February 16, 2022

Get Cash Without Selling Startup Equity

Selling your startup equity used to be the only option for startup employees to get cash prior to IPO. But as the number of unicorns has ballooned and startups stay private for longer, a new option has emerged. Startup employees can finance their options. No money is owed until the startup goes public or is acquired. We discuss the tax treatment of options, the tradeoffs of financing, selling, or waiting, and the growing number of lenders employees can engage.

Hey friends -

Last week's letter looked at the thriving secondary market for startup equity and how early employees can get cash before IPO. The letter built on a previous discussion of startup equity more generally - how to value equity as an early employee, tradeoffs among equity compensation structures, and the key tax considerations.

This week we're looking at how to get cash using startup equity without selling.

In this week's letter:

  • Cash without selling startup equity - the rapidly growing world of financing options and lending against startup equity
  • A Web 3.0 critique, successful adventure capitalism, and more cocktail talk
  • A cocktail request from a good friend, the Painkiller

Total read time: 11 minutes, 47 seconds.

Why Not Sell?

Selling equity means that you give up the potential upside.

That may be the right choice for some founders, investors, and employees. Perhaps the startup equity makes up 90%+ of their net worth and they want to diversify.

Selling is also the least complex arrangement. While the sale process may be lengthy and there will be substantial paperwork, the sale is ultimately a one-time event. Once the cash is delivered to the seller and shares delivered to the buyer, the relationship is over. All of the other structures we're going to explore establish long-term relationships between the current equity holder and the capital provider. While the relationships can be mutually beneficial, they also pose novel risks. They're not for everyone.

The major benefit of not selling is clear - you retain upside if the value of the equity continues to appreciate. For many equity holders, that benefit more than offsets the risks.

Lending Against Equity

The most common reason early employees want cash isn't for living expenses - it's to actually own equity. Most startup employees receive options to purchase equity. They do not receive equity outright. It takes cash - and often a lot of it - to buy the equity.

Option holders have to outlay cash to exercise the options and pay the associated taxes. Options for employees come in two forms - Incentive Stock Options (ISOs) and Non-Qualifying Stock Options (NSOs). In both cases, the option owner will pay to exercise the option and take ownership of the associated shares. Tax treatment differs between the two.

Taxes on Options

Employees can vest up to $100,000 worth of ISOs per year. Any amount above that is treated as an NSO. Startups can also choose to only issue NSOs.

ISOs are not taxed at vesting or exercise unless the alternative minimum tax is tripped. The alternative minimum tax is what it sounds like - an alternative way to calculate income taxes owed. Employees that exercise ISOs must calculate the gain at the time of exercise, namely the difference between the current value per share and the option strike price (the price you pay per share) multiplied by the number of options exercised. If the gain is large enough relative to ordinary income, then the alternative minimum tax rate is used to calculate taxes owed. Those taxes owed will include the gain. There are helpful tools available so you can make an estimate.

NSOs are also not taxed at vesting but they are taxed at exercise. The gain at the time of exercise is taxed as ordinary income.

This is just a rapid flyby of a complex subject. The earlier letter goes much deeper, including covering topics like cashless exercising.

The tax obligations can get surprisingly large very quickly. Take Fireblocks for instance. The startup kicked off 2021 at a $700 million valuation. The company just raised more money at an $8 billion valuation just twelve months later. Hypothetical employee Sally joined in 2021 just after the company raised capital a $700 million valuation:

  • Sally received 40,000 NSOs that vest evenly over four years with a strike price of $10 per share. Vesting means she'll earn those NSOs over the four years. For simplicity, we'll assume the market price per share is also $10. 
  • It's now just after Sally's one-year anniversary. She wants to exercise the 10,000 options she owns. The company valuation increased 11.4x and the price per share also increased 11.4x to $114.
  • Sally needs $100,000 to exercise the options: 10,000 NSOs at $10 per share.
  • Sally's gain is $1,042,857. That means she needs about $350,000 to pay federal income taxes. If she lives in New York or California, she'll owe another $130,000 or so in state taxes.

It's a lot of money. And this is far from a contrived example.1 One startup that helps employees with options estimates that taxes accounted for 73% of their clients' options exercise costs. That doesn't even include the estimated $11 billion in avoidable taxes paid by startup employees in 2021 who delayed exercising their options.

The tax burden on early employees can spiral out of control quickly. By law, startup options must expire within 10 years of issuance, a problem when the average startup takes 12 years to go public. Standard company policy for departing employees is even worse - typically 90 days to exercise options or they're forfeited. That turns options into unintentional golden handcuffs for early employees. And the tax burden grows as the startup gets more valuable.

From a great 2021 state of the market report by Secfi. Source.

Remember - even though the equity values are large, it's not cash. You can't pay your taxes in shares. Cash must come from elsewhere.

It's where options financing comes in.

Startup Options Financing

Most options financing is structured as non-recourse loans collateralized by the startup equity. The cash goes towards paying for the options.

The key attributes of the loans are as follows:

  • Cash upfront: the borrower gets cash today to exercise options and pay taxes
  • Payback: the borrower doesn't have to pay back the loan until a liquidity event, meaning either the startup goes public and they can sell equity or the startup is acquired and they receive cash.
  • Non-recourse: the only assets the lender can seize are the shares. None of the borrower's personal assets are at risk. If the startup fails to have a liquidity event then the borrower doesn't have to pay back the loan.

It's an inherently attractive structure for both the borrowers and the specialized lenders. The value of the loan is entirely dependent on the startup, not the options owner. That means the personal creditworthiness of the borrower isn't a relevant input into the risk model.

The lender only has to evaluate the likelihood of a liquidity event, the time horizon over which it will happen, and the price. Once they are comfortable with the risk profile of a startup, they can lend to all of the employees at the startup without needing to tweak the model. That's the makings of a scalable business.

Loan fees and rates are expensive in absolute terms, but typically far less than the alternatives that incur large immediate tax bills or risk the options expiring. There are typically three key components:

  • Origination fee: 3-6% of the total loan amount
  • Interest charge: 7-10% per year
  • Incentive fee: 5-50% of the equity value when the liquidity event happens.

The origination fee and interest charge establish an attractive rate of return for investors. The incentive fee has an uncapped upside - it gets bigger as the startup gets more valuable. The potential profits materially offset the risks that the loan isn't paid back at all. The order-of-magnitude incentive fee range reflects the differing risks across startups - some may have already announced their intent to go public while others may be years away if ever.

Similar loan structures don't just work for options, but also for startup equity.

Startup Equity Loans

Loans against startup equity can be issued standalone or in conjunction with a loan to exercise options. The only material difference among the various loans is what the borrower will do with the cash.

As long as the equity remains illiquid and the only recourse is to the equity itself, the lenders will remain conservative about just how much they lend. Loan-to-value ratios of 30% are not uncommon, meaning that you can only borrow up to 30% of the current equity value. Quid, one of the main lenders, caps loan-to-value ratios at 35% and lends no more than $30 million per startup.

Such arrangements are well outside the realm of traditional banking. Regulators force banks to hold significant capital against illiquid assets, which makes them comparatively more expensive for both borrowers and lenders. Except for one-off cases involving founders and investors borrowing against tens of millions of dollars of startup equity, banks tend not to participate in this market.

Non-bank lenders are better equipped to make competitive loans. And they're doing it at scale.

Startups Lending to Startups

There are at least five main lenders and one lending marketplace. Each of the lenders has raised hundreds of millions of dollars.

ESO Fund is the oldest. Since its founding in 2012, the company has lent over $1 billion to startup employees, founders, and investors at over 500 companies. Their model is similar to most other private fund structures:

  • ESO Fund raises cash from investors every 2-3 years. They're currently on Fund 4.
  • They lend cash to startup persons as non-recourse loans collateralized by startup equity.
  • They collect and distribute the proceeds from loan repayment to the investors.
  • They make money through a management fee assessed on the value of assets under management and an incentive fee tied to the proceeds.

It's a well-proven model, not just for lending with startup employees but more generally. It's proven effective here as well, which has inevitably led to competition:

  • Liquid Stock closed its $161 million flagship fund in 2019 and is already in the process of raising a new $250 million Fund 2. Investors notably include Goldman Sachs Asset Management and Morgan Stanley AIP, the ultra-high net worth asset management arms of the respective banks. Even though the banks can't compete effectively as lenders, they can lend indirectly via third parties like Liquid Stock.
  • Quid is a spinout. It started life within Troy Capital, a venture capital firm, until it was launched as a standalone company 2018. Independence came via a $200 million Fund 1 and back by Oaktree, the largest distressed-debt investor in the world. Fund 2 launched in 2019 with $320 million from Oaktree, Troy Capital, and Davidson Kempner, one of the largest hedge funds in the world.
  • Secfi is the most recent major entrant. While the company launched in 2017, it only raised its first major fund in 2020 totaling $550 million from Serengeti Asset Management, a private investment firm focused on credit opportunities. Serengeti doubled down in 2021 and provided an additional $150 million in capital. That capital has been put to work - SecFi has loaned to employees at over 80% of startups worth over $1 billion.
  • Section Partners generates fewer headlines but is nonetheless a major player. The company was founded in 2016 and today manages over $350 million. While lending is the primary business, the company also invests in startups and opportunistically purchases startup equity in the secondary market.

I expect many other private funds to enter the market in due course. Startups are staying private for longer and more startups are reaching multi-billion dollar valuations before they go public. Not only is this a growing market of potential borrowers, more startups mean more data to create better lending models. It's a flywheel that'll continue to accelerate.

EquityBee sees a similar future - many more lenders competing to underwrite loans against startup equity. Rather than compete, the startup raised $75 million in two rounds to build a marketplace that connects over 12,000 potential lenders to 1000 borrowers and counting.

EquityBee allows any accredited investor to lend on the platform starting at $10,000 loans. The company charges a 5% platform fee to the lender and an additional 5% incentive fee on profits when a liquidity event happens.

It's an attractive business that will allow EquityBee to facilitate financing for a broader range of startups than the other lenders. Options owners at less risky startups that will soon go public can force lenders to compete to lower their rates. Owners at higher-risk startups that won't go public for years to come can likely find individual lenders with high-risk tolerances and longer time horizons than the big lenders who have to pay back their funders. While EquityBee will likely collect less on each loan, their business is a compelling bet on growing the size of the market.

With many options2, the question remains - should you finance your options?

Should You Finance Your Options?

The answer, as always, is maybe. I can nonetheless leave you with a summary list of considerations so you can make the decision.

If you own options for startup shares, you have three choices to generate cash today:

  1. Pay out-of-pocket to exercise your options.
  2. Sell some or all of your options in the secondary market.
  3. Finance your options exercise through a loan.

The fourth option is always to do nothing. While sitting on ISOs or NSOs won't generate cash, it also won't trigger any tax bills. The options can of course expire if you don't exercise them.

Out of pocket is likely only a viable choice when the startup is young and not yet that valuable. Exercising early will avoid large potential tax bills, but the likelihood that the startup fails and your equity is worth nothing is high. You won't get back the cash you spent to exercise the options.

Selling options in the secondary market will continue to be highly restricted by startups (see earlier letter). Even if it is allowed, the tax bill from the sale will be large - assume you need to sell at least $1.30 of options to take home $1.00 after taxes. The upside of a sale is that you get cash immediately with no further exposure to the startup potentially becoming worthless. That's also the major downside - you won't share in any future value appreciation.

Financing generally doesn't require startup approval - you still own the equity. But it is a loan with a fixed rate. If you finance the options exercise when the startup is at a lofty valuation and the startup later goes public at a lower valuation, you may have to sell most of your equity to pay back the loan. The amount will never exceed the total value of the equity, but it may nonetheless be more than you would have paid in taxes had you never financed. Furthermore, financing is only available for equity at those few startups that lenders think will go public or be acquired soon.

Selling and financing are essentially taking opposite bets. When you sell, you get cash immediately and forfeit the potential upside of the startup growing in value. When you finance, you get much less cash but keep much of the upside potential. The upside potential is tempered by the risks of the liquidity event happening at a low price.

The right choice depends on you.

How badly do you need cash?
What do you expect the startup's future to hold?
Are you willing to give up part of that upside to get cash today?

Cocktail Talk

  • Crypto, Web 3.0, and blockchain offer the hope of decentralization and a break away from the concentrated power of centralized parties like Google and Facebook. Yet despite the immaturity of the emerging technology, it has already trended towards all too familiar centralization reminiscent of Web 2.0. The founder of Signal, a messaging app, took this to the extreme to expose the hypocrisy. He created a supposedly immutable NFT that displays differently depending on which centralized party displays it and then listed it on a popular marketplace. The resulting experiment is as enlightening as it is amusing. (Moxie)
  • "VCs [venture capitalists] fund companies that fit a formula... Funding an expedition into the unknown would require an "adventure capitalist," but they live in a magic palace guarded by unicorns. And as everyone knows: unicorns are extinct." So states the cofounder of Square in his book The Innovation Stack. And yet Josh Wolfe of Lux Capital has produced brilliant returns funding everything from nuclear waste cleanup startup Kurion - years before Fukushima - to Varda Space Industries, a startup building a space factory. (Institutional Investor)
  • Listen to the news and you're likely to conclude that we're going to hell in a handbasket. Another day, another disaster. But look at the long-term trends and the extraordinary progress we've made to alleviate the worst of human suffering becomes readily apparent. In the past century alone, we decreased annual deaths from natural disasters from millions to thousands even as the population quadrupled. (Our World In Data)
  • Modern writing has undergone quiet but dramatic change over the past two decades. The rise of blogging services like Substack, coupled with the distribution via social media, has enabled people like yours truly to write and distribute to sizable audiences across the globe. Writing is no longer limited to the painful prose common to academic journals. Instead, short-form pieces expressed directly using everyday words prevail. It's a change that's remedied much of the damage detailed in George Orwell's Politics and The English Language. (The Orwell Foundation)

Your Weekly Cocktail

A special request from a good friend and a great drink to boot!


2.0oz Navy Strength Rum
4.0oz Fresh Pineapple Juice
1.0oz Fresh Orange Juice
1.0oz Cream of Coconut
Dusting of Nutmeg
Pineapple Wedge

Add crushed ice to a hurricane glass and set aside. Pour everything except the nutmeg into a shaker. Add ice until it covers the alcohol. Shake briefly and vigorously, no more than 10 seconds. Strain the drink into the hurricane glass. Add more crushed ice as needed until it comes up to the top of the glass. Dust with nutmeg and garnish with the pineapple wedge. (Note: you can also do this as a slushy. Instead of crushed ice, pour everything into a pitcher with 0.5-0.75 cups ice and blend.)

Oliver, my ever-helpful work buddy.

The Painkiller is the Pina Colada’s cleaned up relative - weirdly familiar, but so much better put together. It takes the best parts of summertime drinking on a beach and presents it sans accoutrements. On a cold, wintery day it can bring you right back. A good friend kindly offered to take care of my furry companion Oliver while I travel. He had one request - a freezer stocked with Painkillers. Consider it done.



Reality will be somewhat different. Her strike price is likely to be below the market price because she receives common equity rather than preferred like investors. The company will also get diluted during the capital raise so while the overall company value will increase 11.4x, the price per share will increase somewhat less. The calculations are nonetheless directionally accurate and the conclusions remain the same.


Pun intended.

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