is $0.25 and the company’s current FMV is $15, your margin of safety is $14.75 per share. Even if your company does not IPO, there could be a variety of other opportunities, such as tender offers and secondary sales for you to receive liquidity for the value of your shares.

Exercising your options positions you to pursue these liquidity opportunities and retain additional upside upon holding these shares for beyond 12 months. For employees with a large “margin of safety” and/or at promising companies, NOW is an incredible opportunity to consider exercising your options.

Here's why:

• Lower valuations for ISOs means you can exercise more options before you incur AMT.
• Lower valuations for NSOs means less income tax due upon exercise.
• Lower valuations + delayed IPOs = opportunity to implement a multi-year exercise strategy for your options.

Taking a multi-year approach can result in saving taxes upon exercise, more time to accrue cash to put towards exercising options, and any future increase in the company's valuation being taxed at a lower rate upon sale.

These are just a few of many factors to consider prior to exercising stock options. For some startup professionals, lower valuations can be a great opportunity to start obtaining equity in your company and setting yourself up for expanded financial possibilities in the future!

My team and I can help you make a plan for your equity, learn more about it here.

Things we’re digging:

• 💰 We now support secondary sales! If you’re an avid reader of F+F, you’re likely aware that we’ve been helping folks with secondary sales. Well, today we officially announced it! Navigating secondary markets can be tough, so we want to help handle the complexities for you. Plus, we're working with an exclusive network of buyers and markets that you get access to. You can go ahead and submit your interest through your account to speak with someone.
  
  
• 💻 Monitor your equity value over time. Our portfolio shows you the current, and historical value, of your equity. You can also see how important events like funding rounds, vesting cliffs, etc. impact your equity’s value. Simply sign into your account to check it out!
  
• 🐦 Will Threads replace Twitter? Who knows! But, Zuckerberg’s rival product is certainly doing its best. The fact that Elon has blocked Thread links and threatened a lawsuit indicates he’s feeling the heat. But remember Google+? It was dubbed the “Facebook killer” and was swiftly adopted...only to be relegated to the waste bin.