Should you borrow money to exercise private company options? Here’s what you need to know.
One of my brilliant former students called me last week to ask me whether he should take advantage of a ‘free loan from the company’ to exercise the options of the startup he is with. The conversation was a reminder that even brilliant engineers can be unaware of the downsides of these arrangements.
Look, I’m not saying companies are evil for offering these loans. They do so out of the well-meaning desire to help employees turn their potential profits (the upside they may earn from their equity in the startup at some future date) from short-term income into long term capital gain.
The devil however is in the details, and the details can cost you a lot of money — in fact they could cost you even more than you will ever make from the equity.
Let me explain.
The problem you are trying to solve is that you have stock options, but to convert them to actual stock (and start the long-term tax clock ticking) you need to exercise those options and pay the exercise price. Even if the per-share price is low, the cumulative exercise price is often more money than you have, IE thousands or even tens of thousands of dollars.
So, to help you do this, some startups have come up with a way to lend you the money to exercise the options. From the company’s perspective, it sort of doesn’t cost them anything — they lend you the money, you exercise the options and when you pay for them, you send that same money back to the company. They end up with the same cash they started with, and you end up with the stock.
However, you’ve also likely ended up with a big, personal liability.
These loans can appear very attractive to you. After all, you really want that tax benefit of long-term capital gain, which you can only get through exercising and then holding the stock for whatever period of time constitutes ‘long term’ in the tax code that applies to you. Plus, the risk can appear very low at first blush: your per-share price can be far below the price investors paid per share — for example perhaps your strike price is $4 a share while the VCs recently paid $10 for their shares. This seems like a sure thing, right?
Unfortunately, it is not. First of all, the shares you get when you exercise options are almost always common shares, which are different than the shares investors typically buy, which are called preferred shares. Preferred shares have superior terms to your shares (there is a reason theirs are called preferred and yours are called common!) which also explains why, at any given time, the price calculated for the value of common shares (and therefore option strike prices) can often be much lower than the price investors pay for preferred shares — which is generally considered a benefit for those employees getting options.
If a company goes public, generally all shares first convert to common, so everyone has the same shares from that point forward. However, if a company sells while it is still private, which most companies do, preferred shares are in line ahead of your common shares for some of the proceeds. (Understanding this is very important for any person trying to evaluate the value of shares or options in a private company — for a fuller explanation of this critical detail see here.) If your company is a big hit this won’t be a problem — but many companies are not big hits. In my 20+ years as a VC I’ve seen many situations where companies do not achieve their goals, can’t raise further capital or get to cash-flow-positive with the funds they have left, and end up selling for less than the total money raised — resulting in the common shares becoming worthless.
The problem for you, if you borrowed money to buy those shares, is that the money you borrowed is still debt that you have to pay.
Most of the loans companies give to employees are full-recourse loans, which basically means if the asset you bought with the money ends up not being worth the money you borrowed, the lender can come after your other assets in order to fully satisfy the debt. Even if your company is sold, that debt you owe is on the company’s balance sheet as an asset — and the acquirer likely wants to collect.
But wait! What if the very kind board of directors cancels the debt and forgives the loan before they sell the company? You’re in the clear, right?
Yeah, Not exactly.
Why? Because, by and large, even forgiven loans create tax implications.
I once was on a startup board long ago where the top three executives borrowed about $200,000 each to exercise options. They pitched it to us on the board as “free to the company” because the borrowed money would come right back to the company when the options were exercised and paid for, which of course it did.
Then, when the company didn’t do so well, we were unable to raise further capital and we ended up selling for less money than the capital that had been raised. We, the board, truly felt bad for the executives, so we negotiated with the company’s acquirer that we would forgive the loans prior to the transaction. Problem solved, right?
Wanna know why?
Because…you know what the IRS calls forgiven loans?
In the above case, the $200,000 loan forgiven is looked upon by the IRS as if you just earned $200,000 in income — that is, each of these people had $200,000 of income they had to report and pay ordinary income tax on, for which they had no money and no shares with any value to sell. Because these were young people with no other assets (actually “lucky” for them) they declared personal bankruptcy. This is not pretty and trust me, you don’t want to do this if you can at all avoid it.
These same words of caution also apply to those of you who already have stock (private or even public) that you are restricted from selling and use some form of equity-secured debt to get liquidity today for what you technically cannot sell right now. If the debt is full-recourse, by now you know that if the equity you promised to sell in the future goes down, you’ll have to cover the difference from personal assets. And, even in non-recourse loans, in which the asset the lender can go after is limited to the pledged assets named in the debt transaction, there may also be tax liabilities that will add to your cost of having gone this route.
In short: The worst pain you can have with unexercised options is they go to zero, so you get zero. But with exercised options, the worst pain you can go through is that not only may the stock become worthless, but the cash you used to exercise those options is also gone — and if you borrowed it, you are likely still on the hook to pay it back.
So, what to do?
I’m not saying don’t borrow money to exercise options. Rather I’m saying, if you are using full-recourse debt to exercise those options, just recognize that your liability is no different from using full-recourse debt to buy NFTs, shares in GameStop or oil futures (I leave it to you to determine the relative risk!) Unless you plan to earn the money to pay back the debt from some other source, you will either have to pay the debt back by selling the asset for more than you paid for it, or by selling some other assets you hold. If the asset you bought with that dough goes down in value, you likely still owe the money. And even if you have the kind of loan where you don’t owe the money, you may owe taxes on the phantom money you won’t ever see.
If you are going to do this, my advice is to understand the full implication of the risk you are taking and weigh whether that risk is worth it to you. (And here’s a great Forbes column with even more detail on this topic, for starters.) Since each deal is different, and the nuances are incredibly important, it is worth hiring a lawyer and a tax professional to walk you through the implications, both positive and negative. We tech entrepreneurs tend to be optimists and always think things will work out, but unfortunately history has taught us that this will often not be the case. Don’t let it cost you money you can’t afford to lose.