Venture-backed startups rely heavily on employee stock options to attract and retain top talent. Stock options give the employees a piece of the company’s upside, letting them benefit with the company’s success. However, the current environment for IPOs often makes for a very long time horizon to achieve liquidity and has given rise to secondary markets for private company stock. Rather than having your employees distracted by searching for buyers of their shares and sharing confidential information with strangers, private companies should consider a private liquidity program.
In a company sponsored liquidity program, the company allows a third-party such as the ESO Fund to provide cash liquidity to their employees. This means that confidential company due diligence is provided to only a single external entity under NDA rather than risking the outcome from numerous employees individually pursuing their own deals. The use of an ESO advance provides liquidity to employees on a low risk and tax efficient basis while not introducing any outside shareholders to the company's capitalization table. Unlike secondary market stock sales where strangers and possibly competitors get access to control and information rights, a liquidity program through ESO does not extend any management or information privileges to the ESO Fund.
An ESO transaction can provide employees with discretionary cash while simultaneously preserving the employee’s upside potential and thereby maintaining their loyalty to the company's ultimate success. In addition to liquidity advances involving shares owned by employees, ESO can advance the funds to cover exercise costs including the taxes. Employees benefit in numerous ways from exercising such as starting the clock on long term capital gains and avoiding heavy AMT tax consequences that can occur later if the company's stock rises in value. However, the cost of exercising can be beyond the reach of many employees. Moreover, the AMT tax triggered by the company's IRS Form 3921 filing can dramatically increase the cost of exercising.
Companies therefore face a conundrum. On the one hand, they want to incentivize the employee by granting them options. But on the other hand, circumstances that prevent the employee from exercising can cripple these incentives. Owning common shares in the company gives existing employees a current stake in the business which can be a significant motivating factor. If a company decides to assist employees directly, there are tax consequences in addition to just using up valuable capital inefficiently. For example, non-recourse company loans to employees are usually not eligible for long term capital gains. Another concern is when a companies re-purchases common stock, it runs the risk of raising their 409a FMV value to the point that new option grants are unattractive as a recruiting tool. Moreover, the company is potentially liable for witholding tax at the ordinary income tax rates on all employee gains when running their own program.
The ESO Fund provides financing for option exercise and for liquidity based on previously issued shares. The employees retain title to ownership including privileges such as voting, dividends, and the possibility to enjoy future appreciation in value. At the time of the final liquidity event such as an M&A or IPO, the ESO Fund will make a final payment to the employee using a negotiated formula based on the final value of the stock at that time. Any time prior to that, the employee can still buy out the ESO Fund and retain all future appreciation for themselves.
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Employee Stock Option Fund
999 Baker Way Suite 400
San Mateo, CA 94404
tel: +1 (650) 262-6670