In the last couple of years, it’s become the conventional wisdom that the hottest, fastest-growing tech companies benefit from steering clear of public market investors as long as possible.
The trend toward staying private is a pretty lousy development for employees looking to move on with their lives, though. They have to exercise their options within 90 days of leaving or else lose them. And with valuations of billion-dollar companies up a stunning 59.7 percent over last year, according to CrunchBase, the amount of capital needed to buy one’s options has escalated too fast for anyone who isn’t already exceedingly wealthy to afford them.
Put another way, amid a sea of headlines about billion-dollar valuations are many thousands of employees who stand to lose countless millions of dollars unless companies start to go public, or else sell to an acquirer.
The issue is growing more extreme with every new “unicorn,” too. (For some context, 60 companies were valued at more than $1 billion last year. CrunchBase now turns up 94.)
A big part of the problem centers on the option plan structure that startups use. The 90 days that employees have to exercise their shares came out of some tax provision many decades ago when it was “generally feasible for departing employees to pull together the money to exercise their options and pay any taxes,” notes startup attorney Barry Kramer of Fenwick & West.
No one expects it to change any time soon, either, given that for most companies, it still works today.
And there are a seemingly endless number of other, technical issues in the mix. For example, the so-called incentive stock options (ISOs) that employees are given used to be far more attractive before Congress changed the rules roughly a decade ago. Now some employees are subject to an Alternative Minimum Tax (AMT) that they weren’t prior. The longer an employee waits to buy his or her options (and they often have to wait for them to vest), the bigger the tax hit, too.
This is why companies with skyrocketing valuations are particularly dangerous for employees. Shelling out tens or hundreds of thousands of dollars is hard enough for most. You can imagine needing to pay millions of dollars to acquire your options when you don’t have it.
A handful of companies, including Pinterest and Quora, have tried to ease this burden for employees by giving them years, rather than 90 days, to exercise their shares. That’s helpful, but it’s still far from ideal. Ninety days after an employee’s separation from the company, his or her ISOs automatically convert to what are called non-qualified options (NSOs), which wind up resulting in even more taxable income. That’s “still far better than just losing the assets,” as Y Combinator President Sam Altman wrote in a post last year, but they still put former employees in a precarious position.
Some companies (again, including Pinterest) have made it possible for employees to sell some of their shares on secondary markets to raise enough money to exercise their options and pay their taxes. But plenty of other companies have restrictions against secondary sales, for the understandable reason that they don’t want just anyone to own a stake in their company (and potentially acquire information about its financial picture).
It’s easy to imagine other, creative solutions.
In one scenario, suggests Kramer, a company might allow a portion of an employee’s options to be extended for a few years, with the employee forfeiting the rest.
That might sound harsh, but put yourself in the CEOs’ shoes: It’s often in a company’s best interest to be able to reclaim equity if an exiting employee can’t afford to purchase his or her shares within 90 days of leaving.
Companies also want to keep their talented employees. This way, they’d be giving employees a way to leave, but the door would be opened just a teeny bit.
Kramer says another approach companies might adopt would be to extend 10 percent of an employee’s options for every year that he or she has worked at a company (similarly to encourage them to stay as long as possible).
Of course, the best solution of all is for founders to focus less on all the hassles involved in going public and spend more time thinking about what an exit might mean for the people who’ve helped them build their billion-dollar companies.
The reality is that there’s a very real, very current, very unpleasant consequence to staying private. Companies are making it too hard for employees to leave.
“To some extent,” observes Kramer, “that doesn’t seem like a horrible price to pay for those who’ve generated a lot of paper wealth. But employees should have reasonable mobility.”
Here’s hoping they get it before the market turns again.
[Update: This piece has been updated to correct statements made about the way that the Alternative Minimum Tax applies to exercised options.]Featured Image: Bryce Durbin