Non-Recourse Financing

Imagine you've been working at a startup for a few years. Your company has raised several rounds of financing, increasing the value of your stock options. However, because you didn’t exercise your options as they vested, you're now in a tough spot: it will cost you hundreds of thousands of dollars to cover both the exercise cost and the associated taxes on the value gain you helped create.

Even if you have the liquidity to pay, you may not want to divert your capital away from other investments. This is where non-recourse financing comes into play – by using a liquidity platform to exercise options, you can purchase your shares with someone else’s money. You can hold onto most of the potential upside of the shares without the risk of loss that comes from either using your own liquidity or utilizing traditional recourse financing such as a personal loan. It can also save you money on taxes when you sell because your early exercising and holding your purchased shares over time may qualify you for long-term capital gains. 

Another scenario is when you’re leaving a company and facing an expiration window (typically 90 days) to exercise your options. Non-recourse financing can be helpful in this case, allowing you to avoid the risk of your options expiring worthless.

However, non-recourse financing isn’t a perfect solution. While it might be appealing to risk-averse option holders, it can be expensive—often ranging from 20-50% of the value of the shares when you factor in all the fees. Still, the benefits make it an attractive option for many people.

A common form of non-recourse financing is the prepaid variable forward contract. This article will focus on this specific structure, and we’ll guide you through the details step by step.

We’ll explore the following key questions: 

• How do prepaid variable forward contracts work?
• Are the shares transferred immediately or at the end of the contract?
• What are the fees?
• Should you use non-recourse financing?

How do prepaid variable forward contracts work?

A prepaid variable forward contract is an agreement that connects employees who need liquidity to exercise their stock options (and pay associated taxes) with investors seeking to invest in startup equity (but typically don’t have another way to get access to it.) In this arrangement, the investor provides the employee with liquidity, the employee exercises their options and pays taxes, and then when the company has a liquidity event, the employee repays the financing.

During a liquidity event, the investor is compensated in two ways.[0] First, investors often have what's called a liquidation preference, which may guarantee them a certain return on their investment when a liquidity event occurs. This works similarly to interest on a loan, but for prepaid variable forward contracts. Second, investors may share in some of the upside of the shares along with the employee.

A prepaid variable forward contract is not a loan, although it functions a little bit like one. Like a loan, you receive cash upfront and repay it at a later date (or upon certain conditions). The key difference is that it’s not collateralized by any assets, meaning if your company fails and its value drops to zero, you aren’t required to repay the loan. However, if there’s a liquidity event and your shares are worth more than what you paid, it’s likely that the proceeds will go toward repaying the investors in the variable forward contract. Their capital, including any funds used to cover taxes, will be paid back before you retain any gains. 

Here’s a simplified explanation of how prepaid variable forward contracts work:

• The financing provider sends you the cash you need to exercise your stock options and cover any taxes.
• You wait until your company exits (typically an acquisition or IPO). Unlike a typical loan, there are usually no monthly interest payments.
• If your company has a successful exit, you pay back the amount financed, plus the liquidation preference, associated fees and a percentage of the gains.[0] 
• If your company doesn’t exit or goes out of business, you’re not required to pay anything. The financing provider absorbs the loss. Because it’s non-recourse financing, your personal assets are protected. Furthermore, since the taxes were paid in your name, you may be eligible for a tax refund by deducting the loss.

[0] Refer to the “What are the fees?” section for an example.

Are the shares transferred immediately or at the end of the contract?

A key consideration for prepaid variable forward contracts is whether the shares are sold and transferred to the investor immediately or at the end of the contract.

This question can impact capital gains taxes. If you, as the employee, exercise your options and then sell immediately, your incentive stock options will lose their qualified status, and you will have to pay ordinary income tax rates on the difference between the strike (or exercise) price and the price at which the investor purchased the shares. However, if you wait two years from the grant date and one year after exercising your incentive stock options, you can benefit from long-term capital gains tax treatment. The difference in tax rates can be significant.

Typically, contracts are priced with capital gains tax in mind. If the investor receives the shares earlier, you, as the employee, would need to pay ordinary income tax rates on the difference between the strike price and the fair market value, which should result in lower fees from the contract. Alternatively, if the shares are received later you’ll face higher fees. To ensure you're getting a fair deal, calculate the fees and taxes you would pay under each scenario and make your decision based on what’s best for you.

What are the fees?

Typically there are two types of fees, but as with any contract, make sure to read the fine print and consult legal counsel to fully understand the terms before signing.

The first type of fee is a liquidation preference on the purchase of the shares. This resembles a standard loan: it’s a percentage of the dollar amount that is "lent" to the employee. These fees typically range from 1% to 12% or more, depending on the price of the shares when the prepaid variable forward contract is signed. For example, if you need to exercise $50k worth of shares, the liquidation preference might be $55k ($50k of the initial investment plus a 10% fee of $5k). This liquidation preference is typically non-cash (meaning no monthly payments) and only payable when the contract is triggered, such as during a liquidity event.

The second type of fee is a carry fee, which can vary widely but typically ranges from 15% to 30%, depending on the startup's risk profile. This fee is usually calculated as a percentage of the gains on the share price. For example, if your options are worth $50k and increase 10x to $500k, the carry fee would be $90k (calculated as a 20% carry fee on the $450k gain). Other fees may apply, such as initiation or transaction fees, but these are the primary ones. 

When you factor in all the fees for non-recourse financing, they are generally higher than those for other types of financing. A significant and valid reason for this is that equity financing carries more risk for investors, as their capital is tied to a single concentrated, high-risk asset rather than more secure forms of collateral. Despite this, the fees remain quite high, so any transaction involving non-recourse financing should be approached with careful consideration.

Again, read the fine print, consult an expert (like a lawyer or financial advisor experienced in equity funding), and make sure you fully understand all the fees involved in your financing.

Should you use non-recourse financing?

Deciding whether to use non-recourse financing - and exercising your options in general - is complex and should be based on your personal goals and financial situation.

Here are a few questions to consider:

• What are my personal financial goals, such as net worth targets?
• What major purchases do I plan to make in the next 12-18 months (e.g., house, car, wedding)?
• How much liquidity do I currently have? Compound Planning generally recommends keeping at least 3-6 months of living expenses in cash.
• What other sources of liquidity do I have access to?
• How confident am I in the future of my company?

Conclusion 

Non-recourse financing, particularly through prepaid variable forward contracts, can provide a valuable solution for employees looking to exercise stock options without risking their own liquidity. While it allows individuals to benefit from potential upside without the threat of personal asset loss, it comes with substantial costs in the form of fees and liquidation preferences that need careful consideration. Ultimately, whether or not this financing option is right for you depends on your personal financial goals, liquidity needs, and confidence in the future success of your company. It's essential to weigh these factors carefully, consult with experts, and ensure that the benefits of non-recourse financing outweigh its costs before proceeding.

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