The Case of the Dubious Debt

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HEIDI: Welcome to the Startup Solution and “The Case of the Dubious Debt.” I’m Heidi Roizen from Threshold Ventures.

It seems that every few years, I go through a wave of people asking me about using debt to exercise stock options. So, I was not surprised when I got this call from a former grad student of mine, who I’ll call Aisha.

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AISHA: Hey Heidi, wow, it’s hard to believe it’s been three years since I graduated. I’m still at the same startup, and it’s going really well. So, today, they made us an offer to lend employees the money to exercise our options so that we can benefit from long-term tax treatment. I haven’t exercised yet, because it would cost me $25,000 that I don’t have. The loans are interest-free, and my exercise price is a tenth of what the VCs paid in the last round, so it seems like a great deal to me, but I wanted to check with you first before I did it. Am I missing something? I’d love your advice.

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HEIDI: Aisha’s right; it sounds like a great deal. But like many things in life, it’s the details that matter here. And in this case those details can end up costing her a whole lot of money.

Before I unpack what those details are, let me spend a minute on why someone might be excited about an offer like this. Let’s say, like Aisha, you work at an early-stage startup. And you’ve been awarded a stock option at a very low strike price, like 10 cents a share. Investors are, at the same time, investing in a round priced at a dollar a share – so your option means you can buy shares at a tenth of what the pros are paying. That sounds like a pretty great deal. 

Let me remind you, though, as I’ve said before: investors are typically buying preferred shares, while employee options are usually for common shares. This difference won’t matter in huge upside scenarios – but it will matter in lesser outcomes. I’m going to talk more about why this is an important consideration in the debt decision, but let’s finish laying out the details about the options themselves first.  

Options are just that – they’re options to buy shares, not the actual ownership of those shares. You’d think that wouldn’t matter – because you can exercise those options at any time to take advantage of that low price. But the timing of your exercise does matter – because of taxes.  

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As you probably already know, the IRS has a special tax rate for income called long-term capital gains. This comes into play when you sell an asset, such as stock in your startup, after you’ve held it for a long time, usually for more than a year. In such cases, the federal tax rate applied to any gains is going to be only 15-20%, depending on your income, instead of the regular income tax, which today can be up to 37% for high earners. And that’s a big difference.

Before I go any further, let me slap a big red caution sticker on this episode. Tax laws are complex, and they change all the time. There are different kinds of options, which may be treated differently by the IRS in terms of how and when the taxes would be determined. And, for certain assets, the holding period that qualifies for better tax treatment may also be longer than a year. So please don’t rely only on what I say to make your decisions about stock options. I’m going to give you an overview of things to consider, but you really should talk to a tax professional before you take any actions yourself.

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OK, let’s get back to the tax implications on options. Because they are options to buy stock and not the stock itself, holding options does not count as holding an asset. That long-term holding period clock only starts ticking when the options are exercised.

The typical “first world” problem about exercising options is the problem that Aisha has: even though the exercise price may be pennies per share, the “problem” usually is that you have a whole bunch of shares represented by your options. And so even at 10 cents a share, if you have options for 250,000 shares, that’s 25,000 dollars you have to pay in order to exercise. And you may not have 25,000 dollars just lying around.

Because most young startup employees don’t have lots of cash lying around, many well-meaning startups have tried to solve the problem by offering loans to their employees to exercise their options.

But wait, aren’t startups always strapped for cash? How can they afford to lend money to all those people? Well, that’s the nifty feature of this type of lending. The startup is lending you money to exercise options, and when you exercise them, the dollars you pay to do so go right back to the startup. In fact, this is usually accomplished through a cashless transaction, meaning the money doesn’t actually go anywhere; it’s just paperwork. That is, an option exercise and a loan agreement are done simultaneously. The point is that the startup doesn’t give up any cash to do these loans.

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I get why startups think this is a good idea. They do so out of the genuine desire to help employees turn their potential profits on their startup equity from short-term to long-term tax treatment. But there’s also significant downside risk for employees who take the debt route. Here’s why.

The first thing to realize is that the money the company lent you, which you immediately gave back to exercise your options, is still money that was lent to you, and it needs to be paid back eventually. Most of these loans have long terms and low or even no interest, with the expectation being that you’ll pay them back someday out of the proceeds of that very same stock when the company gets acquired or goes public.

But not all companies go public, and not all companies get sold for enough money to have those common shares be worth more than you paid for them, even with that big discount you got relative to the preferred share price.

I’ve talked about the important difference between preferred and common shares in an earlier episode called The Case of the Millionaire Mirage, and if you don’t understand how preferred shares work, you should probably listen to that one sometime. But in short, if a company sells while it’s still private, which most companies do, preferred shares are in line ahead of your common shares for the proceeds. If your company is a big hit, this won’t be a problem — but many companies are not big hits. In my 25 years as a VC, I’ve seen many situations where companies don’t achieve their goals, can’t raise further capital or get to cash-flow-positive, and end up selling for less than the total money they raised — resulting in the common shares becoming worthless.

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The problem for you, if you borrowed money to buy those shares, is that the money you borrowed is still debt that you have to pay. But the sale of shares you were counting on to do that isn’t going to happen because those common shares now have no value.

Most of the loans companies give to employees are full-recourse loans, which basically means if the asset you bought with the money ends up not being worth the money you borrowed, the lender can come after your other assets in order to satisfy the debt. And even if your company is sold, that debt you owe is still on the company’s books as an asset — and the acquirer will probably want to collect on it.

But wait! What if the very kind board of directors cancels the debt and forgives all the loans before they sell the company? You’re in the clear, right?

Unfortunately, probably not. Why? Because even forgiven loans can create tax obligations.  

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I learned this through one of my first experiences as a VC. I led a round in a startup where the top three executives had borrowed $200,000 each from the company. I noticed the loan obligations on the company’s balance sheet and asked the CEO about it. He explained to me that it was a crafty way for them to get long-term capital gains on their option grants, and there was ‘no cost to the company’ since the money lent out had immediately come right back when they exercised. I hadn’t seen anything like this before, and to be honest, it sort of made sense to me at the time.

After a few years of trying to grow that company, things hadn’t gone well, and the company was unable to raise further capital. We looked far and wide for a buyer, but the only offer we got was for less money than the total capital that the company had raised. Which meant that the common shares these three execs owned would be worthless. It sucked, but it was still better than a complete shutdown, so the board and the executives agreed to accept the offer.  

All of us on the board felt really bad for the executives, who had worthless stock and $200,000 each in debt owed to the company – that they didn’t have the money to pay. So, we negotiated with the acquirer to let us forgive the debt and take it off the books before the transaction closed. Problem solved, right?

No, it wasn’t. Want to know why? Because the IRS has a name for forgiven loans. They call them - ordinary income.

The loans forgiven to each of the three executives were looked upon by the IRS as if they had each just earned $200,000 in income. That’s right, each of these people had $200,000 of phantom income they had to report and pay ordinary income tax on, for which they had no money and no shares of any value to sell. Because these were young people with no other assets (which was actually kind of “lucky” for them), they each declared personal bankruptcy. This was not pretty, and trust me, you don’t want to do this if you can avoid it. They learned the hard way, and I learned too though certainly less painfully, that those seemingly no-brainer loans had real downside consequences.  

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Maybe some of you right now are thinking creatively about another way we might have solved the problem. Maybe if we’d had enough cash to bonus each of them an additional $200,000, they could have used it to pay the taxes on both the forgiven debt and on this new bonus – and that might have solved the problem. But what startup living on fumes has the cash to do that? And also, why would any of the other shareholders consider that a good use of cash? Remember, as I’ve talked about in many episodes, the board has a fiduciary obligation to all shareholders, and giving this type of preferential treatment to the execs, especially given the poor performance of the company, could get the board in a lot of hot water. So even if we’d had the money, which we didn’t, this is not something we would have done.

By the way, this scenario would be similar to what an employee would likely face if their company issued what are called ‘non-recourse loans’ to exercise their options. With non-recourse loans, a company can usually only come after the common shares you bought with the exercise – which at least means they won’t come after your bank account or your house. And if those shares are worthless, the company will have to write off the loan. But that situation will still likely be taxed by the IRS as if the face value of the loan was ordinary income to you.  

My words of caution also apply to those of you considering borrowing against stock you already own but can’t sell because the shares are restricted. 

If the debt is full-recourse, by now, you know that if the equity you plan to sell in the future goes down, you’ll have to cover the difference from your other personal assets. And even with non-recourse loans, you may end up with the same tax problem those three execs had. Oh, and depending on the form of restriction, the IRS won’t be the only government agency to take an interest in you. These types of transactions might end up in violation of SEC rules, too. So definitely consult with a good tax professional and a good securities lawyer before you consider doing anything like what I’ve just described.

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Anyway, for Aisha, my former student with the unexercised stock options and the tempting loan offer, my summary was this: with unexercised stock options, the worst financial pain you can have is that they end up being worthless, so you end up with no gain. But with exercised options, the worst financial pain you can have is that not only might the stock go to zero, the cash you used to exercise those options is also gone. And if you borrowed that cash, you’re likely still on the hook to pay it back. Even if you don’t have to pay it back, the IRS may look upon that very gone money as ordinary income and tax you on it.  

I told Aisha that I appreciated the good intent of her company in trying to do this, but if it were me, I wouldn’t borrow that money. And if she ends up so lucky as to have a big windfall from those options and then she has to pay ordinary income tax on it, she should consider that a very nice first-world problem to have!

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And that concludes "The Case of the Dubious Debt." For the record, this situation is real, but Aisha is a composite. And no startups were harmed in the making of this podcast.

Thanks for listening to The Startup Solution. We hope you’ve enjoyed this episode, and if you have, please pass it along to someone who could use it. I’m Heidi Roizen from Threshold Ventures

Further Reading

Here it is, straight from the IRS, what capital gains are and the rate at which they are taxed. 

And also, straight from the IRS, how they look at forgiven loans as ordinary income. 

And here’s a comprehensive Forbes article on using debt to exercise options. 

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