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How I'm thinking about down rounds and equity during a downturn
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If you’ve been under a rock lately, you might have missed that the sky is falling throughout the tech world. Lots of layoffs being announced, high-profile companies shutting their doors entirely, and the down rounds are starting to trickle in. It’s easy to make money on stock in a bull market, because stonks only go up. In a bear market, things get way more complicated, in public and private markets alike. So let’s strap in for what is definitely going to be a bumpy ride, and talk about some stuff that’s likely to happen over the next months (or years) and how it might affect your thought processes around startup equity.
The dreaded down round
As we exit the forever bull market of the last decade and a half or so, we’re already starting to see the waves of cost-cutting measures as companies rush away from growth-at-all-costs philosophies to the safety of high margins and profitability. Not everybody’s going to get where they need to be before the company coffers start to dwindle. Only seven months ago, Tomasz Tunguz at Redpoint was musing about the 100x ARR multiple as the fundraising meme of 2021. Now there’s chatter of multiple contractions everywhere. Functionally what this means is that the unicorn round you thought you were getting? Forget it. That’s not happening anymore. And for many organizations who get stuck raising in this climate, they’re going to have to be firing on all cylinders just to maintain a flat valuation.
We’ll likely see more down rounds, like Klarna’s, in the coming months. A down round doesn’t necessarily have to be a bad thing for employees, though it depends a bit on when you joined your company, and how severe the haircut in the down round was. If you joined very recently, a down round could mean you have underwater stock options (note: the story is much different, and less dire if you have RSUs, which are tantamount to free cash). If you’re not familiar with the term “underwater,” it means that the cost for you to exercise the option is higher than the price that you can sell the stock for.
To illustrate this, let’s look at the examples above. It’s important to remember, as always when talking about employee stock options, that investors pay a different, higher price (the preferred price) than employees do to exercise options (the fair market value or FMV on the date of their stock grant). That spread is where the vast majority of employee equity value actually comes from.
In both of these situations, you got your stock grant sometime after a pretty serious up round, but before a down round. In the “Could Be Worse” scenario, however, the preferred stock price that investors are paying in the down round is still higher than your exercise price, so even though your stock isn’t worth as much, it still has value to you, if you were to sell it today, and your options aren’t underwater. In the “Danger Zone,” however, the down round actually brought the price of the preferred stock below the fair market value when you received your stock grant (which determines your strike price), so it would cost you more to exercise your stock than you would be able to sell it on the market for, even to an existing investor. That’s seriously no bueno.
Will we see startups repricing?
One trend to keep an eye out for is startups taking down rounds, and using it as a means to reprice their equity for employees. If this happens to you, and you still believe in the product you’re building/selling, it’s likely a net positive! Here’s the scenario that would play out:
Let’s say you join company X today, and company X last raised funding in January 2021 at the market peak at $10/preferred share. Let’s say the FMV (which determines the strike price on your grant) is $4/common share, which imputes a net value of $6 for each share. That $4 price is actually determined by independent 409A auditors who come in and evaluate the stock – it’s not a price that’s actually set by the company.
Now let’s say a down round happens, and the company sells new equity at $7/preferred share. A new 409A valuation is completed by an independent auditor, as required by the IRS, who determines that now common shares are actually only worth $2. This still falls into that “Could Be Worse” scenario, because anybody holding options at a $4 strike still has options that are theoretically worth a net of $3 on the open market today.
The company could now say: “well, we can actually make this sweeter for employees, and encourage them to stay longer.” They do this by canceling your existing stock option grant (the one at a $4 strike) and issuing a new one with the same number of options at a $2 strike. The only thing that the company can’t control is the strike price (which is always set to the FMV price on the day the grant is issued), but they can backdate the vesting. So they set your new grant, at a $2 strike to have a vesting start date that matches the original grant. Presto, change-o, more valuable shares! The shares are now worth $7 - $2 = $5/share. The employee hasn’t made back the entirety of the value from the new grant (originally, they were worth $6), but they’ve recouped a significant chunk of the value lost in the down round.
Again, the key question here is: is the company still standing on solid fundamentals? If growth is good, investors are still bought in, and the company merely had an inflated price in the last round, this might actually be a very reasonable outcome for the employee!
It’s worth noting that RSUs would work differently in this situation. Since you don’t have an upfront cost to exercising RSUs (they’re just vested, without requiring an exercise), a down round’s impact would be to reduce the paper value of your RSUs, and the goal of a repricing would likely be to provide additional RSUs to employees on the basis that each RSU is worth less after the down round. This would help preserve the value of the equity package by adjusting the volume instead of the price.
Timing the market: should you exercise?
So, this all brings us to the real question that people should be asking themselves: should you exercise? There are loads of studies in the world showing that timing the market is generally a really bad idea. However, that’s generally the rule in an efficient market, and the private markets are anything but efficient. When it comes to exercising, I am always an advocate for being intentional about when, and how many options you exercise. But in this market climate, it becomes more important than ever.
Depending on how much transparency you get in your organization, you may actually have fair warning of an impending fundraise, which can be an extremely useful signal in deciding whether and when to exercise stock options. The most naive, but safest thing you can do, in a market where down rounds can happen, is wait. I’ve seen both situations where I had a lot of advance notice (such as companies giving deadlines for employees to put exercise requests in) as well as situations where raises happened with near zero notice. A lot of it depends on company culture. Once a company gets ready to raise, the important question to know the answer to is: is this going to be an up round? Or a down round.
In the case of an up round, exercising only gets more expensive as the valuation of the company goes up (if you hold NSOs, this is because you pay income tax on the spread between your strike price and the current FMV, and if you hold ISOs, it’s because you will have greater AMT exposure). If you plan to exercise, it’s always going to be more advantageous to exercise before the round.
In the case of a down round, however, you’ll actually end up in a better situation if you wait till after the round completes. Again, this is because the post-round FMV will be less than the current FMV (in virtually all situations), and so you’ll have less tax exposure if you exercise after the round than before the round. Granted, if your company is taking a down round, you need to think hard about how viable the business is, and decide whether or not the equity will be marketable in the future. I’m definitely not tackling that decision here.
Putting my money where my mouth is
I don’t typically talk about my own situation, but to provide a concrete example of how I think about this situation, I’m looking at the following details (for reference, I only hold ISOs):
My employer raised money at a significant valuation in early 2022
Realistically, I expect it to take time to grow into that valuation, but our current trajectory is such that I don’t fear an outcome where my stock becomes worthless, or even decreases in value materially
My strike price is low enough that, even if there was a down round, I feel very confident that my stock would still hold value
On these facts alone, I feel good about exercising my stock. The real question is: how much, and how often? To answer those questions, I have to consider some other factors.
The company is well-capitalized and has a multi-year runway, so it’s unlikely we’ll have to raise anytime soon
Why it matters to me: I don’t feel like I’m rushing to exercise to beat a deadline for valuations going up, so I can exercise somewhat leisurely, and intentionally.
The company has raised enough money that we are well past the point of exercised stock being QSBS
Why it matters to me: If I could get QSBS treatment, I would exercise everything all at once, because the potential future tax savings would be so significant. Since I’m not eligible for QSBS, I feel much less timing pressure.
I can’t say, with 100% confidence, that we wouldn’t eventually raise a down round
Why it matters to me: I don’t want to overpay on taxes if the valuation were to go down. By exercising a lot of options at the current valuation, I would end up paying AMT based on the current FMV, which is based on the valuation of our most recent round.
The company has previously provided liquidity to employees through secondary transactions, and I believe there could be more in the future
Why it matters to me: I’m incentivized by this to exercise early, to aim for having stock that is in long-term capital gains territory by the time I have an opportunity to sell it.
So what I’m actually doing is working with my accountant to figure out how many options I can exercise before I start having to pay AMT, and then targeting an exercise that gets me right up to that line. In reality, I just crossed my one-year vesting cliff last month, and then did a quick back-of-napkin tax planning exercise to estimate how much I think I can exercise before I hit AMT. For my family, calculating that limit is a little bit of guesswork, because our household income is substantially made up of variable commissions, and the amount of money we bring in impacts where that AMT line is. Once I had a rough number, I exercised about 25% less than that. That gets me to a safe exercise where I don’t feel like I’m seriously risking paying AMT. I’ll go through the exercise again right before the end of the year, once I have much firmer numbers on our total income, and I can get a much more accurate picture of where the AMT limit is for us. I don’t want to wait till the very end of the year, because that would mean waiting 6 more months to exercise, and I’d rather get the long-term capital gains timer started on some of my stock, than wait till I have exact numbers, on the off-chance that I end up eligible for a secondary tender offer down the road.
Down markets bring a number of additional factors into the equation. They definitely complicate the calculus of startup equity, but the same fundamental ideas apply. Understanding the dynamics between preferred and fair market valuations, and the basics of our tax system are critical to making intelligent, informed decisions.