Understanding equity at tech companies, with Billy Gallagher of Prospect

This week, Patrick McKenzie (patio11) sits down with Billy Gallagher, the cofounder and CEO of Prospect, to discuss the equity grant structures in startups. From understanding when to early exercise options to navigating 83B elections and tender offers, they discuss the critical decisions that have a shot clock ticking the day you sign your offer letter.

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Timestamps

(00:00) Intro
(01:07) Equity management challenges
(02:29) The importance of equity compensation
(04:53) Equity grant structures in startups
(06:09) Understanding vesting terms
(07:09) The value of equity over time
(08:48) The myth of options as lottery tickets
(11:23) Career tailwinds from startup experience
(14:25) Breaking into the tech industry
(15:16) The role of equity in compensation
(17:49) Employee equity plans and dilution
(21:06) Stock options vs. RSUs
(21:55) The decision to exercise options
(27:11) Tax implications of exercising options
(33:03) The role of HR in equity management
(36:14) Bootleg spreadsheets and vibes-based investing
(38:09) Navigating tax complexities in different scenarios
(41:31) The importance of extended exercise windows
(44:18) Challenges with tax residency and remote work
(49:43) The role of accountants in managing equity
(53:41) Understanding the 83(b) election and QSBS
(01:01:03) Tender offers and secondary sales
(01:08:38) Strategies for exercising and selling options
(01:12:28) Navigating financial decisions in startups
(01:16:59) Wrap

Transcript

[A brief note on our transcripts.] 

Patrick McKenzie: Hideho everybody. My name is Patrick McKenzie, better known as patio11 on the Internet. And I'm here with my buddy Billy Gallagher today, who's the CEO of Prospect, a company which is trying to improve how employees manage and exercise their equity. Billy, thanks so much for joining.

Billy Gallagher: Thanks for having me. Long time reader and so excited to be here.

Patrick McKenzie: I'm also excited to have you here. This is a topic that is near and dear to my heart for several different definitions of "equity." But why don't you give people a sense of your professional background and then we'll get to the nitty gritty.

Equity management challenges

Billy Gallagher: Yeah, for sure. So I started out my career on the investment team at Khosla Ventures. So I was doing early stage venture investing in a bunch of awesome companies. They'd already invested in Stripe, which I know you know quite well, before I joined. So I got to kind of ride that wave.

I was there for a couple of years and then joined Rippling when it was about 30 people. I was there as we grew from 30 people to a few thousand. Working at Rippling, I saw kind of the same equity pains over and over. You know, trying to recruit people into Rippling and explain, what is this private company stock worth? Why should I join Rippling instead of enjoying my large paycheck at Google? You know, managing my options, helping my teammates and friends with their equity. You know, I'm going to exercise this option. Now I owe taxes on this illiquid stock.

We were fortunate enough to have a few tender offers. "Tenders" are, roughly, annual opportunities to sell your stock. [Patrick notes: Discussed extensively later.] Everyone had to navigate all of that. It just felt like everyone who works in tech gets paid this pretty big portion of their comp in equity, but they're not venture capitalists. They don't know what to do with the equity, how to get the most out of it.

I started Prospect, my startup, to solve that problem. Think of us as a robo-advisor that helps employees consistently earn more from their startup equity and better manage it, lose less to taxes and sell at the right times.

Patrick McKenzie: I'll make a disclaimer off the top. In addition to being a small investor in a number of companies, although not Prospect at the moment—that could change—I previously worked at Stripe. I was there for a number of years and have left as their full-time employee, but I'm still currently an advisor. People should assume I've had a Stripe equity decision or two to make over the years, but I'm not speaking on their behalf.

Billy Gallagher: Yeah, we can negotiate live.

The importance of equity compensation

Patrick McKenzie: One of the reasons that I think this is just so important as a topic is employees have a fundamental right to their compensation. [Patrick notes: A topic so old and contentious it is mentioned several times in the Bible; Luke 10:7 among many other places.]

We are making promises when we bring them on inside our companies. We are making promises to them as they do very diligent work, often very hard work for a period of many years. And we should keep our promises to our employees.

And yet, particularly with regards to some situations for managing one's equity, people who are given equivalent promises are not treated equivalently by the system because they have different levels of savvy in their ability to manage that. Often that difference in savvy is down to sociopolitical makeup of the employee base, where if you went to Stanford, if you have someone in your family who has been through this before, if it is your second time at a unicorn, you are descriptively advantaged in society. You are more likely to make better decisions early.

And we'll talk about some of those decisions, but some of them have an expiry date, which the clock is ticking as soon as you sign your offer letter.

And conversely, if you are less well-advantaged, if it's your first job in tech, if you did not go to a place where a lot of people went into the tech industry, you're going to get hit with a blizzard of terms like RSUs and early exercise and long-term capital gains and vesting and blah, blah, blah. Because the people talking to you at your company seem to be very enthusiastic about you, and they are very enthusiastic about you, and they seem to be kind, you don't assume that there are landmines that you could step on in any given conversation or any given clicking of buttons on your web interface.

And thus, people who did the hard work, they got to this position in life where they have useful skills, they exercise those skills for years, can cost themselves hundreds of thousands or millions of dollars because of clicking the wrong buttons on an interface where they were like picking between A and B because I don't know, vibes man, it's Thursday and someone at work told me I really need to click a button today.

And extremely frustratingly, if they go to the trusted people in their life at work, go to HR and say, hey, I got this email about equity. I don't really understand what's in this email. HR is going to give them a very carefully rehearsed sentence, which does not give them any useful advice. And we can talk about the reasons for that, but it's a bit enraging.

Equity grant structure in startups

Patrick McKenzie: Let's talk about the thorny sort of landmines later in the episode probably, but for people who might also be getting into Silicon Valley for the first time, how do startups at a variety of stages typically structure an equity grant?

Billy Gallagher: Yeah. Just to echo what you were saying, I think at its best, equity can make everyone owners in the business and can be really meaningful. And at its worst, you wind up with some classes of people that pay no taxes on their vastly appreciated stock and others who end up paying quite large tax burdens on much, much smaller grants. So, yeah, I agree with sort of some of the issues you outlined.

But yeah, typically when you get an equity grant, it varies by stage of company. So typically the earlier you're joining, the more you're getting options. So an option is what it sounds like. You have the option to pay money to buy stock in the company. Those can be tax-advantaged compared to the other structure, which is typically RSUs, which is you're just receiving stock in the company, but typically paying higher taxes on that. Those are kind of the two broad classes. Like all this stuff, you can always go one layer deeper and deeper and deeper, but those are kind of the two high level groups.

Understanding vesting terms

Patrick McKenzie: And when you get your offer letter, and this is usually disclosed in your offer letter, although it might have been part of the negotiation prior to joining, you will typically be told what the vesting terms are for your options. These can vary. Folks, please do actually read your offer letter and equity docs very carefully. But overwhelmingly, the most common among first-rate Silicon Valley startups is four-year vesting with a one-year cliff.

What that means is you don't receive any equity for the first year. You receive 25% of your grant on day 365 plus or minus one day. And then you receive the remaining 75% rateably over the course of the next 36 months. So if you are promised 100,000 shares for joining the company, what the company really wants to do is give you 25,000 shares for each of the four years.

Importantly, unlike your salary, the value of those shares is, in successful cases, supposed to go up over time. [Patrick notes: Startup employees receive raises/promotions/cost-of-living increases/etc much like many employees do, but the supermajority of improvement in a compensation package is due to equity appreciation in successful cases.]

And this is something that employees often have difficulty modeling.

The value of equity over time

Not that venture investors necessarily have an easy time with it. You expect if you're offered, I'll make up a number, $180,000 for a salary, that you'll get $180,000 and not $187,000 and not $125,000. But with equity, it's almost nonsensical to have a discussion about what is 25,000 shares worth? Because you can give an answer today. But what is your true compensation in year four depends a lot on what those 25,000 shares are worth in year four.

And also, implicitly, you're also getting compensated for the 75,000 shares that you earned before year four and some portion of that is sneaking into the fourth year grant, which is just a concept that both humans and Excel have difficulty modeling.

[Patrick notes: To say a few more words on this topic: you, I, or almost anyone else in the world can invest in Google today. The price is as fair as capitalism can possibly make it, and anyone who disagrees with it can sell any time they want.

One reason a startup says that their equity is valuable is not just anyone can get it, and one reason you're getting an opportunity to earn that 25,000 share slug in year four is you (by construction) were there for three years and your management has, several times, assessed your continued presence at the company as being worth the exclusive opportunity to those 25,000 shares even though the shares are now much more valuable than before.]

Billy Gallagher: The only thing we can be sure of is whatever value is described today is not going to be correct. It'll be much more in the future or much less. But importantly, I think something we believe that a lot of other folks maybe don't believe is the value is difficult to project, but it's not random, right? If it was truly a roulette wheel or a lot of people like to compare it to the lottery, then there'd be no point in trying to understand the value.

But if your best friend is Alfred Lin at Sequoia, and you ask him, give me a list of companies I should join. The list he's going to hand over, you know, a bunch of Sequoia companies. And if you're really good friends, maybe some non-Sequoia companies, those are going to have much better odds than the median startup. And so there are signals that we can get into that can sort of boost the odds in your favor. But yes, something we think a lot about is what is the range of outcomes for this company?

The myth of options as lottery tickets

Patrick McKenzie: I think that no single line has done more damage to the interests of tech people as a class than the notion that options are a lottery ticket. And it was received wisdom in places like Hacker News. I think I probably repeated it a time or two to myself over the years prior to getting into a more central example of the tech industry. And it's poison. There's all sorts of reasons why.

Billy Gallagher: Because the lottery ticket, yeah, the odds are literally stacked against you when you're playing the lottery or going and spinning the roulette wheel. If you're joining the right startups—

Patrick McKenzie: Positive expected value versus negative expected value. Another thing that people don't appreciate is that even if one believes the commonly cited stat that 90% of startups fail, I don't think I believe that stat, but it seems to be received wisdom in the community. That does not imply that 90% of people offered equity grants get nothing for the equity grant because companies de-risk themselves as they build more product, sell it to more users, get larger, et cetera, et cetera. And most employees join the company after it has been periodically de-risked.

Billy Gallagher: The distribution of employees looks very different. By definition, if the company hires a thousand people, they're probably doing decently well. So the distribution of where people work looks very different than the distribution of what gets funded.

Patrick McKenzie: Yep. And even if you have no particular useful place in the Silicon Valley network graph, just the fact of you deciding this problem is the one that I want to spend the next four to 10 years of my life on. And this team is the one I want to spend four to 10 years in the foxhole with. Like both of those should be material updates for you versus like, I'm picking a startup at random here. There's an infinite universe of things that you are choosing not to do.

Hopefully you have some amount of taste which makes this a better than random choice and indeed when—there are certainly very talented folks who do not have a successful outcome in multiple bites at the apple. But most people, I think, that are just very talented at the core job, whether that's engineering or whatever, that talent comes with a bit of taste. And they end up selecting into options that are better than what truly random chance would suggest.

[Patrick notes: "If taste is valuable, professional investors would pay for it." This is a good sanity check, to the extent that one believes that professional investors are good at making money, and their skin in the game for this hypothesis is so-called "scouts." VC funds give often relatively young non-investors their own money to invest into companies, with those tech employees/founders/etc keeping all the upside from the scout check, purely so the VC firm gets a first look at something someone with taste thought was promising. If the company flames out, the e.g. $25,000 is gone. If it turns out to be interesting, then the VC fund swoops in for the A round (or later), and hopefully at some point in the future the "scout" gets compensated via the appreciation of "their" $25,000.]

Billy Gallagher: Exactly. When I was interviewing at Rippling, I also interviewed at a few other startups, most notably Quibi, which was Meg Whitman and Jeffrey Katzenberg's sort of micro TV startup and Atrium, which was Justin Kan's legal startup. And neither of those companies worked out from an equity perspective.

Career tailwinds from startup experience

But I have a bunch of friends that worked at both and super talented people who've gone on to do really interesting things. So even if you were sort of saying, hey, you're going to take a swing at bat and it's not going to work, there are these sort of career tailwinds from working with great people that go on to do cool things that I think are not priced in enough.

Patrick McKenzie: I think this is particularly true for people who are early in their career. It is well-known that the tech industry is unserious about hiring, unfortunately. And so there are people who don't have the right degree or the right institution already on their resume find a great deal of difficulty getting hired at AppAmaGooBookSoft, which is my sardonic phrase for  big tech. And they often have, unfortunately but accurately, they often have difficulty at joining whatever the hottest startup is today.

Billy Gallagher: Definitely.

Patrick McKenzie: And so if one were to put a finger to the wind, the startup that is the hottest at any given moment will feel like it is constantly constrained for talent. This is a problem the AI labs likely have at present. But people applying there will feel like they are the ugliest person at the dance because everyone is trying to apply there at the same time.

But all the other startups are constrained for talent too. Many of them will react to that constraint by being less selective—is not quite the right word, but they will not have ossified into the same procedures that cause you to need a Stanford degree or a pedigree at the hotter startups. [Patrick notes: One of my least favorite Silicon Valley tics: describing previous employment relationships as "pedigree."] And then you can get their name on the resume, learn things there, improve your professional network.

And then the next time your resume gets reviewed by a recruiter who is doing the absolutely brutal process that recruiters do where they're judging someone's life in 30 seconds and deciding whether it needs a 31st second of attention, that you don't get swiped. I've never actually used one of the apps that swipes left or right. Swiped in the direction that means "no."

Billy Gallagher: I think, I think left is bad, but it's been a minute for me as well. Yeah. If you think about the book Moneyball, the whole point there is the Yankees have the highest payroll. They can afford the most legible players, right? You know, today it's Aaron Judge. Back then, I think it was Giambi who was like, slugging a million home runs and had all the stats and looked like a Hall of Fame player. And the Yankees can just go, cool, he seems like the best we can afford the most. We'll take him.

Same thing today, whether it's OpenAI or Google saying, okay, you went from Stanford to Stripe to Uber, like great, we'll hire you. The whole book is about the Oakland Athletics saying, to your point, we're not trying to get bad players. We want to win the title too. But we can't afford to just go after the legible ones. And so we have to look for the people who are undiscovered talent.

And startups have to do the exact same thing. You can't afford to pay the same amount as top companies. And so there's a chance there for people who are genuinely quite talented, but don't have that pedigree to get their foot in the door. And I think that's true of everything from going for a Series A, Series B startup that has amazing investors, but it's just like, not a household name yet, and kind of going out on the risk curve. And then it's also true for breaking into the industry.

Breaking into tech

I think it's one of the strongest arguments for going for a startup that's not one of the ones on the sort of bleeding edge of, hey, this first at bat you may not make as much on the equity, but you're going to get a good name on the resume. You know, you're going to get maybe the title you want, maybe you want to break into product or sales. And then sort of the next one is the move where you can maybe make more on the equity.

Patrick McKenzie: My general advice to people earlier in their career is there are typically things where a smart person with taste understands that X company's product is good. They seem to be doing pretty well and there seem to be interesting people there. That company is probably better in expectation than joining whatever the name that is on the front page of Fortune magazine or, conversely, the "replacement rate" opportunity in Silicon Valley.

[Patrick notes: When I speak to e.g. YC founders I have to give the corollary of this, which is that they should understand the product they're offering prospective employees is actually worse than the one that companies a few years older than them are offering, and they need to work to compensate for that difference in expected value. An employee will be offered less of a company that is a few years derisked but doesn't necessarily get proportionately less.]

The role of equity in compensation

But, echoing another thing you said, we're all capitalists here mostly and the decision to put a lot of people's total compensation into equity is not simply because we as an industry just love dumping buckets of cash on top of people's heads stochastically. It solves a real problem for companies too where they are cash constrained. They are—you know, CEOs going out every 18 months to places like Khosla and Sequoia and others and trying to say, I will sell you little bits of this company that I really want to own a lot of to get enough money to continue paying my team and hire the new people for the next 18 months.

And I'm aware that I cannot sell enough to the people who are professional money managers to hire people at competitive market salaries. And so therefore I will hire people for below the cash compensation or de facto cash compensation that they could get at, without loss of generality, Google and give them upside in return for that.

Billy Gallagher: Something that I think is just interesting. Yeah.

Patrick McKenzie: I think everyone should be okay with that. Occasionally there are people that grouse about it later when we roll history forward seven years and say, there was a massage therapist who earned a million dollars on their equity. There is no crying in baseball, darn it. You were a capitalist. You walked into that one with your eyes wide open. It was well bargained and done.

Sorry, I get passionate about that one. Anyhow, you were saying.

Billy Gallagher: I was just saying, I think what's so interesting about where we are today, Thinking Machines Labs has raised billions before they launched their product. I saw yesterday, Jeff Bezos has started a new company, Prometheus. They've raised, I think, six billion. I don't know specifically if they've issued employees equity, but I'd be quite surprised if they didn't. I know Thinking Machines and similar, you know, Safe Superintelligence, other folks do issue equity.

And so what's interesting is even for these companies now that have removed cash as a constraint. It's so embedded in the culture and sort of the ethos of Silicon Valley that you can imagine someone thinking about joining Thinking Machines. They tell their friend, well, I got 400K in cash, but no equity. They'd be like, no equity? Like, why are you joining the startup?

And so I think it is in some ways become even larger than a simple economic exchange and become sort of this cultural artifact. You know, I think the original reason was to make the employees owners, but it's also just become sort of this accepted or sorry, expected part of your comp. I think it's really interesting that even removing that constraint, which is real for 99.9% of startups, which is certainly real for us, but even when you remove it, giving the employees equity is still part of the package.

Employee equity plans and dilution

Patrick McKenzie: And for folks who haven't looked at this from the other end of the table, the typical way it's structured is that relatively early in the lifetime in the company, somewhere around, say, Series A, there is an equity plan written down on paper, and that becomes the Bible for the cap table for the next 10 years. And that will typically allocate 20% of the company to the employee equity plan, where most of it is not issued yet because you can't simply give it to all the people who are there on that wonderful Tuesday, but need to reserve most of it for future issuances.

The tough thing about companies is they can always issue more shares, but you can't issue more percent in the company. It will always sum up to 100. And so what happens as the company does more financing rounds is that it does issue more shares. And everyone who owns something in the company as of day one after a new financing round will find the total number of shares in the company larger than they were on the previous day. And that will what's called dilute someone's existing equity.

And so in the earliest day when it's written down on paper, the employee equity plan, so employees as a class will own 20% of the company, that will typically by the point where the company is large and successful have been diluted down to about 10%, which sometimes people say, why do employees only get 10% of the company? But it is a singular thing in capitalism as practiced anywhere or even in the United States to say employees actually own 10% of the company at the time of IPO and a little bit after it for descriptively the largest companies in capitalism.

Where if you look at like other storied firms like say Ford or something, non-managerial ownership of Ford is basis points if that. Even if the company has theoretically some sort of employee stock purchase plan or similar so they can tell people yes you too will get an extra—boy, then the—I was a participant in an employee stock purchase plan once back in the day in a Japanese megacorp. They were like yes, good news, your shares did an extra 2% better this year, which means all of you can afford almost an entire lunch in Nagoya! So...

Stock options vs RSUs

Patrick McKenzie: Yeah, where should we go? Let's see. So we have the stock options versus RSU distinction. The employee will not be forced to make a choice between stock options or RSUs unless you're making choices between different companies. This choice will be made for you by the company and they're giving the same choice to everyone at the company at the same time. So there is no sort of equity dimension to that that you need to worry about.

Stock options in particular have a function called exercise and a decision to exercise quote unquote early or not, which causes a lot of grief. And since they're issued early in the life of the company, when that grief happens, it will often happen to people who were subjectively in quote unquote the best position if you allow them to roll time forward into the future at IPO day or later. Can we talk a little bit about the decision to exercise?

Decision to exercise options

Billy Gallagher: Yeah, for sure. So we can maybe break it into two buckets, early exercise and regular exercise. So early exercise, as you were sort of mentioning, is the option to exercise your options or some portion of them. It's not binary. It can be any number between zero and a hundred percent ahead of your vesting schedule. So what an extreme example would be: you join a Series A company. They just raised Series A from Kleiner Perkins. You're super excited. You exercise a hundred percent of your options your first day at the company.

What you're doing there is really sort of increasing the variance of your outcome. In the best case scenario, the company goes on, becomes—I think Glean is a great example—becomes an awesome success. You will lock in the lowest possible tax burden as you typically get taxed on the spread between the fair market value of the company and your exercise price. And if you early exercise, that spread is often zero and so there's often no tax. So, kind of best case scenario there, you lock in a minimal tax burden. The worst case of course is the Series A company goes bankrupt and whatever money you spent, you don't get back. So that's early exercise and it can be very, very valuable.

Patrick McKenzie: And for the benefit of people who haven't been through this before, options embed a strike price. And the entire reason we use options in the United States is a bit of consensual fiction that employees, companies, and the IRS all pretend that giving an option to someone has not given them something of value, and so they don't need to pay taxes on it immediately.

Whereas, obviously, an option is something of value. You turn them into homes eventually and many other things in the world. And we run our entire industry on them. But this is the consensual fiction that the United States has through its duly appointed representatives seen fit to endorse and some other countries too.

The strike price of that option is the fair market value (FMV) as of not necessarily the day you join, but the last time they priced the company via (typically) the expert opinion of their outside 409A valuation service.

[Patrick notes: This is the basis for the consensual fiction. "Well the share is worth $5 and so if you paid $5 for it, you haven't received anything in return for services rendered, which would be income and therefore taxable." But, of course, the choice to exercise or not is a thing of value, which Black-Scholes and the entire edifice that is New York financial capitalism have a rich literature on pricing out to six decimal places. That is even before one reaches the question of whether the 409A valuation is truly "fair." And, as stated previously, you have rather exclusive access to invest that $5 in the company, where almost nobody can choose to make that investment, and where professional money managers engaged in a knife fight over SMS messages and emails to get their clients' money in on roughly equivalent terms.]

Billy Gallagher: And the 409A is a very funny kind of dance for people that haven't been through this. I've seen this on sort of both sides of the table where a founder goes out, they raise money, they're out pitching up and down Sand Hill Road saying, this is the greatest company ever. You know, based on my unique genius, we're going to be this hundred billion dollar company in X time.

And then they turn around the next day and they need a new 409A valuation. And they go to their auditor and they go, this is the worst company ever. You know, we have no money. We have all these competitors. This could go belly up any minute. Because what you're basically trying to do there when you're talking to the VCs, you're trying to get the highest price possible. And when you're talking to the auditors, you're trying to get the lowest price possible so that your employees have the best tax advantages or the lowest tax burden, essentially, within reason, obviously.

And so it's a funny number that really neither of those numbers has a ton of bearing until you get much, much later stage and you're actually able to sell at any of these prices. In the early stages, it's particularly hand-wavy math.

[Patrick notes: As one of many tricks of the trade, the natural anchor for a 409A valuation is "Well, if sophisticated money managers say the stock is worth $5, then it is probably worth $5." But the professional investors are getting a different bundle of rights than employees are, typically; preferred stock versus (options on) common stock. There is a very material difference in outcomes for those share classes in disappointing futures for the company, and also some differences in e.g. information rights and similar. The savvy startup management team and 409A valuation consultant will say "Well those rights are really super valuable, I mean all the VCs make a point of buying them, and therefore the residual value of the common stock with those super valuable rights stripped out of it is barely worth the paper it is printed on."

And thus the company accomplishes the objective of being valuable on paper to VCs buying bits of it and less valuable on paper to 409A consultants who are establishing how much of a cash hit newly joining employees will take this year if they early exercise.]

Patrick McKenzie: And so if you are one of the earliest employees of a company, your strike price might be extremely little. This company is a figment of someone's imagination and a laptop in the corner of the room. Your strike price might be a penny a share or less. And if you're granted, make up a number, 100,000 shares, you might owe $1,000 to the company to exercise your shares on day one, which is real money. But to put it into context, if you are joining a company at, say, Series C, when they are still using options, you might be asked, OK, would you like to exercise all of your options today? The cost of doing that might be $300,000.

And many people who have not been through the game before do not have $300,000 of promptly available cash. And as you mentioned, the decision to exercise that really increases the variance of your outcome. And this is one thing that people really need to understand. Like if you choose to pay the company $300,000 to lock in the low tax basis, under zero circumstances does that $300,000 come back. Hopefully you get different money from selling the shares, but that money is no longer yours.

If the company goes belly up, enters bankruptcy, et cetera, et cetera, you do not have a bankruptcy claim for $300,000. You have paid for a thing of value from the company. They have delivered it and you are even stevens on it. And so there are some people who worry about like, could I be ruined if I early exercise these options? So I want to wait a couple of years and see whether this company is likely to be successful or not to exercise my options.

And that causes another landmine that you can step on. Because what happens if the company does very well between T-0 and T+three years and then you attempt to exercise your options?

Tax implications of exercising options

Billy Gallagher: Yeah, so what happens is you then owe a bunch of taxes. This certainly happens with a lot of our users who joined some of the very buzzy AI names, where they joined a hot AI company a few years ago. They turned around, they'd just been working for the last three years. And now all of a sudden the preferred price has increased, tenfold in a few cases, actually much more than that. And the fair market value actually goes up by more than that because the fair market value as a percentage of the preferred is actually increasing. And so the tax burden usually grows faster than even top line growth of the overall company.

So your tax burden might have gone up, let's say 20X. Now, the good thing is you're saying, okay, I joined this company, they gave me a million dollars in equity. That million is now worth 10 million. And my tax burden is four and a half million. Tax burden of four and a half million is not super fun. But certainly the net result of five and a half million after all the taxes is still interesting.

But we have to decide then is, okay, we're sort of partway through this journey, right, of joining the company. We're now in year three. And then hopefully at some point in the future, I can sell shares in a tender offer or we get acquired or we go public and I fully exit the position.

We have to decide: do I just leave these as options, take on zero risk? I'll pay the highest taxes. Certainly if we go public and I sell every share and I'm in really any state for the amounts we're talking about, you're going to pay the highest tax burden. Or do I exercise the options today? You pay a decent tax burden just for exercising—tax on the spread between the fair market value and the strike. But you can then lock in long-term capital gains on the appreciation moving forward.

So if you're saying, I'm at XYZ great company that's valued at $5 billion, but I think it's worth $20 billion, you can lower your future tax burdens. Of course, if the company goes down in value, you risk the capital. So that's kind of the crux of the trade-off. Risk and reward and balancing those is non-trivial.

Patrick McKenzie: I hate throwing out more vocabulary words for people, but here's a useful concept to have: the concept of a bargain element, which is, as you said, the spread between what your strike price is to exercise the option and what the shares are worth on the day that you exercise. The bargain element gets taxed at ordinary income rates, which in the United States are higher than the rates that we give to long-term capital gains.

And then if you hold the stock for at least I believe a year after the point where you exercise it, then the gain on that stock from the point of exercise is taxed at the long-term capital gains rate, which is much lower than the ordinary income rates. It will depend on what state you're in and similar, but you're what is it, 15 or 25 percent? You can tell I've never had the option to pay long-term capital gains for a material amount of money. Fun Japan stories for you, but neither here nor there.

[Patrick notes: The top Japanese marginal rate for employment income is 45% (plus a ~1% surtax for reconstruction after the Tohoku earthquake). I like to think of the wires as if Japan made a bold non-consensus investment decision in me back in 2004 and ~20 years later saw its patience rewarded.]

Billy Gallagher: Yeah, and that's all true of non-qualified stock options. So I think you mentioned earlier, there's kind of two types. So the NSOs are taxed as ordinary income. As if this wasn't all complicated enough, ISOs actually have a different tax system, which is more beneficial, but much more complicated, which is very annoying.

So ISOs are taxed under something called the alternative minimum tax, which you've maybe heard the acronym AMT, which people tend to dread. And this is essentially—to vastly oversimplify—calculating your full taxes under the regular system, calculating them fully under the alternative minimum system, and then comparing them and paying whichever tax burden is greater.

And just two, maybe three quick things to highlight there. Those rates are typically less than ordinary income. So they're usually around 26, 28%, whereas the ordinary ones can top out at 37%. There can be cases typically where you can exercise a small number of options without actually incurring AMT because your AMT tax burden is less than your regular. And so you can sort of exercise a very small number of ISOs every year without actually paying taxes.

And then when you incur AMT, again, as if this wasn't complicated enough, you incur something or you get something called an AMT credit, which is a tax credit you can use in future years. So yeah, the IRS does not make it easy to calculate and properly manage all these moving pieces.

Patrick McKenzie: And I'll say the thing that the IRS always says when people give criticism of them: Hey, we're just the messenger. We did not write these rules. The rules were written for us by Congress. And we just tried to implement the legal code as the duly elected representatives of the American people have told us to do.

I have some amount of sympathy for that point of view.

But be that as it may, the thing that HR will tell you if you say, I have a series of very difficult decisions to make here where I don't know if I can swing $300,000 at the moment. So I have essentially a decision every day for the next 10 years that I'm at this company or some portion after on whether I exercise today, how much to exercise today, and how that will impact my taxes both in the current year and future years. Either I have like the best Excel spreadsheet of all time or hopefully someone is helping me out with this.

In our previous discussion, you had some choice words for how people typically make these decisions. And I would love you to articulate some of those choice words because they rhyme painfully with my experience.

The role of HR in equity management

Billy Gallagher: Yeah, for sure. And I do have a lot of sympathy for the HR folks here just in that, if you think about the typical HR person and the skills they have, or the skills required for this, they're not a venture capitalist, they're not a CPA, they don't have expertise in sort of all the different areas this touches. And exactly, maybe the CFO understands it well, but you know—

Patrick McKenzie: They have equity, too, and they don't understand it either.

Billy Gallagher: Their time is quite valuable versus sitting every single employee down. And B, they've kind of had it drilled into their head of never ever give anyone anything even remotely approaching the slightest bit of financial or tax advice. So typically the way this works, I think just kind of—

Patrick McKenzie: Can we say a few more words on why it isn't simply that lawyers are risk-averse here? There is a very legitimate reason why companies clam up with respect to giving anything that sounds like investment advice or tax advice. Basically, that is because the United States, to the extent that it has securities regulation, which goes up and down over the years. The enforcement environment was pretty forceful for a while and then now who knows? That is neither here and there.

To the extent it has securities regulation, it's largely to protect unsophisticated investors from companies or stock promoters that might be doing them wrong. And when you're selling equity to Khosla, et cetera, you're largely selling under an exemption to these regulations, which says, OK, these are the big boys with sophisticated people working for them. They can manage their own risk.

But you don't have that option when you are "selling" equity to rank and file employees. And again,  this is a product, it is being sold, you are transferring to the company valuable goods and services and often cash money to get that equity.

And so the worry from the lawyer / HR / company management is: if you make representations to someone that aren't true, even if you were attempting to make representations that are in their best interest, they could potentially have a put right against the company or you specifically. And a put right means if this company underperforms expectations, but you've told someone, yeah, you should really pay $300,000 cash on the barrel to exercise these because this will help you on your tax burden in a couple of years, they might be able to come back to you personally five years down the road.

Bob, you told me to spend $300,000 on my shares, Bob. I'm not an accredited investor, Bob. You owe me $300,000, Bob. The company is bankrupt, I don't care. And my lawyer tells me that doesn't matter either. You have a house, figure it out.

[Patrick notes: This really happens! I think the SEC shamefully underperformed in its supervision of crypto over the years, but they did file non-zero disgorgement actions. Many, many more should have been filed, and VCs up-and-down Silicon Valley should have gotten very large bills in the mail after e.g. the ICO boom, because there was open and notorious flouting of our securities laws.]

Billy Gallagher: Yeah, particularly the folks that do know this—the CFO, the founders, the VP of finance, the people that are in the rooms negotiating with the investors. They often are the sophisticated actors, the sort of key players. So there's certainly real reasons why they don't want to be giving employee by employee guidance here.

Bootleg spreadsheets and vibes-based investing

And so what typically winds up happening, there's kind of two flavors of this. Typically there's a sort of bootleg spreadsheet that's kind of passed around the company that some startup veteran, you know, engineer number three, who's on their third tour of duty has made. It's essentially—I think anyone listening who's worked at a startup has probably seen some version of this. An Excel spreadsheet, it's sort of, hey, very clear instructions, make a copy of this, don't mess up my formulas, punch in how many options you have here, punch in the FMV there, and here are some very basic calculations for you.

And then often, the comparisons to, okay, if we have an Uber-sized outcome, here's what your equity is worth, a Stripe-sized outcome, here's what your equity is worth. I can't imagine what the AI companies have been punching in as their comparisons in these, as they exceed the sort of hundred billion mark being impressive. But that is sort of the good version.

And the bad version is essentially vibes-based investing of people sort of deciding, well, I'll exercise everything or I'll exercise nothing, or I'll sell everything I can, or I'll sell nothing. And sort of YOLOing and hoping for the best, which I don't think is the greatest investment strategy.

Patrick McKenzie: And I've seen arbitrarily complicated bootleg spreadsheets" from... a number of places over the course of the last 10 years. More power to people who want to help themselves and their fellow employees in understanding this kind of thing. I think it is a service and in the cause of righteousness that employee number three might knock that spreadsheet together.

Navigating tax complexities in different scenarios

However, there is a reason that Wall Street does not run on spreadsheets that are knocked together by engineers doing it in their spare time. Even if they get all the math right, et cetera, et cetera, which is not a given on bootleg spreadsheets. Excel is a complicated thing, and you screw this up a little bit and people end up owing hundreds of thousands of dollars extra in taxes. Even if they get everything right, there is scenario planning that needs to be quite tied to people's particular circumstances.

Again, it is a wonderful thing that the bootleg spreadsheet option exists, but it will typically assume like, okay, you are the most typical person who has been in the state of California for the entire time of your service. After you do things like, well, remote work is the thing these days. In year three, I moved to Nevada or moved to Texas or moved to Illinois. (Those are three very different scenarios, by the way.) But I move somewhere for family or for whatever reasons. Or, God forbid, we had a divorce.

One hopes on the first day to be there for the entire length of one's next stage of the career journey. Or minimally to vest out the next four years. But sometimes that doesn't happen. Someone in the family got sick. The company had a different idea of where it was going in your department. There was a PIP involved, yadda, yadda. Perhaps you only vested two years.

And by the way, if you get voluntarily or involuntarily exited from a company in the middle of a vesting grant, your timeline for making decisions about exercising just got moved up by quite a bit. Notionally you had this issue of every day I have to decide whether I exercise or not and whether to lock in some taxes now to save lots of taxes later. Now, my decision is like, do I want to exercise or do I want to lose the value of these shares? I will never get it in the future. You have 90 days to make the decision and it's often not the number one thing on your mind because, speaking bluntly, you might have just been fired.

Billy Gallagher: Yep. And you often have 90 days to make that decision in the midst of a lot of other things.

Patrick McKenzie: And are trying to line up a next job or like people sometimes, you know, God forbid, but sometimes people have to leave companies due to family tragedies. And one would hope that companies would extend as much grace as possible in the circumstance. But again, that document that they pre-committed to five years ago often doesn't leave them a huge number of options for giving grace to people.

And so there might be a clause in it that says, if the employee dies, which unfortunately does happen to some people who work at startups, we will give their family 365 days to make the decision on the options, which is longer than 90. We're doing what we can here. There is often not a "my wife has stage four cancer, I cannot deal with this right now" compassionate delay option in the employee stock plan. Make a decision in 90 days, or don't. We will make the decision for you and forfeit the value of these shares.

[Patrick notes: This is not due to heartlessness! One of the requirements for options to be fit-for-purpose for tax optimization is there must be a "material chance" that employees do not receive the stock! But we, as an industry, have not spent nearly as much brainpower on getting that material chance to be closer to the material chance of a database crashing due to cosmic ray-induced bitflips than to the material chance of the Space Shuttle exploding.]

Billy Gallagher: Yeah. And so many of these terms to your point, it starts with, okay, I'm a startup founder, started this company. I work with one of the normal Silicon Valley law firms. I pull a template off the shelf and say, here's all the different terms you need. The founder is extremely busy and goes, cool. That's a template. That's what you normally do. Sounds great. They don't often go through with a fine tooth comb and say, does this align with the way you want employees to be incentivized? Is this the right way to sort of handle this?

There's been a little bit of progress in the last few years.

The importance of extended exercise windows

I think something great is there's more frequently extended windows to exercise. So you're seeing two, three, a number of companies doing even seven to 10 years to give employees to exercise. I think it's fantastic. You know, one of our angels, Zach Holman was instrumental in kicking this off.

Patrick McKenzie: I think the extended exercise window is probably the most pro-employee change that I've seen in startups since the course of my professional career 20 years ago. I kind of view it as YC and similar were great for—apologies to former colleagues who work in investing—they helped to appropriately re-balance the balance of power between founders and professional managers of money in a way that was very founder friendly.

Similarly, longer exercise windows are pro the interests of employees. Unfortunately again, all parts of a cap table have to sum to 100%. So necessarily, this means that some other people on the cap table "lose out" as a result of employees actually exercising all their equity. As someone who, again, I lose out as an investor every time someone exercises equity. But this is the business we have chosen. We made that commitment to someone. We should feel great about the fact of them exercising the equity successfully.

I think Silicon Valley should feel morally scandalized every time an employee is forced into not exercising by circumstances. It has not always covered itself in glory here. When Zach was popularizing extended exercise windows, there was an article written by a venture capitalist that said, well, this is just compensating people who are no longer with the company and withholding equity from us virtuous venture investors and founders and other people who could join the company tomorrow.

That remains the most cynical thing I've ever witnessed someone write in a professional space.

Billy Gallagher: Yep, yep. And it appropriately caused quite a blowback to that firm. I know, I remember what you're discussing. And I've seen that with certain investors we've met where I kind of walked them through our whole mission, our idea of basically if employees understood their equity better, managed it better, consistently added up 2%, 5% improvements in their management here and there, it can accumulate to employees making 20% more on their equity over the course of their careers.

And I've had some investors who were like, that's amazing. I'm a great investor. You know, if anything, employees acting like owners will lead to us having better outcomes. And I've certainly met investors who are like, it's a zero sum game. And that's a slice coming out of my slice of the pie. And I'm like, I don't want to work with you and I hardly want to know you. So definitely an interesting difference in approach there.

Challenges with tax residency and remote work

Patrick McKenzie: Yeah, so we mentioned some of the things that can cause complexity here in making decisions. They don't start as easy decisions, but you add just something which seems like only a little bit of complexity. I mean, oh, here's an example. You can be a part-time resident of a state very, very easily. And it turns out that in generation-defining companies, there are people whose job it is to keep a spreadsheet of how many days certain employees above, say, X watermark in the company spent in various other states.

If you attend a conference for a week in Chicago for work, you might not think I was an Illinois resident for a week. But if you've vested $4 million that year, Illinois will certainly think that you were a resident of Illinois for a week.

Billy Gallagher: Yes, we are.

Patrick McKenzie: And you know, four million divided by 50, Illinois would  like 80 grand please. Patrick corrects himself. Well, 4% of $80,000, at any rate.

Even if the state is not the one doing this compliance work and your company is not keeping the spreadsheet, you should, because ideally you have a respect for the law and your accountant should if they have a respect for the law. And so, in years where I resided in neither Illinois nor California, I've managed to write personally significant checks to Illinois and California because I traveled to those states and had a laptop for the duration of that travel and did work on that laptop in a one to two week period.

And I do not think that I'm anywhere near the top end of most complicated situation.

Billy Gallagher: And it can be particularly tricky with the folks who are doing sort of the digital nomad piece. I was talking to a partner of ours who was a CPA about this a few days ago. And we were talking about how sort of the most important thing is establishing residence, right?

So if you move from a high tax state, California, New York to a low tax state like Texas or Florida, but you sign a one year lease and you change your driver's license and you start putting down roots, certainly if you bought a house, you know, even if you've only been there for a month, it's going to start to look like you are a resident and you've moved. And then certainly if you're traveling for work, you should keep track of that. But you're establishing residence.

But in tech, we see a lot of folks who are sort of saying, well, I work remotely and I can be in an Airbnb in North Carolina this month. And then Florida the month after that, and then in California and kind of hop all over. And unfortunately, some of the hardest stories I've heard is whatever the highest tax jurisdiction you spend any time in is saying, we're going to claim you as a full-time resident. Yeah, you exercised a bunch of options. You owe us quite a tax bill. So yeah, definitely something very important to track.

Patrick McKenzie: The legal reality doesn't match the reality people have in their heads. Tax positions don't necessarily match the reality people have in their heads. They match some sort of iterated negotiation between taxing authorities and taxpayers as a class.

And I feel a little bit for the taxpaying authorities here. Like, you were in an apartment and you had a refrigerator in that apartment and you had food in that refrigerator? Yes. There are many residents of our state who rent an apartment and have food in the refrigerator. That's what residence means. Why should I give you the rich and sophisticated person a tax benefit when I do not give that benefit to people who are working at 7-Eleven? That fundamentally offends my sense of justice and the orderly administration of taxes.

Hearing that argument, I'm like, hmm, yeah, there's something to it. But as you said, renting a residence is one of the many bright lines that gets mentioned in this sort of thing. People might see Airbnb as a close competitor to hotels, but tax agencies see it as like, you are literally physically adjacent to an apartment which is rented on a year-to-year basis, and you have the same product, morally speaking. Sure it might have only been for seven days, but the law doesn't care about that.

You established residence for those seven days and then I'm going to say you established residence here. Now prove to me you established residence somewhere on day eight because if you can't, your residence here is continuing. And then that leads to the really perverse from the perspective of the taxpayer outcome where they—

Billy Gallagher: And I think it's one of those funny kind of really lagging examples of just how the tax law or law in general has not caught up with this sort of Internet laptop class world we live in now. You know, even going back to say the 1990s, sure, you might live in New Jersey and commute over the bridge to New York for your job in the office, but those two points were typically fixed.

You know, you would not have many people that were like, well, I work as a lawyer or accountant or carpenter in New York this month, and then I'm up to Maine next month, and then I am out to Colorado. You just didn't have that sort of class of folks that were so migratory. And so I think it is something where the tax law hasn't quite caught up.

The role of accountants in managing equity

Patrick McKenzie: And to the extent that you had folks that have those issues, they were often in a professional community where everyone had the issues, their accountants were very good at them. I love all accountants and I love my accountants, but I will say that it is dissatisfactory when work says you need to get professional advice on this sort of thing. Because if you do the standard things that people do to find accountants, the person who is giving you professional advice, which they were duly educated and duly licensed on, has—

Let me be blunt here, no earthly clue about the issues that this presents for them. It is very possible to have a CPA and not understand what an RSU is. When you get into the sort of heady, multi-jurisdictional tax issues or complicated tax positions or those major life events that can really throw a lot of complexity into this stuff, basically nobody but the Big Four is going to have anyone in the building that has done it before. And even the Big Four, like maybe you get the best answer that they are capable of giving or maybe you don't.

Billy Gallagher: Yeah. In large orgs you have variance in abilities.

Patrick McKenzie: Yeah, unfortunately for many of these things, you as the taxpayer need to have a consistent strategy and a consistent story starting well before you were rich. And, you know, indicative finger to the wind, if you want to get tax advice from the Big Four, that's about a $30,000 a year proposition.

And if you work at a high-flying company, there are people who attend meetings with you who should pay $30,000 a year for tax advice services. However, you in your first day at working at that company are probably not going to say like, I did my own taxes in TurboTax last year for like $75 or whatever it is, but I should really start paying 30 grand or so. And if you don't, like you will be dragging around the tax consequences of year one decisions for the rest of your life.

Billy Gallagher: Well, it's crazy, even at much lower numbers. You know, we have partners who are CPAs who will refer people and you know, someone starts working with us, they're building a strategy, exercise their options, they're saying, hey, before I pull the trigger on $400,000, I'd like to work with a CPA.

And even at the $1,000, $2,000, $3,000 a year range, I see some folks that are sort of taken aback by that number. I think for some reason, accountants are like—like you're saying, hand-me-down clothes that we just like pass off. The number of people I've worked with that are like, oh, I use my like mom's old accountant. And I'm like, well, do they know what an ISO is? And they're like, not really.

And you think about the sums of money you're managing here, a slightly better improvement there can save you 10X what you pay. But it is something that's sort of odd that people are not used to paying for. I think probably because it's not very fun.

Patrick McKenzie: Yeah, for—I have a relatively complicated situation, but a lot of the complexity comes from things that are not uncommon in the "works for high-flying Silicon Valley company" class, and I pay about 10 grand a year to do taxes in two countries. That will probably hit at least a few people that listen to this, given how many immigrants that tech hires and how many people do a tour of duty at a foreign office of the company that they start their career at.

So yeah, the hand-me-down clothes of accountants is a real thing. You might not understand the degree to which you have gotten into a complex situation early in your career. Knowing what I know in year four, I would not have made the decision to have this accountant prepare tax returns for years one, two, and three. And that can increase your cost in year four to have someone redo the tax returns from the last couple of years.

In a bad circumstance, your return might be past the point at which things can be redone on it. Or returns can be resubmitted but election decisions cannot be remade three years after the.

A related issue: failure to file the obvious document. Do you want to explain that lovely landmine to people?

Understanding the 83(b) election and QSBS

Billy Gallagher: Yes. So when you early exercise, in order for the election to really matter in the eyes of the IRS, you file a document called an 83(b), which is essentially saying, I want to be taxed now on this property that I'm acquiring, not in the future. When you file this, you then lock in your early tax burden.

It's particularly important for a tax break called QSBS—qualified small business stock—which is probably the most advantageous tax break available in startup land. You can get up to the first $10 million in gains tax-free. This has become slightly more complicated in a good way in that it's more advantageous to employees now as it starts to phase in percentages like half is tax-free in three years, 75% after four years, 100% after five years. But to suffice to say, it's a very important tax break.

If you file the 83(b), and you lock in your tax burden, you can usually often hit QSBS and you can often hit a lower tax burden. But if you do not file that within 30 days of exercising, there's nothing you can do. And so it is quite important.

Patrick McKenzie: Yep. Just to say a few more words on what 83(b) does, we talked about vesting earlier. So while you might have the experience of, I was at this company for four years, so I got all of my initial equity grants all up front. The documents that describe the equity grant say, well, actually, you got 25% of it on day 365 and the remaining 75% rateably over the next couple of years. And it was worth a different amount of money, and a higher amount of money on all of those vesting days than it was on that first day.

83(b) says, I expect this to be worth more in the future. You, the IRS, take no position on it, but just like putting you on notice, like tax me on it now, please, because it's worth nothing right now in this early exercise case.

If you don't say that, the IRS will say, well—and this happens to company founders, not infrequently—you vested $4 million of stock this year.

Billy Gallagher: Yep. Yes.

Patrick McKenzie: Stock is not liquid. No one will give you $4 million cash money for that. But the laws of the United States do not care. If you earn $4 million of chickens, we don't want you to send us drumsticks. We want you to send us money. If you earn $4 million of stock, we'll take the money. So you need to come up with $1.4-ish million cash money this year.

And if you say, shoot, I'm an innocent taxpayer here. I didn't know what an 83(b) was or I knew about it, but I was busy. I had a company to run, et cetera, et cetera. Look kindly upon me. What the IRS will say is there is no statutory authority for us to look kindly upon you. In addition to that, of all taxpayers in the United States, why should the rich and sophisticated person get a $1.4 million gift from the taxpayer? No. We want that $1.4 million. If you don't have the cash, that's fine. We can start the penalty clock working right now and we will pursue you till the end of the earth, till the end of time because the United States will be around. Thank you.

Every CPA in startups has a story about a founder and some of them are people you know who was personally bankrupted by this sort of thing. And many more people who are not literally personally bankrupted but huge amounts of stress, had to call in favors, yada, yada, yada.

There are ways to find $1.4 million in a hurry in Silicon Valley and that is to our credit but often they sound like, you know, calling up one of the richest people you know and saying, there will be like heavy legal and personal consequences for me if I don't come up with $1.4 million dollars. Can I please impose upon you Bob to lend me $1.4 million dollars? And as a person who has had to make a phone call not for that reason but with like similar content over the years, that's never one you want to have to make.

Billy Gallagher: No. And 30 days goes fast. I mean, even for us at a startup where our entire ethos is understand the equity, get the most out of it. I still have to hound folks of, you know, hey, welcome to the team. Did you file that 83(b)? File the 83(b). Because you know, you get into your work and a week passes, two weeks pass, and all of a sudden you don't have many days left.

Patrick McKenzie:

Stripe Atlas was helping people who were early stage startup founders and we weren't—we're not lawyers, we're not allowed to give people legal advice, but we tried to give them as much information as possible to encourage them like, you really need to put this in an envelope. And then in the intervening years, Stripe figured out a way to file the 83(b) elections compliantly. They have to be filed on paper, the IRS, what are you going to do?

So Stripe scalably sends out paper on behalf of founders so that nobody forgets to file their 83(b) election unless that is a considered choice, which almost no one should make. Ask your tax advisor if you disbelieve me here. Not giving legal advice or tax advice.

I actually just probably stepped over the line. Thankfully I spent a few years of my career working with the people who are literally world experts on the topic of "What is unlicensed practice of law?" So I know what it is. Thankfully, they are no longer on the hook if I accidentally overstep for a few sentences. [Patrick notes: But for forms sake I will reiterate that Stripe does not necessarily endorse spontaneous glosses of how various products work that I write in my personal spaces.]

Billy Gallagher: Yes, I think some of the great people that introduced us, as we both kind of asked them from different angles, how can I phrase it this way or can I phrase it that way?

Patrick McKenzie: Yeah, and it sounds very quotidian, but it's very real. There's reasons why I use certain locutions like "a company which blah, blah, blah, blah." It's not advice. That's information about what the tax law is. "You should blah, blah, blah." That's advice. It's had the word "you" in it. And even though the word "you" crops up into like informal English speech all the time, "a company, a founder who dot dot dot..."

Billy Gallagher: Yes. It reminds me of there was a very entertaining book, Uncanny Valley, a few years ago, where the author clearly worked at—and I'm going to forget the startup, of course—but it was sort of a work that has started with all the descriptions were probably getting around an NDA. They were sort of like, what if I worked at the hot analytics startup in the Mission Bay.

And a lot of the better advice you can give is, if you were a California taxpayer with double trigger RSUs in a payments company that just converted those into single trigger RSUs, here are things you might consider.

Patrick McKenzie: Yep. And my highly paid legal advisors would say, you are thinking in a good direction on how to phrase that sentence, but take out the word "you" minimally and then avoid particularizing it to like a payments company, yada, yada, and wink heavily. But to resume. Time check, we're at about an hour 20.

Billy Gallagher: Yeah, the only things that if you want to get into any of the more expert things. I think maybe two things that are interesting are just tender offers being much more prevalent. There's so many—we talked a ton about buying your equity, so many opportunities to sell a portion of your equity. And all kinds of interesting things we can talk about there with like, you can sell earlier now. You're often capped at selling 20%. So it's easier to get partial liquidity, but harder to get full liquidity.

Patrick McKenzie: So this is not a static set of problems. The market practices evolved over time with regards to equity, first to actually offer it, but there have been changes in how high-flying companies work in recent generations of them versus say back during the dot com boom. Companies grow for a while longer.

One change that has been remarked about is companies stay private for longer, which means that there are more decision points people have to make and more liquidity issues they have to manage. They might have to manage liquidity around some sort of loan option, which is its own ball of wax.

Tender offers and secondary sales

But you mentioned to me another issue which is adjacent, which is companies are doing tender offers now. For the benefit of someone who hasn't been in a tender offer, it's simply like prior to the company going public, the company finds an investor or some pocket of money. It might be an existing investor, might be new investors, it might be the company itself, which is willing to repurchase equity from employees at some price.

Often the tender offer will come with strings like you're allowed to sell only a certain percentage or you're allowed to sell up to X dollar value and it'll be a take it or leave it offer. This will not be negotiated on an employee by employee basis. You have two weeks to decide whether the most important financial transaction in your life goes through or not. What do you want to do?

And because this will often be in the case where it happens, the most cash money that hits an employee's account in that year, there will often be a secondary consideration on, if I have that cash money hit my account, one, tax consequences, obviously, but two, should I think seriously about using the tender offer to exercise other options?

And this is, as you pointed out, a thing that employees have not previously had to wrestle with and that at high-flying companies, they basically have to wrestle with annually or more now. Can you talk a little bit about what you have seen from employees at various high-flying companies and then a little bit about how Prospect helps people think through these sort of problems?

Billy Gallagher: Yeah, for sure. We kind of see maybe two flavors of it. In addition to just tender offers being more common in general, we're also seeing them happen earlier and earlier. You know, where secondary used to sort of be a dirty word, it's kind of had this connotation of the founder is selling a bunch of their shares to buy Ferraris and go on expensive vacations and not build a business. You know, I think everyone's kind of realized, actually, yeah—

Patrick McKenzie: Can I jump in for a minute there just for the benefit of people who haven't worked in VC? A secondary is a secondary sale where every time a company raises an investment round, it is selling parts of itself to somebody. That is the primary sale. The secondary sale is in a sidecar agreement to that initial agreement usually. Someone else who owns part of the company, like say the founder, is selling part of the company to either the same investors or different investors.

And in the mists of prehistory, this was largely used to have founders, sometimes very senior executives like the CEO, take quote, "a little bit off the table," both so that they were recognized for performance in the first couple of years and also—bluntly but accurately—there's a certain lifestyle that is expected of high-flying CEOs of Silicon Valley. You cannot sustain it on e.g. $200,000 a year.

So some of them would say, okay, well, I'll get a partial paycheck on my equity for $20 million in year three and then have a nice condo to entertain guests in for the next couple of years as we continue building this business and hopefully have the rest of the equity be worth a lot more than 20.

[Patrick notes: I think there are wildly different aesthetic reactions to founders having wealth, and the display of it is sometimes managed/messaged differently to different audiences. Speaking generally and descriptively: many founders will have to repeatedly convince rich and powerful people they are peers or at least useful, and that is often not compatible with continuing to lead the nothing-on-the-walls, don't-even-own-a-bedframe grindset lifestyle. If you and your spouse want to have a prospective CFO, late of corporate America, over for dinner to woo them to your cause, that dinner will have to be at least "middle-class San Franciscan" standards, and the buy-in for that is a $2 million condo.]

And for a number of years there was stigma on VCs—didn't like people doing secondaries at all and then market norms shifted power in the direction of founders and so secondaries were broadly destigmatized but still only available to founders and sometimes very senior employees, management and similar.

And then the tender offers have largely been—partly for legal reasons but partly for internal fairness and communications reasons—available to some combination of say all current employees or maybe all current employees and past employees. Or I suppose you could have a tender offer that only went to past employees. Although that would be a bit odd.

Billy Gallagher: Yeah, haven't seen that one exactly. And, you know, all of these things, I think it is sort of the dynamics of a recruiting market, right? Where a great software engineer could work at Nvidia, they could work at Google, they could work at OpenAI, they could work at Cognition. And so all these folks are kind of competing by recruiting for top talent.

And so what we're seeing is companies are doing tender offers far earlier in their life cycles.

Hey, if this company is just worth a billion dollars and only a few years old, if a few key early employees want to sell a stake, you know, within guardrails, the investors and founders—and I think appropriately so—want to make sure people aren't selling 90% of their stake and becoming misaligned. You know, A, we're seeing this earlier.

And then in some of these larger companies, certainly seeing tender offers every year. We've even seen a few companies where the value is appreciating so greatly that they maybe did a tender offer in January or February or March, and then halfway through the year they're saying, the business has grown a ton, you know, XYZ tailwind has kicked in and this investor is really excited and we're gonna do another one at double the price. And you know, we've seen that.

And so just the complexity for employees is going up and up and up as you're deciding now, okay, any of these 365 days in a year, I can buy my options. Now I've got one or two times a year, or in some cases, one time every two years that I can sell the equity.

You know, something important about tender offers is companies will never promise that they'll have it again in the future. They're always sort of saying something to the effect of, we will try to do this in the future, subject to investor demand and subject to our ability to, but no promises.

And so every time you're selling, you're kind of faced with this trade-off of, I work all day, every day at this company. I really want to make the equity valuable. I believe in the story. Should I hold the vast majority of my net worth from this company? At the same time, I don't know when I'll be able to sell again, whatever cash I need, if I'm thinking of buying a house or taking care of a family member or, you know, spouse is going to start a business. Should I take that out now or might we double in value in six months and I should sell then? So shameless plug, we—

Patrick McKenzie: And before you get into the description of Prospect, I'm sorry for cutting off there, I will say when shares were illiquid for the first seven years of a company's life up until the point of IPO, you could be forgiven as an employee for understanding that stock prices only ever went in one direction: up and to the right. Because you got them at a very low strike price and then IPO day was a number much greater than the strike price and after IPO day—

Billy Gallagher: Yeah. No, you're fine.

Patrick McKenzie: Yeah, sure, it'll wiggle around a little bit, but you will have the ability to either sell your shares or get a loan against them relatively easily.

In a world with more liquidity, more liquidity is unambiguously in employees' interests. However, it increases variance in both the value of your shares and in your ability to make decisions well or make decisions poorly. Many people who remember what their company's price was at because it was on documents in say 2021, also remember what it was at in 2022.

Those are very different numbers. They're very different in a straightforward way where: if interest rates go up, the value of all equity goes down, period.

This is drilled into the head of people who work on Wall Street. But sensibly many people come to Silicon Valley because they don't want to work on Wall Street. And they don't necessarily have the like "equity prices are heavily tied to Fed interest rate announcements" tattooed onto their forehead.

And so for the benefit of people who don't have that tattoo on their forehead, we have either the bootleg spreadsheet that is doing vibes-based exercise decisions, or we have Prospect, which makes software to help people think through these questions.

Strategies for exercising and selling options

Billy Gallagher: Yes, exactly. Yeah, we build out pretty sophisticated strategies for you. So these can be combinations of exercise and sales steps across many years. And so all the things we're talking about. Well, should I exercise 25% this year or 50%? Should I use 50K or 100K? Well, next year, what if I sell my options in a cashless exercise, which is a lovely bit of complexity we didn't even get into, or should I sell common stock to help with long-term capital gains?

You kind of, as you were saying, should I elect to sell this option grant with the higher price or that one? All that kind of complexity we handle and kind of model for the employees.

Patrick McKenzie: Yeah, specific identification of lots is probably something that no one ever wanted to learn about when they got into engineering school, but it is a topic that you will eventually encounter at least once. That is the sort of thing where a CPA certainly knows what specific—the word "certainly" is doing a lot of work there. One would hope that a CPA understands that like specific identification of lots and FIFO are two different things.

Billy Gallagher: Yes, and—

Patrick McKenzie: They might not though and the difference between those two is quite material.

Billy Gallagher: And paradoxically, the punishment you get for doing well in your career and your company doing well is if you are year seven at a great startup, you've probably gotten a number of refresh grants at all manner of strike prices. And then you've exercised across all these different years and have all these different acquisition costs. And so, yeah, it's a lot of fun combing through those and figuring out what's the right combination to use.

Patrick McKenzie: For the benefit of people who haven't worked at a startup before, we discussed the most common case where someone vests equity over the course of their first four years. But it would be a terrible thing for Silicon Valley if everyone got to four years plus a day and said, I'm out. And if they only get equity for the first four years, a lot of people would say that because you get to four years plus a day and your effective compensation just decreased by 80%.

So what companies do to avoid that is for employees that they would really like to stick around longer, they start saying relatively early in their employment, okay, we're going to give you a new window where you will vest equity over time in the same fashion that like you vest salary every month—we just pay it to you every month.

So like brass tacks, it is probably not going to, if the company is doing well in the course of the four years, it probably won't replace the initial equity grant. But it will make it feel less like you're getting punched in the face when you see your compensation package in year five.

And as you mentioned, complexity increases quite a bit. You have essentially a waterfall chart of, okay, I had these four years with these exercises, and then I'm going to layer on top of that a number of refresh grants that started at different dates. They have different prices associated with them, yadda, yadda, yadda. And then some of them were like partially rescinded for whatever reason. Some of them were partially exercised, some of them were partially sold in a tender, blah, blah, blah, blah, blah.

And the wonderful engineer who did that great version of the bootleg spreadsheet that is going around has probably not modeled all of these out the way an entire engineering team would.

Billy Gallagher: Yes. Well, and there's a lot more complexity oddly in refresh grants. So the four year, one year cliff is like pretty standard. And if you give someone that framework, that should work at most startups, but there's a lot more variance in refresh grants. Some people do stacking one year grants that vest quarterly, some do a new four year vest, some do these crazy back-weighted vests. And it's not even worth digging too much into this, but just suffice to say that there are a lot more flavors of how you handle refresh grants than the initial.

Patrick McKenzie: And then I'll say one other thing, although it could be worth its own episode. The liquidity problem for people making early exercise decisions is one of the great aesthetic and moral problems in Silicon Valley to me. And there are legitimate reasons why companies are extremely averse to people doing a transaction which sounds like "Loan me money today and I will give you upside on my equity in the future" and there exist a number of companies that want to facilitate that transaction which companies—the companies issuing equity—would love if they could burn their business to a cinder for various reasons. We don't want to get—I don't have to get into that.

That said, those loans which are ones that your company would certainly prefer you not take advantage of are not the only loans available in capitalism. And there are some people who probably should think hard about like, is it worth me getting a $25,000 cash advance from American Express to exercise my equity now that I've just joined this company?

And that is, again, a thing that is probably not in the bootleg spreadsheet. But I remember when you showed me a demo of Prospect that you can model things like, if I'm in a lucky position in life and have family that have money, can I get a family loan for this versus can I convince someone in my professional network to help me out versus can I go down to a Main Street lender versus can I deal with one of the companies that work would prefer me not deal with.

Billy Gallagher: Yep. And there are—yeah, and there's wide, as you're kind of saying, there's a wide variance in what you can order off the menu here from, I borrowed something from my brother to against my own 401(k) or my home equity loan to American Express, as you said, to some of the folks that do specific equity loans that companies dislike for good and bad reasons.

And I would say there, it also really depends on the company you're at, and it's hard to give blanket advice besides saying that it's bad to get blanket advice, right? In that, if you're at a very mature late stage company, the SpaceXs of the world, the consideration set should be quite different than if you're at a Series B company that's still fundamentally risky. And we try to help you—

Patrick McKenzie: Yep. Unfortunately, the financial industry is very good at solving the problems of rich people with liquid equity. As you get into the 10 plus years in the company and start to get in the happy, terrible position in life where you understand that there are private bankers and then there are private bankers and that contracts can be bespoke with banks. You get more options available to you in tapping liquidity.

But again, decisions you made when you had relatively less money and were not on the radar of private bankers and where even if you were, banks with private banking practices would say, yeah, no. We're not VCs here. We don't take equity risk. We want to loan you money in the certainty that you will repay it. You will not have the tools available in year one to minimize your tax exposure that you might have available to you in year 12.

Billy Gallagher: Yep, it's a bit like being at like a very high end restaurant and just realizing over the course of the night, there's like always one more private dining room kind of behind the next wall. You know, as you progress in your career, you make it into different dining rooms, but there's always another one.

Patrick McKenzie: I am—random anecdote for you from a particular large bank's customer service software. They have a scale to inform all employees of the bank of the relative wealth that their current customer that they are speaking to represents just so that you don't accidentally offend someone who is an extremely lucrative customer of the bank. And because this bank is crass about this, that scale is a $1 sign through $5 signs.

And indicatively—I haven't seen their training docs, but I know some people who know some people—much of the game in startup land is that the vast majority of us start out at $1 sign, some of us will make it to two, and some people who are a combination of very skilled and very lucky will make it to $3 signs. Potentially some founders get to four or $5 signs.

Every time you go up a dollar sign, life is great for you and you also get a new class of very hard problems that no one grew up knowing how to solve. Well, relatively few of us grew up knowing how to solve. Perhaps some people have a special interest in tax optimization from an early age, but I did not.

And so I'm very glad that you are helping people navigate this thing. Where can people find you and Prospect on the Internet?

Billy Gallagher: Yeah, for sure. Prospect is at joinprospect.com and then I'm on Twitter at @GallagherBilly.

Patrick McKenzie: Awesome. Well, thanks very much for taking the time with us today, Billy. And thanks everyone for your time and attention. Hope that was useful for you. I can't give you advice if you email me on this stuff, unfortunately, but you can read this transcript and the stuff that Prospect will be publishing over the next couple of months and hopefully make good decisions for yourself, your family, your loved ones, and causes you support over the next 10 plus years of your career.

And on the much shorter timeframe, I'll see you next week on Complex Systems.