SharesPost Designs a Loan Program to Make Options Attractive Again
Venture-backed companies in Silicon Valley are in a fix. They’ve issued oodles of stock options as a low-cost way to convince smart people to come work for them at salaries far below what they could make at Fortune 500 companies. But with the path to an IPO stretching out indefinitely for many startups, these options have less and less value on any time scale that’s relevant to young employees. If the trend continues, options could lose most of their meaning as a form of compensation—and startups might have to resort to more expensive enticements.
Greg Brogger, the founder and CEO of SharesPost, thinks he has a new way to ensure the attractiveness of stock options as an incentive. It’s a loan program that helps tech-startup employees exercise their options before an IPO—thereby lowering their tax bills when they finally do sell their shares and, in theory, realizing more of the value they’ve built up.
The program also opens up a potentially lucrative new line of business for SharesPost, and offers the investors backing the loans a way to obtain shares in sought-after companies before they hit the public markets. But it’s unclear so far whether employees themselves will bite.
You’ve probably heard of San Bruno, CA-based SharesPost. Alongside SecondMarket, it was one of the companies that facilitated a frenzy of private trading in Facebook shares in the year or two preceding the social networking company’s public offering. It helped investors obtain pre-IPO shares in the social networking juggernaut by arranging for Facebook employees and early investors to sell their shares on the so-called secondary market. Brogger (pictured above) says SharesPost handled 2,000 such transactions in the 12 months before Facebook went public in May 2012.
The big goal at SharesPost, Brogger says, was always to build an efficient trading platform for shares in private, venture-backed companies valued at $100 million or more. There are at least 2,000 of these companies in the U.S. and perhaps as many as 6,000. But for the first couple of years after SharesPost’s founding in 2009, he says, the company had its hands full dealing with just two of them—namely, Facebook (NASDAQ: FB) and LinkedIn (NYSE: LNKD). That meant SharesPost didn’t have time to develop other lines of business.
“It allowed us to become profitable as a company and to build a bit of a war chest, but it was also a bit of a detour,” Brogger says. “There was a price to be paid, and it was a focus internally and externally on a small part of what needed to be built rather than on the larger vision.”
Over the coming year, SharePost plans to introduce three or four new services to round out its business. The option loan program, announced in October, is the first. It’s designed to help employees exercise vested stock options before an IPO or other exit event, even if they can’t afford the out-of-pocket costs.
This isn’t standard procedure for most startup employees, precisely because of the high cost—but there’s a potentially large tax advantage down the road. Employees who wait until after an IPO to exercise their options and sell their shares wind up paying regular income tax on the proceeds. Those who hold their shares for a least a year before selling, on the other hand, get taxed at the much lower capital gains rate.
“The primary use case for these loans is a situation where an employee received an option grant three or four years ago, and the company is doing well and anticipates a sale or IPO or some kind of liquidity event,” Brogger explains. “Typically that employee will have an ‘Aha’ moment where they say, ‘There is a liquidity event on the horizon, maybe I should exercise my options today so that when I sell the shares I get taxed at the long-term capital gains rate.’ The CFO says ‘Great, but you have to write us a check for the exercise price.’”
Say the employee has 50,000 option shares with an exercise price of $1 per share—he has to come up with $50,000. And there’s another piece of bad news. Because his company’s value has likely appreciated since the option grant, he’ll owe income tax on the difference between the exercise price and the current fair market value of the shares. If the difference is large, the taxes can run into the tens of thousands of dollars.
The typical startup employee doesn’t have a nest egg large enough to cover all those costs, so that’s usually the end of the story. He or she just holds on to the options and takes the income-tax hit after the liquidity event.
What Brogger has invented is a program that matches an option-holding employee with outside investors who are willing to loan him enough to cover the cost of exercising the options, plus the tax on the appreciation. It’s a cashless transaction for the borrower—he simply ends up owning the shares. After the liquidity event, he pays off the loan plus the interest using the proceeds from the stock sale. He also owes capital gains tax—but in theory, his net proceeds are higher than if he’d paid regular income tax.
SharesPost and the outside investors make money on the interest, and the transaction also involves a stock fee of between 4 and 8 percent of the exercised shares. The shares themselves are the collateral on the loan. If, in the worst-case scenario, the stock ends up being worth less than the borrower paid for it, no repayment is due, and the lenders end up holding the bag.
Brogger argues that this approach is less risky for employees than holding on to the options, or even self-funding the purchase. “Think how invested you already are in the company,” he says. “Do you also want to put in another $150,000 of your own cash?”
These kinds of loans aren’t actually new—many large companies offer them to senior team members as a perk to help them cash in on a startup’s growth. But it’s a benefit that has never been available to rank and file employees, mostly because companies can’t afford to lay out that much capital. Banks, too, shy away from option loans, because regulations prevent them from counting shares as collateral.
“We’re not a bank,” Brogger notes. To fund the initial loans, SharesPost is working with a new firm called The ESO Fund, which is made up of a group of venture industry veterans and has allocated between $15 million and $20 million for the program.
At the time of my interview with Brogger in late October, two option loans had been completed and another 15 were in the pipeline. That’s not exactly what you’d call a rush, but Brogger says the program is still in its beta phase. “There is not the same intensity to it that there was around Facebook. We are going to perfect it and build a marketplace gradually,” he says.
Without programs like this to unlock the value trapped in employee stock options, it will ultimately become much more expensive for Silicon Valley companies to recruit and retain employees, Brogger predicts.
“Private companies are staying private longer,” he observes. While a few big tech companies like LinkedIn, Facebook, Zynga, and Groupon have managed to go public in the last year, there isn’t a clamor to follow them through the door. In fact, the market has brutally punished some of these companies over unstable earnings and other problems. “There are lots of advantages to staying private, and in fact the JOBS Act makes it easier to stay private even longer,” Brogger says.
And that’s putting a big strain on traditional incentive stock option programs, which are intended not merely as a form of deferred compensation, but as a way to build loyalty.
“It’s a treasured part of the Silicon Valley model—you align incentives, you generate a sense of ownership, and you create the carrot of a wealth-creating event,” Brogger says. “But now you have people who have been in the company for five, six, or seven years, who have vested options, and they want to go start their own businesses, they want to buy a house, they want to diversify.”
“Engineers who sign on when they are 25, they can wait until they are 29,” Brogger continues. “What they can’t do is wait until they are 37. Only the largest endowments and institutions have that kind of investment horizon.” If there isn’t a realistic prospect that their options will pay off within four or five years, Brogger says, employees would be better off working only until they’re vested, then moving on. “If your sweat equity is your capital, that is the only way to diversify.”
Brogger sees SharesPost’s option loan program as a natural extension of the secondary markets, which emerged a few years ago as a response to shareholders’ unmet need for pre-IPO liquidity. He thinks other options will eventually come along as well, including programs serving employees at smaller startups. “People with these valuable assets in these illiquid shares and options need a way to turn them into a usable part of their financial lives,” he says. “If it doesn’t emerge, the system will stay broken, and people will start saying ‘Thanks for the options, but I’ll take cash.’”