employee equity compensation in tech startups
July 19, 2021
May 14, 2021
July 19, 2021
May 14, 2021
As a startup employee with stock options, you know that exercising (or buying) those options can be a big financial undertaking. In fact, it could be one of the biggest financial decisions you’ll ever make, similar to buying a house. And just like buying a house, it’s likely you don’t have the cash needed. Often, the taxes due at exercising are more than most can afford out of pocket.
Fortunately, there are ways to help cover the cost of exercising (like getting a mortgage for a home purchase). One way is non-recourse financing, an option which puts none of your personal assets at risk and often begs the question, “is this too good to be true?”
So, what is non-recourse financing and how does it work? Let’s walk through the specifics to help you decide whether non-recourse financing is right for your situation.
We can split financing into two types: Recourse and non-recourse. The difference is determined by how the lender can recoup its money.
With recourse financing, the borrower is personally liable, which means your personal assets can be at risk.
With non-recourse financing, the lender isn’t able to collect any money beyond what the relevant collateral is worth, which means your other personal assets aren’t at risk.
For example, say you take out an auto loan. If you fall behind on your monthly payments, the lender can take possession of the car (the collateral) and sell it at market value to recoup the amount you owe.
What if you owe $15,000 on the loan but the car is only worth $10,000? If the loan is recourse financing, then the lender can try to make up the $5,000 shortfall by pursuing your other assets.
Alternatively, if the loan is non-recourse financing, then the lender takes the loss and you aren’t required to put up your personal assets, like your car, to pay them back.
Non-recourse financing can help private company employees (like you) exercise stock options. Your equity is the collateral — and because it’s non-recourse financing, your other personal assets are never at risk.
Before we jump into the details, let’s look at why financing could be helpful in the first place.
Typically, it’s better to exercise your stock options earlier rather than later. Assuming your company continues to grow, exercising earlier means less tax on exercise and less tax after the IPO — which means more profit for you.
(To see firsthand the advantages of early exercising, check out our case study on Snowflake stock options.)
However, for many employees of high-growth companies on the path to IPO or exit, exercising options can be financially out of reach. Case in point: On average, it costs nearly 2X the annual household income to exercise options.
What’s more, exercising options becomes more expensive and unaffordable over time as startups explode in value. That’s because the higher the 409a valuation of your options is, the more tax you could owe.
This is where non-recourse financing can help. It acts like a cash advance, providing you with funds to exercise your startup stock options without paying out of pocket.
Here’s how it works:
If your company has a successful exit (like an IPO), you pay back the amount financed, plus associated fees.
If your company doesn’t exit or goes out of business altogether, you don’t owe anything. The financing provider takes the loss. And because it’s non-recourse financing, your other personal assets are never at risk.
If you already own shares of your company, non-recourse financing can help you tap into liquidity for other financial priorities — like buying a house or diversifying your stock portfolio — without selling your shares.
Since your personal assets are not at risk and no payment is due until your company exits, many people ask “so what’s the catch?” Non-recourse financing can be a life-changing tool for startup employees struggling to afford the upfront cost of exercising — so it’s not surprising that some people think it might be too good to be true.
To recap, two things are true: (1) Your personal assets are not at risk with non-recourse financing, and (2) The financing provider takes all the downside risk. So, the question is, what’s in it for the financial provider?
The provider shares in the upside with you: The more successful the exit, the better for everyone involved. Ultimately, the amount you owe is tied to how much your equity ends up being worth.
In the event of a successful exit, the financing provider receives a percentage of your payout plus a return of the original advance (plus any interest).
If there isn’t a successful exit, the financing provider takes the hit. There’s no payout for the financing provider to collect a percentage of, and you don’t have to return the original advance.
Financing providers can take this kind of risk because they’re uber selective about which companies they choose to work with — meaning, which employees they choose to finance. Providers also spread their risk across numerous startups.
We are on a mission to help startup employees and shareholders understand, maximize and unlock the value of their equity. We offer non-recourse financing for stock option exercise to help you benefit from the advantages of exercising early. We also offer financing products that help you tap into the liquidity of your hard-earned equity ahead of exit, without selling your shares.
Ready for personalized equity insights? Get started today.