Understanding ‘the benefit of your bargain’

A young friend is undergoing a crash course in mathematics and money, learning the lesson of how a technology company where he works can make you crazy rich with money that you can almost never touch.  

Everyone knows that to get rich, you go to work at a startup, you get stock options, they raise venture capital money (that in and of itself comes with enough fishhooks to give pause even to Jaws), the company gets bigger, they raise more money and the founders (key word) give you more stock options in lieu of salary and then at some time, the time comes. Time for what?

Show me the money.  

Herewith a very short course in how the startup compensation system works for you and against you. 

Let’s start with founder stock.  

Spoiler alert: Listen, lawyers, do not send me emails telling me the nuances that I did not discuss. This is not the “Paper Chase,” but the basic themes here remain solid, and I only get 732 words.

On day No. 1, you start a company with a couple of co-founders. You and your pals get “founder stock,” and for tax purposes, the value of these common stock shares is less than a penny. After all, you have nothing, no revenue, only a napkin. You write a very modest check to buy those shares. You get to make an 83B election (OK, lawyers, have at it), and your stock starts to vest.  

This means you are starting to run the clock on the holding period for long-term capital gains. So far, so good. Then, the napkin turns into a tablecloth, there is revenue, you hire more people and rather than pay them a full salary, you dazzle them with the prospect of stock options. And the company keeps making more money and issuing more stock. Life is good. Maybe you can’t buy a Lambo yet, but on paper, you are thinking ski in-ski out chalet in Aspen.   These options are vesting right along the way. But the company has to account for these options, and as they raise more money, they have to get a 409A, which is an outside opinion of value.  

This is where my friend begins to wake up. His option strike price of $1 now has a new current value of $6. He has some vested stock, but he doesn’t have enough cash to buy his stock, because not only does he need cash to exercise his options, there is also a taxable gain between his purchase price and the FMV (fair market value) of the stock.  And he still needs more cash to pay that tax.

At that moment in time, he owns the stock. He has paid the taxes. He has started the holding period for long-term capital gains. And now all he has to do is hope the company finds liquidity before he dies.

But if he doesn’t exercise his options, then the holding period for long-term capital gains doesn’t start, so if and when there is some liquidity, he ends up with ordinary income, which is taxed less favorably than long-term capital gains.

Catch 22. They get you coming and going.

The four-bedroom Aspen condo may have to be replaced with a two-bedroom at Big Bear.  There are some tricks like “restricted stock with a right of repurchase,” but the point of this column is to alert the unsuspecting geniuses who sign on for the startup ride that AI will not save you here. Maybe a good lawyer will help.

The issue of “getting the benefit of your bargain” is complex, and to some extent it depends on a decent founder/CEO and similarly inclined investors. For fun, do some research on Windsurf or Scale AI.  

My friend is still richer than when he joined the company four years ago, but he serves at the pleasure of the VC investors, and their timing and desires (and greed) do not always line up with the 1,000 people who work at the company.

At the end of the day, I support giving stock to the geniuses who make your company work, and lots of it, but there is a concomitant obligation. Don’t let them die in the desert with paper they can neither eat nor drink.

Rule No. 792: Remember who brung you to the dance.

Senturia is a serial entrepreneur who invests in startups. Please email ideas to neil@askturing.ai.