Startups are the only place you can go bankrupt for making a million dollars.
Startups are full of fresh college grads who will sign any paperwork you put in front of them. They think the company would warn them about financial disaster. They think, “I’ll worry about equity when it’s worth something,” but by then it’s too late.
When people ask for advice about joining their first startup, I always mention “83(b) Election.” It can be the difference between a lottery ticket and an arrest warrant.
Startups pay lower salaries in exchange for ownership of the company, which you earn over four years. However, you aren’t just handed company stock– that’s far too simple. You’re earning stock options, which let you buy shares of the company at a fixed price. If you leave the company, you will have 90 days (or less) to buy your stock, or “exercise your options.”
Take Johnny, a fresh college grad who joined a company worth $1 million, and negotiated 1% equity. It will cost him $10,000 to buy his stock. If the company tanks, he can just walk away without buying it. He got lucky, and four years later, his company is worth $10 million. His stock is now worth $100,000, and he stands to make a $90,000 profit.1
Four years is a long time, and Johnny is ready to try something new, so it’s time to exercise. $10,000 is a lot of money, so he gets a loan from his parents. He cuts the company a check, signs some paperwork, and he now owns 1% of the company. Time to pay off his student loans.
The gotcha is turning stock into real money. It’s easy with a public company; the company gives you a brokerage account and you press a Sell button. This company isn’t public, and nobody knows when it will be. Even if Johnny found someone ready to write a check for his stock, company equity agreements restrict you from selling until a “liquidity event,” which means “the company is bought or goes public.”2
It looks like Johnny will be sitting on his stock for a while. It’s a good thing his parents don’t charge interest, but that’s the least of his problems.
Next April, he gets a letter from the IRS. When Johnny exercised his stock, he “made” $90,000, and the IRS expect $25,000.3 It doesn’t matter that he can’t actually sell the stock. It doesn’t matter that he didn’t know. He owes $25,000.
It could be worse. Imagine if he made a million.
Now let’s take Grace, a seasoned developer with a similar deal at a different company. She talked to her accountant after her one-year mark, and instead of saving up for a house, she set aside $40,000 to cover her stock options and taxes. Four years later, she’s decided to take a job offer as a CTO at another company.
Unfortunately, her company was even more successful than Johnny’s. At a valuation of $20 million, her equity is worth $200,000, but she can only afford half of her stock. For the last two years, she’s endured all the downside of a startup– high stress and below market pay– for none of the upside.
Finally, consider Alan, a developer in the same situation as the others. He was hired for his Python expertise, and the ability to lead agile teams. He loves the company, so after four years he decided to stick it out until liquidity.
For context, Facebook and LinkedIn took eight years to go public. A lot changes when you go from an early stage startup with a dozen people to a mature company with thousands of employees. At year five, his company moved from Python to C#. At year six, his new manager dropped Agile and moved to three hour spec meetings. At year seven, his team was laid off. The valuation was through the roof, and due to taxes he could only afford one year of stock.
Enter the 83(b) Election
When you tell your employer you’d like to make an 83(b) election, you are allowed to exercise all your stock at any time, instead of waiting four years. If you exercise before the company’s value goes up, your profit for tax purposes is $0. You owe taxes when you actually sell the stock, which is how you’d think it would work in the first place.4
While you technically own the stock, you agreed to repurchase rights. You still earn the stock over four years, and if you leave before then, the company can buy back what hasn’t vested.
You should have this conversation with your future employer before you take the job. For one thing, you’re racing the clock. You want to exercise your stock as soon as possible, before the company’s value can go up. Then, you only have 30 days to file your paperwork with the IRS.
The most important reason to have this conversation before taking the job is that some employers will just refuse to allow 83(b), and I’d consider that a deal breaker.
There are a few theories why companies don’t like 83(b). The cynical theory is “golden handcuffs,” but I think most companies prefer employees who actually want to be there.
Maybe companies don’t want to sound like they’re giving you advice. 83(b)’s are not right for all situations, and they carry their own risk: if the company shuts down, the stock is worth nothing, and you’ve lost $10,000.
The simplest reason is it’s more of a hassle for the company. There’s more legal paperwork, and if you leave, they have to buy back the stock. With all the hassle of running a startup, it’s easiest if everyone takes the path of least resistance
Do Not Try This At Home
This post cut out many details, partly for illustrative purposes, and partly because I’m pushing the limits of my understanding. I don’t think 83(b) is the solution 100% of the time. I haven’t even touched on RSUs, an alternative to stock options. While I think I have a grip on a lot of this, I still wouldn’t do anything around equity without first talking to a qualified professional.
Some people cringe at the cost of an accountant. You will spend hundreds of dollars for a professional to tell you to spend thousands more. You are looking at things with the wrong perspective. Money is replenishable. The only unreplenishable resource is time. Don’t balk at a little money and planning to insure the next four years of your life.
2. Sometimes a company will arrange a private stock sale for employees and early investors to liquidate some stock. Don't rely on this.↑
3. We're going with a round, plausible number for illustration purposes. An accurate number is dependent on tax bracket and AMT calculation.↑
4. Another nice benefit is it "starts the clock" on long term gains. If you're going to sit on illiquid stock for several years, you might as well get the tax benefits.↑