Venture backed startups rely heavily on employee stock options to attract and retain top talent. Stock options give the employees a piece of the company's upside, letting them benefit with the company's success. However, the current environment for IPOs often makes for a very long time horizon to achieve liquidity and has given rise to secondary markets for private company stock. Rather than having your employees distracted by searching for buyers of their shares or contemplating a long NSO extension program for all employees, private companies should consider a private liquidity program.
In a company sponsored official liquidity program, the company allows a third-party such as the Employee Stock Option Fund to provide cash liquidity to their employees. This means that confidential company due diligence is provided to only a single external entity under NDA rather than risking the outcome from numerous employees individually pursuing their own deals and sharing confidential information with strangers. The use of an ESO advance provides liquidity to employees on a low risk and tax efficient basis while not introducing any outside shareholders to the company's capitalization table. Unlike secondary market stock sales where strangers and possibly competitors get access to control and information rights, a liquidity program through ESO does not extend any management or information privileges to the ESO Fund.
In recent years, many companies like Palantir, Pinterest, and Luxe have addressed this issue by adopting long expiration periods on their stock option grants. Although appealing to the most risk-averse employees, this method has multiple problems. First, it encourages employee turnover and dilutes stakeholders. Early employees can join when their option grants are very large and inexpensive and then just leave after vesting even a small portion. Subsequent employees won't get nearly as many shares and their strike prices will be higher, but the later employees will be responsible for doing most of the work needed to reach the 8+ year average time for reaching a liquidity event. Yet, the early employees who quit will get most of the benefit despite working a shorter period of time. Every departure of an employee will continue dilute the capitalization table and possibly force a recapitalization to make the situation more equitable for the current employees. This type of outcome is viewed very negatively by the investment community and even the presence of a no-expiration option program implies this vulnerability and general weakness in recruiting. In contrast, a liquidity program creates the market perception of a hot stock and addresses the same issue but can be selectively applied to only current employees or just a few on those occasions when warranted. Moreover, option extensions cause tax-advantaged ISOs to be replaced with NSOs which are subject to very high ordinary income tax at the point of exercise. In contrast, ISOs can be exercised piecemeal while vesting to avoid most if not all Alternative Minimum Tax (AMT) and gain eligibility for the substantially lower long term capital gains tax rate after the required holding period.
An ESO transaction can provide employees with discretionary cash while simultaneously preserving the employee's upside potential and thereby maintaining their loyalty to the company's ultimate success. In addition to liquidity advances involving shares owned by employees, ESO can advance the funds to cover exercise costs including the taxes. Employees benefit in numerous ways from exercising such as starting the clock on long term capital gains and avoiding heavy AMT tax consequences that can occur later if the company's stock rises in value. However, the cost of exercising can be beyond the reach of many employees.
Companies therefore face a conundrum. On the one hand, they want to incentivize the employee by granting them options. But on the other hand, circumstances that prevent the employee from exercising can cripple these incentives. Owning common shares in the company gives existing employees a current stake in the business which can be a significant motivating factor. If a company decides to assist employees directly, there are tax consequences in addition to just using up valuable capital inefficiently. For example, non-recourse company loans to employees are usually not eligible for long term capital gains. Another concern is when companies re-purchase common stock, they run the risk of raising their 409a FMV value to the point that new option grants are unattractive as a recruiting tool. Moreover, the company is potentially liable for withholding tax at the ordinary income tax rates on all employee gains when running their own program.
The Employee Stock Option Fund provides financing for option exercise and for liquidity based on previously issued shares. The employees retain title to ownership including privileges such as voting, dividends, and the possibility to enjoy future appreciation in value. At the time of the final liquidity event such as an M&A or IPO, the ESO Fund is repaid. Any time prior to that, the employee can buy out the ESO Fund and retain all future appreciation for themselves.
Please contact us if you'd like to learn more.