Startup Equity #3: What do Exits Actually Look Like

Hey everyone and welcome back to our deep dive into the intricate world of startup equity. In previous articles we covered the basics of startup equity, the complexities of ISOs, AMT, and the undervaluation strategies startups use. If you haven’t read my previous articles in this mini-series on startup equity, I recommend reading those first:

Startup Equity Part 1: Stop leaving money on the table and understand equity grants

Startup Equity #2: Why Startups Purposefully Undervalue Themselves to IRS Auditors Every Year

Today, we’re focusing on the endgame: liquidity events. We’ll explore acquisitions, IPOs, and secondary markets, and explain why early startup employees usually make more money during these events — even accounting for their larger share counts.

Understanding Liquidity Events

Liquidity events are the moments when your equity can be converted into cash. These events typically include IPOs (Initial Public Offerings), acquisitions by other companies, or secondary market sales. Each type of event has different implications for startup equity holders, and each comes with its complexities and potential pitfalls.

Acquisitions

This is one of the most common forms of exit that startups have and typically happens for companies with valuations of under $500M simply due to the limited amount of buyers and the additional regulatory and due diligence burden placed on large acquisitions.

Here is a chart from Carta that shows at what stage startups typically get acquired. We can see here that it primarily happens for startups in early stage rounds (up to series A), partially because there are way more startups at that stage, but also because companies typically raise A rounds at less than $200M valuation.

What Happens During an Acquisition?

When a startup is acquired, the acquiring company purchases the startup’s shares. This can be done in several ways:

• Cash Buyout: The acquirer pays cash for the shares. So every shareholder will get a fixed dollar amount per share.
• Stock Swap: The acquirer offers shares in exchange for the startup’s shares.
• Combination: A mix of cash and stock.

Impact on ISOs/NSOs:

• Vesting Acceleration: Sometimes, acquisitions trigger accelerated vesting, meaning unvested options may vest immediately. (By far the best case for startup employees)
• Cash-Out Options: Employees can exercise their options and sell their shares as part of the acquisition deal, this can be a good reason to make sure you have

Impact on RSUs:

• Double-Trigger RSUs: These typically require both time-based vesting and a liquidity event. An acquisition often satisfies the liquidity trigger, potentially accelerating vesting.

Potential Pitfalls:

• Unfavorable Terms: The acquisition terms might be adverse for common shareholders (employees), especially if the deal prioritizes preferred shareholders. This is unfortunately a common reality for companies run by founders who don’t care about their fellow employees.
• Tax Implications: Employees might be stuck with giant tax bills from AMT or capital gains taxes. If they exchange their ISOs for private stock in another company without liquidity, they might not have a great way to pay it off — something that can arise from stock-based acquisitions.

IPOs

This is the lottery dream that all early employees hope for, with payouts potentially reaching the tens of millions, it is the dream of every employee to be able to participate in such a payday.

What Happens During an IPO?

While structuring an IPO, the company will raise capital from public markets with some of its shares immediately up for grabs. Let’s take a look at some of the outcomes of different types of equity grants:

Impact on ISOs:

• Lock-Up Periods: Post-IPO, there’s often a lock-up period (commonly 6 months) during which employees can’t sell their shares.
• Taxation: Exercising ISOs before an IPO and holding them for over a year can result in long-term capital gains tax rates, which are significantly lower.

Impact on RSUs:

• Vesting on IPO: Double-trigger RSUs typically vest upon the IPO, turning into common shares that can be sold after the lock-up period.

Impact on NSOs:

• Flexibility: NSOs can be exercised and sold post-IPO and are subject to ordinary income tax rates on the spread between the exercise and market price. To understand this, here is a chart showcasing this:

• So if you were given NSOs when the FMV was 1$, then exercised when the FMV was $3, then you would pay income tax on the difference, the rest is capital gains. (This is different from ISOs where you pay AMT instead)

Potential Pitfalls:

• Market Volatility: The stock price can be volatile post-IPO, affecting the value of the shares.
• Tax Liabilities: Exercising options close to the IPO can result in significant tax bills, particularly if the stock price increases rapidly.

Secondary Markets

Many people have this common misconception that unless the company gets acquired or IPOs, you can’t make any money as a startup employee. This is why startup equity gets treated like lottery tickets.

Especially in the later stages, there are many potential ways for you to “take money off the table” as an employee, with the most common being to sell your shares on secondary markets.

What are Secondaries?

This is where accredited investors like hedge funds, private equity/venture capital firms, and angel investors purchase shares directly from employees — typically at a discounted price. These trades usually can’t happen without company board approval since they can impact the 409A valuation, which is why they are most common during fundraising rounds.

Impact on ISOs:

• Exercise and Sell: Employees can exercise their ISOs and sell the shares on the secondary market. The main consideration here is the FMV at the time of exercise.

Impact on RSUs:

• Limited Availability: RSUs are less commonly sold on secondary markets, as they often require the company’s approval for transfer.

Impact on NSOs:

• Similar to ISOs: NSOs can be exercised and sold on secondary markets, subject to the same tax implications as ISOs.

Potential Pitfalls:

• Discounted Prices: Shares are often sold at a discount, reducing potential gains, it’s not uncommon to see 30% discounts to what preferred shares go for.
• Liquidity Risk: make no mistake — secondary markets are not public markets. There are fewer buyers and the transactions act more like over-the-counter (OTC) trading. You are rarely able to sell large portions of your equity at once.

Early vs. Late-Stage Employees

It is well understood that the earlier employee you are, the larger your equity grant is. Here is an example graph for software engineers, by funding round:

Source: Pave

It makes a lot of sense — the earlier you join, the smaller the company and the larger the risk premium. What is less known, is that the early employees get much larger payouts for the same equity grants as later employees.

Why Early Employees Often Make More Money Per Share:

1. Lower Entry Price: Early employees typically receive equity at a much lower strike price due to the company’s lower valuation when joining.
2. Higher Growth Potential: The value of the shares can increase significantly as the company grows, leading to higher potential returns for early employees.
3. Qualified Small Business Stock (QSBS): Early employees may benefit from QSBS tax exclusions. If the stock qualifies and is held for more than five years, up to $10 million in gains or 10 times the adjusted basis can be excluded from federal taxes. This can significantly increase the after-tax value of early employees’ equity.
4. Tax Advantages of ISOs over RSUs: ISOs — if exercised — require an employee to pay capital gains taxes instead of income taxes like for RSUs. Exercising the options can almost be thought of as the employee “investing” their money into the company at the FMV instead of what the real rate is (preferred share price)

Here is a chart from Carta showcasing all the different ways you pay taxes on ISOs. This is much better overall than with RSUs where you pay income taxes.

Example Using Different Scenarios:

To illustrate the differences in outcomes, here is a breakdown of four different employees (all of whom got the same equity grant) who all join a company that exits at $25 a share:

Scenario 1: Early Employee with QSBS Benefits

• Strike Price: $0.25 per share.
• FMV at Exit: $25 per share.
• Number of Shares: 10,000 ISOs.
• Initial Cost to Exercise: $2,500.
• Total Value at Exit: 10,000 shares * $25 = $250,000.
• Gain: $250,000 — $2,500 = $247,500.
• QSBS Benefit: Assuming QSBS qualification, up to $247,500 could be excluded from federal taxes.
• Final Amount After Taxes: Since QSBS excludes federal taxes, the final amount is $247,500.

Scenario 2: Early Employee Without QSBS Benefits

• Strike Price: $1.15 per share.
• FMV at Exit: $25 per share.
• Number of Shares: 10,000 ISOs.
• Initial Cost to Exercise: $11,500.
• Total Value at Exit: 10,000 shares * $25 = $250,000.
• Gain: $250,000 — $11,500 = $238,500.
• Capital Gains Tax (15%): $238,500 * 15% = $35,775.
• Final Amount After Taxes: $238,500 — $35,775 = $202,725.

Scenario 3: Mid-Stage Employee with ISOs

• Strike Price: $4 per share.
• FMV at Exit: $25 per share.
• Number of Shares: 10,000 ISOs.
• Initial Cost to Exercise: $40,000.
• Total Value at Exit: 10,000 shares * $25 = $250,000.
• Gain: $250,000 — $40,000 = $210,000.
• Capital Gains Tax (15%): $210,000 * 15% = $31,500.
• Final Amount After Taxes: $210,000 — $31,500 = $178,500.

Scenario 4: Late-Stage Employee with RSUs

• RSUs Vesting: 10,000 RSUs vest at $25 per share.
• FMV at Vesting: $25 per share.
• Initial Cost to Exercise: $0 (RSUs don’t require exercise costs).
• Total Value at Vesting: 10,000 RSUs * $25 = $250,000.
• Gain: $250,000 (all treated as ordinary income upon vesting).
• Income Tax (35%): $250,000 * 35% = $87,500.
• Final Amount After Taxes: $250,000 — $87,500 = $162,500.

Comparative Analysis

Taking these four scenarios we can create a chart here:

Here you can see how advantageous things like QSBS are or paying capital gains taxes. The early-stage employee vs the late-stage employee made around 50% more for the same equity!

Conclusion

Understanding liquidity events and their implications is crucial for anyone holding startup equity. Early employees often benefit more per share due to lower entry prices, greater growth potential, and potential QSBS tax benefits. By asking the right questions and preparing adequately, you can maximize the benefits of your startup equity and make informed decisions about your career and financial future.

In my next post, I’ll explore all the questions you need to ask when evaluating an offer and how to maximize your equity.

Stay tuned, subscribe to my Substack, and feel free to share your experiences or questions in the comments below!