Gilt Groupe Is a Cautionary Tale for Startup Employees Banking on Stock Options
recode.net
recode.net
The pre-IPO valuation thing is a mess. It's probably going away; investors are tired of being clobbered when the price goes down on a company that's supposedly successful.
Well it only affects VCs and founders at a secondary or tertiary level. Even early employees at the seed stage aren't that badly affected by it if the founders structure things to minimize capital gains (ex: allow early exercise with a buyback clause).
Who is hits the hardest is the post Series A employee. Those with the strongest muscles likely aren't going to go bat for them in Washington quite yet.
What exactly is the combination of factors that produces that outcome?
It may have been as simple as 'this stock price is going to go up after we go public, so it's in your best interest to buy the shares now'.
That's what I thought. Exercised too early.
(And yes, the solution is to not exercise until you're able to sell.)
The fear of paying more taxes (or waiting longer for the 1 year period after exercising) causes a significant amount of people to expose themselves to a potentially devastating downside by exercising ASAP.
While this seems like a silly thing to do (and it is, IMO) it has to be seen in the context of a company full of people experiencing (often for the first time) what seems like it will be a very successful "exit" and everyone in the company is in euphoria mode, counting their Lamborghinis before they are hatched.
Of course, after you see the results of this happening the first time you get to be the Debbie Downer who warns people of the possible downside in subsequent companies. IME this is a tough position to be in because you look like a negative asshole when everyone else is in party mode (often being egged on by upper management selling the dream).
Exercise early, pay little tax because the FMV is low.
Exercise late, pay lots of tax because the FMV is high. Exercise late and sell, pay lots of short-term cap gains tax.
Exercising late, while still unable to immediately sell some shares to cover the tax bill you know will come seems like taking a huge risk.
Pre-IPO employees were encouraged to pay for shared before they vested. The idea here is that you can hold those options for 5 years and get capital gains rates on that appreciation which for small companies was 10%. I.E, you pay now, shares vest later. According to the AMT, you will owe taxes on those shares equal to the market price when they become yours minus what you paid for them. That is, when the stock vests. Not when you pay for it, and not when you sell it.
So you can buy 1000 pre ipo shares for $1 each. Company goes public hits $100/share. You think it's going higher so you hold. Shares drop to $10. Now you're in a pickle. You owe taxes on 1000 shares * $99 of gain. But you're only sitting on 1000 shares * $9 of gain. When somebody finds themselves in this situation, they must sell those shares before that tax year ends, which means you're now paying income taxes instead. If your tax year has ended you are out of luck.
The one thing that stops this from being a real problem for most founders is the IRS 83(b) form, which is to notify the IRS that you want to recognize the income associated with your option when you buy it as opposed to the default which is when it vests. Why doesn't everyone file their 83(b)? Clearly, the risk here is too complicated for many to understand and it's a very unusual situation to arise.
Here is the story of how our CFO(!) at that company ran into this exact problem to the tune of $316,040 tax liability for shares he bought with money borrowed from the company(!): https://www.washingtonpost.com/archive/business/2000/07/02/k...
Some references: https://www.nceo.org/articles/stock-options-alternative-mini... https://blog.wealthfront.com/always-file-your-83b/
In fact nothing has any worth except the bowl of soup you are currently eating, and the cardboard box above your head to keep out the rain. Just ask this homeless guy outside. Just ask him, seriously.
No reason to think it works any differently in a private company - in fact private shares often carry a much higher risk of becoming worthless.
There is no certain guarantee that shares in your current or past employer "is gonna pay for your house".
If you have such an attitude you really should be thinking twice.
This whole "share options for everyone" mentality is a problem.
Share options are for risk/reward seekers - which means you accept the RISK just as eagerly as the reward.
Options are not supposed to be some sort of freebie lottery ticket for everyone.
Its meant as incentive for people with an entrepreneurial spirit who may be taking risks in terms of job security, or those who bring highly specialized knowledge to a startup at below market salary, or as an incentive for employees to work far harder than they would normally be expected to be working.
Tax considerations - definitely get real expert advice
And see what others have said below.
It used to be that you could buy your options and hold them without any tax hit. After holding them for a year, if you could sell them, any gain was taxed at the long term capital gain rate. Since the long term capital gains rate (LTCGR) was much much lower than the short term gain, this strategy reduced the amount of taxes you paid. It was deemed a "loop hole" that the rich used and it needed fixing.
The fix was something called "Alternative Minimum Tax" or AMT. The way AMT works is it ignores the fact that you cannot sell your stock, and asks you to compute if you had sold the stock options you just exercised and treated all of that gain as ordinary income, how much tax would you have owed in that fictional scenario? Then it asks you to compare your tax bill in that fictional universe, and your bill without considering that fiction, and which ever is higher? That is how much you owe in taxes. It doesn't matter how you came by the stock, it could be through restricted stock plans (no cost to you to vest) or incentive plans. The difference between how much you paid, versus how much that stock is theoretically "worth" is treated like ordinary income.
What that means from a practical standpoint is that you are screwed either way. But if the stock becomes worthless you are doubly screwed. First you lose all the money you paid to exercise (the value is now zero) and second, while you can claim a capital loss, that loss can only be applied against an offsetting gain of "like" kind. So back when it was an AMT calculation you had to treat it like ordinary income, but now as a capital loss you can only offset other capital gains. The small concession is that you can consider up to $3,000 as a loss against your income (so you adjust your income down by $3,000 and you end up not having to pay the marginal rate income tax on that $3,000. If you're in California and an engineer making $100K+ annually that means you are probably in the 28% tax bracket paying 28% federal and 11% CA state tax, (39%) so you get to "keep" 39% of $3,000 or $1,170 that you would have paid in taxes.
So are you keeping score? You paid $3,000 in tax on an asset you could never sell, and you got to offset your income by $3,000 so you got "back" $1,170 of it, letting $1,830 of it evaporate into smoke.
You can get it back, dollar for dollar, if you have some capital asset that you're selling and seeing a gain on, then you can apply every dollar of your loss against that gain, up to all of your loss, and not pay any tax on that gain. (that doesn't work for offsetting AMT but does work for an actual capital gain, like sale of property or equity you were already holding).
The system is designed to take money you might have otherwise been entitled to out of your pocket and to put it into the general fund of the government so they can spend it poorly on their own programs (ok that is a bit cynical but seriously, I would be totally ok if they told me I had to give some to charity.)
If you don't have capital gains you want to offset, don't exercise your options until you can actually sell them. If they are going to expire before you can sell them, the safe play is to let them expire.
Will speak to an accountant either way but keen to hear your perspective.
Of course had that not been the case I would have been writing off $3000 a year against my income for slightly more than 100 years :-(
And the ability to carry those losses forward is actually not present everywhere so to some extent you're still lucky, it could have been much worse.
I always joke that if I ever invent time travel I would go back to that date and figure out some way to sell puts or something which would have locked in the pre-crash value. And I was fortunate that I could sell some stock and was able to pretty much cover the tax bill so at the end of the day after everything went pear shaped I was just sitting on a huge capital loss. I continue to feel fortunate that I came through the dot com crash wiser but without a giant pile of debt or tax liabilities.
One of my peers had taken on a huge debt to build their dream house in the Santa Cruz mountains which they were going to pay off with their stock proceeds when the house was done. They ended up basically penniless trying to unwind that. When you are in a disaster and the person laying next to you is so much worse off than you are you feel very grateful for what you have left.
Time will tell if we see some more people who have these experiences as we unwind the Unicorns which can't survive.
Things went very fast from there and before we knew it all our competitors had simply vanished, right along with their paper gains. A lot of people that were riding high one day were back where they started in '95 or worse, we simply got lucky.
I mortgaged the house that I'd already paid off and bought out the other shareholders, from there it took a long time to make any serious profits but in the end it did and the final sale of the main domain was the icing on the cake. Crazy wild ride. But in another universe you're sipping champagne on your second yacht and I'm a penniless dude run into the ground by a well funded competitor.
It wasn't all that sure which way the future was going and all that tipped off that things were going to get ugly real soon was a single missed cheque from 24/7 media. I figured if they can miss a payment they might go under entirely and they actually did about 6 months later. By then we were more or less ready for it.
We're seeing a repeat of this kind of sillyness right now, in many ways. But there is a big difference, there is also a lot of actual validation, and real underlying value. Just a couple of totally overblown companies that will likely spoil the IPO market and some areas of investment. The rest of us will survive just fine, I don't think we'll see a repeat of march '01.
My suggestion to all engineers is to use the leverage you have and insist that vested ISOs convert to NSOs if you leave a company. If they don't want to do this, well, there's a reason, and it's not good for you. At minimum, they intend to crank those golden handcuffs tight, and if you have life changing events in the 5-10 years it takes a company to go public (want a house, partner wants to live somewhere else, kids, etc)... tough luck. If you continue even without a conversion clause, apply a massive discount (on top of the massive discount you should already be applying) to the "value" of those options.
As for your anti-tax rant... if you want nice things (roads, schools, universities, clean air, judges, police, hospitals, child protective services, efficient postal mail, etc), someone has to pay for them. Charity is no substitute for our collective choice to pay for things.
Upvoting to support the idea that taxes as a concept aren't the problem, here. The problem is this obnoxious system of taxing things which likely have no value.
It sucks that giant multinational corporations can pay effectively zero taxes (or negative taxes thanks to rebate programs and such) and much of the population will support this simply because they don't like that a significant percentage of their income goes to taxes.
Instead of "let's have corporations pay a fair share and me pay less" the message ends up "taxes are bad, let's not have any taxes!" (ignoring the rather obvious issue that without any sort of public funding the country would literally fall apart).
That's not even remotely true. They may have zero or negative rate for some taxes, most often corporate income tax, but that's to be expected, when you have a rate of 35%(!). There are many other kinds of taxes, though, and the effective rate for any given corporation, or any sector, no matter how you slice the economy, is not going to be zero.
Wait, are hospitals taxpayer funded in America? If so, why do they charge my insurance such vast amounts of money for tiny services?
I care pretty deeply about this, and I want to start pushing more startups in this direction. I think the tide started turning in the last six months or so and more companies are allowing for a >90 day exercise window on NSOs, but it's still a pretty small club. I've been keeping a list in a repo, since I think it's important to help promote companies that are doing this for their employees: https://github.com/holman/extended-exercise-windows
The target was "the rich" but when a tax policy bankrupts someone (as it did to people in the dot com crash, and will do to people in the unicrash) I disagree with it.
Companies are not only far better situated to understand the tax situation (wilson sonsini or fenwick make a living understanding/optimizing for it) but also have, and afaik always had, the choice to make employee-friendly comp choices such as turning ISOs into NSOs, giving RSUs in lieu of options, or perhaps even early exercise and 83b elections for all.
It's fair to say that golden handcuffs aren't exactly making CEOs cry themselves to sleep at night, and it might be fair to say they even like them.
The story I expect to read is probably an Unicorn employed engineer who exercises their options (perhaps this month) because they are leaving, and owes a huge tax bill come April 15th of next year, and by the time next year roles around their Unicorn is dead and they have worthless stock and a huge tax bill, and they are in debt because they borrowed money to exercise their option. The very definition of being 'upside down' in accounting terms.
I'd love it if that doesn't happen, but given this story on Gilt I'm pretty sure we'll see more like it.
I meant that, from CEOs' perspectives, the tax code is a feature not a bug. CEOs have the ability to work around this for their employees in multiple ways (NSO conversion, early/83b, RSUs, allowing sales via eg secondmarket) and don't.
It would seem silly to use the VC valuation, because A.) It's a preferred stock valuation and B.) You'd have a '37signals problem' if nobody else is actually willing to buy the rest of the company for that price: https://signalvnoise.com/posts/1941-press-release-37signals-...
This can include other taxes that you cannot deduct. So you are essentially paying taxes on taxes. Heard about the unfairness of the AMT for years and never really worried about it until it affected me.
The claims were not exaggerated. It's a mother.
http://www.businessinsider.com/pinterest-will-let-employees-...
Yes, that Hudson Bay Company. Founded in 1670. Among the oldest joint-stock companies in existence, I'd warrant.
As a rule of thumb: don't count on your stock options being worth millions if you are leaving a job for a better opportunity in a product you like better. Your actions are saying everything you need to know about the value of those options.
See, this is why companies use worthless stock options in the first place.
I guess some things never change, oy vey