Startup employees are scrambling to offload equity options as layoffs sweep Silicon Valley, but many forget the major tax bills that might come with it

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• EquityBee, a startup that lets startup employees sell vested equity options to a group of investors, said its activity in March was an all-time high as layoffs swept across Silicon Valley’s startup community.
• Cofounder and CEO Oren Barzilai told Business Insider that there are roughly 6 million tech employees with stock options in startups as part of their compensation packages.
• When these employees are laid off, they have to choose whether to exercise those options by purchasing the shares outright within 90 days of leaving the company, which often comes with a tax bill that can be higher than the total cost of purchasing the shares outright.
• Barzilai advised startup founders to extend the exercise window for laid-off employees beyond the 90-day window to allow them time to assess the state of the market and buy them time to get together the funds they might need.
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Silicon Valley’s golden parachute might have a few holes.

As any early tech employee will tell you, high salaries have little to do with long-term financial security. Instead, they negotiate for options, or unvested shares in a private company. In exchange for working long hours and building the company, employees are essentially granted a small stake in the company itself.

According to EquityBee, a startup that lets startup employees sell vested equity options to a group of investors, there are roughly 6 million startup employees with options in private companies.

But as layoffs sweep through the startup industry, those options look more like a liability than a ticket to millionaire status. “We’ve seen a significant increase [in activity] during March, almost double from the previous month,” EquityBee cofounder and CEO Oren Barzilai told Business Insider. “We’re projecting even more for April because more are being laid off — or think they will be laid off and need capital to purchase their options.”

EquityBee allows employees sho don’t have the kind of major cash on hand to outright buy options to match with potential investors who want a piece of the pie. The investor can essentially loan the employee the full cost of purchasing the options in exchange for a percentage of the profits once the employee is able to cash out. 

Unexpected tax hits in an uncertain market

The out-of-pocket costs associated with those options are one of the key considerations employees need to make, Barzilai said. Although options are typically outlined as additional income in many compensation packages, eligible employees are able to use their salaries to purchase those options at lower prices. However, they are subject to taxes on the difference between that price, called the strike price, and the current value. That leaves many employees on the hook for tax bills that could be even higher than the initial purchase price.

“Many employees don’t understand that there is a tax payment associated with stock options,” Barzilai said. “That payment can be way higher than the actual strike price. If they joined at the right time, early on at the company and it grew significantly, that tax bill can be very significant.”

It helps to make that calculation before deciding to cash out, Barzilai said. He has had startup employees using EquityBee that were planning to spend roughly $50,000 on their options, but the taxes were almost $400,000. That is a significant out-of-pocket cost in boom times, but even more precarious during a period of widespread layoffs and hiring freezes. One way to offset that, Barzilai said, was to extend the exercise window beyond the standard 90 days.

That uncertainty is compounded by the fact that purchasing the options becomes a very long-term investment that is hard to get out of, should an employee need to. Because options are shares of a private company, employees won’t see any potential return until the company has an exit, such as an acquisition or public offering. The current market has made those prospects even unlikelier than before, and so laid-off employees might have to wait until 2021 at the earliest to see a return on their investments.

“It’s an illiquid investment,” Barzilai said. “They will need to wait for a liquidity event at the company, and with this market situation, all the planned IPOs for 2020 likely will not happen this year. They need to understand that amount of cash they are committing won’t be accessible for a long time.”

A hot time for alternative investments

Barzilai said that the investors that use EquityBee have had mixed strategies even as demand from employees has skyrocketed. Some are pausing their activity on the site, he said, to see how the market shakes out and evaluate which companies have better exit prospects. Others have pulled out entirely in favor of more traditional investments.

But a large percentage are ramping up their investments, he said, and expecting better terms from the employees, just as traditional VCs have started negotiating with founders themselves.

“We are living in a time of uncertainty,” Barzilai said. “Nobody knows if there is a downturn, how long it lasts, or if the market recovers later this year or early next. I’m optimistic the market will recover in the near future, and if that’s the case, alternative investments like this are a very compelling opportunity.”

If the markets do recover as Barzilai predicts and investor interest remains mixed, startups will continue to offer employees options as part of compensation packages, he said. The tight labor market made options a key negotiating point in the past, but now employees may not have as much of an upper hand, making options even more appealing to startups in the long haul as they look to cut massive overhead costs by slashing salaries.

“When they are looking at compensation packages, a high salary or good salary is good but it will not change your financial future,” Barzilai said. “Employees that understand equity will still insist on getting their proper share of options in equity, but I don’t see any significant changes to that strategy.”

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