What are your options when you don't have cash to exercise?
Or: This post was an excuse for me to learn more about forward contracts
Lately, I’ve been increasingly getting asked something along the lines of: “I want to exercise my options, but I don’t have cash to do it. What options do I have?” The truth is that there are a variety of ways to navigate these waters, and some are better than others.
Option 1: Start saving yesterday (this is the best approach)
Ok, this option is kind of a joke, since it is predicated on you having cash to exercise your options, and I recognize that some folks will simply not have the capital to exercise their options. In an ideal world, you are able to save cash, set aside cash for ridiculous money games, and use ridiculous money game cash to exercise options. Tragically, golden handcuffs exist, and sometimes company valuations rise too much, too fast, and even if the exercise cost is tractable, sometimes the tax liability is not.
My critical reminder to you here is: company valuations can and do go to zero. This happened to me early on in my career, after early exercising a whole chunk of stock, and was a fantastic lesson in risk management. It wasn’t world-ending for me, but I lost about $10,000 (thankfully the loss came out of a prior winning startup lottery ticket).
As a general rule, when exercising options, I only use money that I can afford to lose. For net worth accounting purposes, I assume that I’ll make back what I put in, and nothing more. It’s just helpful in managing expectations, in my opinion.
Option 2: Get a loan (this is a bad approach)
Let’s say you’re an employer who wants to be super employee friendly, and you’re thinking: “How can I make sure that my employees are able to own their piece of the company even if they don’t have tons of cash on-hand to exercise their options?” This is a nice thing to want to do, and you might say: “I’m going to make it super easy for my employees to take out a loan to exercise their options, but I’m just going to cover exercise costs since I don’t want to overextend the company’s cash reserves.” And you might also say: “And also, because I want to make sure that they can limit their tax liability, I’m going to let employees exercise their options early, so that they don’t get hit with a huge AMT bill.” And as an employee, you might be thinking: “This is such an awesome perk, I am definitely going to take advantage of it.” This is what Bolt did.
So how does this fall apart? Well, as it turns out, sometimes, markets go down. Sometimes there are “macro challenges.” And in Bolt’s plan, if you were no longer in good standing with the company, you had 90 days to pay back your loans.
So…markets went down. People got laid off. If you were lucky, you hadn’t vested your options, and the company repurchased them and canceled your loans. If you were unlucky, you now owned a whole bunch of much-less-valuable stock with no liquid market to sell it on, and also you owe a whole bunch of money. And naturally, this is exactly what happened.
The Bolt snafu is a little bit of an extreme situation, since most loans can’t be called back in full after 90 days. So theoretically, you could go and get your loan from a bank, as well, probably under the auspices of a personal loan, but those personal loans are still likely to carry relatively high interest rates (7-9% is around where I typically see offers, but with the Fed fighting inflation, it’s probably increasing rapidly).
Again, stocks can go to zero. And with a loan, you are still on the hook for that principal. And depending on your situation, you may or may not be able to write off your losses from your taxes. My guidance: don’t take a loan to exercise your options. It’s a bad idea. Equity is a high-risk (and potentially high-reward) investment, but it’s not worth exercising options with money you don’t have.
Option 3: Execute a forward contract (this is an interesting approach)
Here’s a different idea. Let’s say you want to get some liquidity to exercise your options, and you find someone who’s really interested in investing in your company. And the two of you go back to the company and say “we want to make a deal!” But then your company says: “well, you can’t, because we don’t allow secondary transactions.”
Your investor friend might say to you: “Hmm. Well, what if we agree on a price, and I give you some money now, and we agree that, at some point in the future, you’ll give me some stock.” And you shake hands, and transfer money. This is basically how forward contracts work.
Depending on how you structure this, there’s some obvious risk. If your investor friend says: “in 10 years, if you haven’t given me any stock yet, I’m going to need my money back,” then this is a recourse forward contract, and is essentially the same as a loan, and is just as bad as a normal loan. Because, if you recall, companies can fail.
However! If your investor friend says: “If you’re never able to provide the shares, c’est la vie,” then this is a non-recourse forward contract, and is actually pretty compelling. If the company never has liquidity, you don’t owe a dime.
There are some really nice benefits to this:
You can execute a forward contract a lot quicker, because the company isn’t involved.
As the seller in the transaction, you reduce your risk, because you’re using someone else’s money to exercise your options.
Coincidentally, I think these benefits map onto the most common reasons you would want to leverage a forward contract:
You just left your company, and have 90 days to exercise your ISOs (keeping in mind that even if your options don’t expire after 90 days, ISOs will automatically convert to NSOs, which are a lot more expensive to exercise), and need capital to move fast
You have vested options, don’t feel confident enough in the company to risk your own cash, but still want to benefit from the possibility of some kind of positive outcome
At this point in the article, you’re probably thinking: Wow! This is such a cool financial instrument! This can’t possibly get more interesting and exciting! You’d be wrong. Because we still have to talk about taxes! Let’s call this next section…
Forward contract taxes
Let’s add another character to our story. Let’s call them Sally, your friendly neighborhood IRS agent. Now Sally catches wind of your arrangement with your investor friend and she comes over to your place of business, and says: “Hey, I heard about your arrangement with your investor friend, and I’d like my piece of the stock sale.” And you respond to her: “Oh, but I didn’t sell any stock yet, my friend just gave me money now, and I’m going to give him the stock later, so we haven’t actually completed the transaction.” Unfortunately for you, Sally is unfazed.
In Sally’s IRS agent parlance, the situation you now find yourself in is what she would term a constructive sale. It bears all the markings of a sale, and so as far as the IRS cares, you sold your stock, and now you owe income taxes! (Or maybe capital gains taxes if you have some already-exercised, held-for-more-than-a-year stock that you claim you’ve effectively pledged as a part of this forward contract.)
“Alright,” you say to your investor friend. “How are we going to do this differently to make sure that Sally can’t just claim a constructive sale?” And your investor friend is smart. They say: “I’ve got the perfect plan! We’ll just make it so we don’t know exactly how much stock you’re going to give me when we settle up!”
Taking a step back, a typical forward contract goes something like:
You give me $50,000 now, and I’ll give you 20,000 shares of stock at some later date.
There’s a clear share volume (20,000 shares), sale amount ($2.50 / share), so it’s very easy to compute the tax liability.
But what if we do something like this instead:
You give me $50,000 now, and we’ll call it a cash advance, and I’ll give you back your $50,000 plus 10% of the total proceeds from a liquidity event.
Now it’s totally unclear how much the IRS should get, because neither party in the transaction knows how many shares are actually being transacted, since the final sale is dependent upon a future, currently indeterminate value. In practice, when a liquidity event happens, the price is then set, and the investor and seller are generally able to decide amongst themselves whether they want to settle up in cash or by transferring an equivalent number of shares.
You and your investor friend take this proposal back to Sally, and say “How do you like them apples?” And lo-and-behold, Sally’s like, “Oh, yeah, this is just an open transaction. We’ll settle up later.”
This, friends, is the basis for the prepaid variable forward contract. The beauty of the PVFC is that there’s no upfront tax liability due to a constructive sale, though there’s still potential tax liability from the exercise (AMT if it’s an ISO exercise, and income tax if it’s an NSO exercise).
In practice, there’s a few extra details that come along with these forward contract structures. In the variable version, the cash component that is paid to the seller is typically structured like a non-recourse loan. The cash advance you receive is effectively the principal of a loan with an associated interest rate, and you accrue interest over the life of the contract, and then have to pay back the principal and the associated profit share with proceeds from a liquidity event.
It’s also really important to note that, in the event that the company goes out of business, the forward contract is likely to be canceled. If the forward contract is canceled (the non- in non-recourse), the money you received as a cash advance becomes taxable as ordinary income. So while you don’t owe your stock to anybody, the IRS still knows you got that cash, and now they’re here for their piece.
Forward contracts in an applied setting
There’s quite a few companies that offer these sorts of financial instruments: Secfi, Vested, Equitybee, and ESO Fund are all examples of companies that offer forward contracts, though many of them operate slightly differently, or optimize for different things.
As far as I’ve been able to determine, most of these companies offer prepaid forward variable contracts, although notably, Vested actually offers plain old forward contracts. This has some disadvantages on the taxation front, but the advantage is that if your stock is reasonably well-appreciated, and you expect it to appreciate much more in the future, you can potentially maximize your upside by agreeing to sell a set amount, instead of some variable amount in the future.
There’s also some nuance in terms of who is actually funding the cash advances to you. Equitybee, for example, is more of a broker. You go to them, and they market your securities out to their network of investors. If someone wants to invest in your company, they can pay Equitybee a broker’s fee for finding them the opportunity. The downside to this is that it might take a while to actually get an answer on whether or not your contract will be funded. Vested takes a much different approach, where they are, themselves, the buyer. This is interesting from a business model perspective, because they’re effectively holding their own portfolio, which means they likely have an investment committee that can determine internally if a deal is worth doing. Presumably that allows them to be very nimble and make go/no-go decisions quickly, though they probably have a higher bar for making that go decision.
You’ll also see some variation in terms of fee structures, especially with the prepaid forward variable contracts. As an example, Equitybee will typically have a very low-interest cash advance component (as low as possible, ~3%), but generally they’re looking for higher profit sharing (think 20-50%), whereas Secfi has higher interest rates on the principal (more like 7-14%), but lower rates on the profit sharing side (about even with the principal rates). Each has different effects on long-term upside, so if you’re really close to an IPO/liquidity event, you might prefer the Secfi model, and take a bigger hit on the principal, but be able to preserve more of the upside, since you won’t have as many years of principal interest accrual. On the other hand, if you’re early-stage, and have a long way to go, Secfi’s interest rates on the principal might hurt pretty bad, and it might be better to go with a lower-interest cash portion, and accept the higher rates on the profit sharing side. The best possible thing you can do is consider several scenarios (and be honest with yourself as to how likely each of those scenarios is) to figure out where you end up in any configuration.
Option 4: Cashless exercise (a very solid idea if it’s available to you)
One last option I’ll call out that I think is probably the second best option after using your own cash, is something called cashless exercise. The kicker is that this isn’t a particularly commonly-available option to employees. This is likeliest to show up if your company happens to be a rarity and offers this directly to employees, or as a part of a tender offer (which is just another name for a secondary sale) that the company is sponsoring. The concept is pretty simple: the company or buyer sets a purchase price for the underlying share, and then the seller sells some number of options, whose aggregate price is equivalent to the total exercise cost.
There’s a couple major caveats here, which is that 1) the sale price has to be higher than the exercise cost of the options, so even if your company offers it, you may not be able to do a cashless exercise until the company has gone through at least one upround, and 2) you may not have the option to cover your tax liability in cashless exercise. Both of these caveats might be less correct in the case of cashless exercise in tandem with a tender offer, since the buyer is external (i.e. not your employer), and so they’re probably purchasing at a price closer to the preferred price than the FMV, and if you’re doing cashless exercise and sale at the same time, you’ll be dealing with short-term income taxes that may come directly out of the proceeds, rather than AMT liability due to exercise-and-hold.
This list is non-exhaustive
Honestly, there’s probably a lot of other ways to skin this proverbial cat, including walking away from your options. With any luck, this info gives you a little more confidence to choose your own adventure!