Imagine that you have been working at a startup for a few years. Your company has raised a few rounds of financing and so the value of your stock options has increased. However, because you didn’t exercise your options as they vested, you’re in a tough position: it will cost you hundreds of thousands of dollars to pay both the exercise cost and associated taxes from the value gain you helped create.
Even if you have the liquidity to pay, you may not want to allocate 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 you’re leaving a company and there’s an expiration window (typically 90 days) within which you must exercise your options. You may want non-recourse financing for the exercise event to avoid a situation where your options expire and you walk away with nothing.
Of course, non-recourse financing isn’t a silver bullet. While it might sound alluring to risk-averse options-holders, it’s expensive – sometimes between 20-50% of the value of the shares when you add up all the fees. But it has a lot of other great benefits that cause a lot of people to use it.
A common type of non-recourse financing is a prepaid variable forward contract. It’s the structure that Compound partner ESO Fund uses. This type of contract is going to be the focus of this article, and we’ll walk through everything step by step.
In this article, we’re going to cover a series of questions related to non-recourse financing:
- 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 a contract that matches employees who need liquidity to exercise their shares (and pay taxes) with investors who want to invest in startup equity (but typically don’t have another way to get access to it). Investors provide employees with liquidity, employees exercise their options, pay any taxes, and then when the company has a liquidity event, the employee pays back the financing.
During a liquidity event, the investor is compensated in two ways. First, investors have what’s called a liquidation preference that might guarantee them a certain return on their investment, given there’s a liquidity event. You can think of this like interest on a loan but for prepaid variable forward contracts. Second, may benefit from some of the upside of the shares with the employee.
A prepaid variable forward contract is not a loan, although it acts a little bit like one. It’s similar to a loan in that you get cash today and have to pay it back at a later date (or under certain conditions). The very important way it is different from a loan is that you don’t have to pay it back if your company goes to zero (it’s not collateralized by any assets). If there is a liquidity event and your shares are worth little more than what you paid, it is highly probable that the full value of that liquidity will go towards your variable forward contract investors. Their capital (including any that was applied for taxes) is paid back before you keep 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 pay taxes.
- You wait until your company exits (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.
- 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. Moreover, since the taxes were paid in your name, there is usually an opportunity to still receive some benefit in the form of a tax refund by deducting the loss.
 See the “What are the fees?” section for an example.
Are the shares transferred immediately or at the end of the contract?
One key consideration for prepaid variable forward contracts is whether the shares are sold and transferred to the investor immediately or if the shares are sold and transferred at the end of the contract.
This question can affect capital gain 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 ESO Fund purchased the shares. But if you wait 1 year after exercising your incentive stock options, you can pay long-term capital gains if you sell your stock to ESO Fund after then. This difference can be large: up to 20% on your federal taxes. Note - if you are based in California, there is no state capital gains tax rate - all gains are taxed as ordinary income so 20% is the maximum savings, but the savings can be higher in states that have discounted tax rates for long term capital gains. This question of the capital gains “clock” also applies to the investor – they would prefer to receive the shares from you earlier to start their clock on long-term capital gains.
Typically the contracts are priced in accordance with this capital gains tax – if the investor receives the shares earlier (and thus you as the employee have to pay ordinary income tax rates on the difference between the strike price and the price ESO Fund is paying) then you should receive lower fees from ESO Fund. In the opposite structure, you’ll have higher fees. To ensure you’re getting a fair price, calculate how much you would pay in fees and taxes 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, although as with every contract, make sure to read the fine print and consult legal counsel to fully understand the contract’s details before signing.
The first kind of fee is a liquidation preference on the purchase of the shares. This resembles a normal loan: it’s a percentage of the dollar amount that is “lended” to the employee. These fees are usually 1-12%+ based on the price of the shares when the prepaid variable forward contract was signed. So if you needed to execute $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 (there aren’t monthly payments) and only payable upon the triggering of the contract (such as a liquidity event).
The second kind of fee is a carry fee. The carry fee can vary widely, but 15-30% is common depending on the risk profile of the startup. This fee is typically calculated as a percentage of the gains of the share price. So if you have options worth $50k and they increase 10x to a value of $500k, the carry fee will be $90k (calculated as a 20% carry fee x the $450k gain).
There may be other fees including initiation or transaction fees, but these are the main ones.
Again, read the fine print, have an expert (a lawyer or a financial advisor with experience in equity funding) read the fine print, and make sure you understand all of the fees associated with your financing.
When you add up the fees for a non-recourse financing, they are typically higher than other forms of financing. A big (and we think legitimate) reason for this is because equity financing is riskier for investors since the capital is tied to one concentrated, high-risk asset rather than to other forms of collateral. Still, the fees are very high, so any such transaction must be approached with caution.
Should you use non-recourse financing?
The decision to use non-recourse financing – and exercising your options in general – is complex and should take into account your personal goals and circumstances. Here are a few questions to consider:
- What are my personal financial goals? For example, net worth goals.
- What large purchases do I want to make in the next 12-18 months? (House, car, wedding, etc.)
- How much liquidity do I have right now? Compound typically recommends at least 3-6 months of living expenses in cash at all times.
- What other sources of liquidity do you have?
- How bullish are you about your company?
If you’re interested in someone helping you answer these questions and get set up with a non-recourse financing provider, Compound offers 45-min one-time consultations for situations just like this. Request access here.