#84 – Startup Equity 101: ISOs, NSOs, RSUs, Secondary Sales, and other things you should know (Sam Corcos, Zac Henderson & Henry Ward)

Equity can be an overwhelming concept. What’s the difference between RSUs, RSAs, ISOs and NSOs? In effect, those acronyms are all different equity offerings with different tax implications for their recipients—your employees. As a business, you want to do what’s best for your team members. In this episode, Sam Corcos and Zac Henderson of Levels sat down with Henry Ward, co-founder and CEO of Carta, to discuss what various forms of equity look like and how to make it as easy as possible for your employees to get some liquidity in the long run.

04:34 – The difference between public and private stocks

Henry explained the difference between publicly registered stocks and private ones and what restrictions come with each.

There’s a bit of a legal challenge where in the public world, because all these stock and securities are publicly registered, the government basically said that anybody can buy and sell these things and the company can’t put restrictions on that. In the private world, because they’re unregistered, not anybody can buy and sell these things. And the company is allowed to put, and it’s usually credit investors are allowed, it’s not everybody. But also that the company can put in restrictions preventing these things, preventing the stock from trading. And I can talk about why the world works that way, but that’s a current state of the world. So there’s never been a market that’s really developed to allow people to buy and sell private stock because there’s so much friction and that only certain people are allowed to do it. And then also there’s all these legal hurdles that you have to get through with the company to allow it to happen.

12:06 – Why the strike price matters

Most of the value of stocks is in the strike price, not in the upside. This is where restricted stock comes into play.

That strike price actually matters a lot because that’s most of the value is in the strike price and not in the upside. And so what public companies do to address that is they give restricted stock, which is effectively stock with no taxable event. That’s why it’s restricted stock unit versus restricted stock. It’s a right to have the stock versus the actual stock because if they gave you the stock right away, you have the taxable event. So they give you a unit which represents the stock that you can redeem later. And that means if I give you 100,000 dollars of RSUs, that’s now actually worth 100,000. It’s 100,000 of options where the options strike, it’s basically worth zero yet, the stock for the company. And that’s why if we work for a better company, you usually have a lot more guaranteed cash with salary plus RSUs, which is a guaranteed amount. You get the full amount of the stock value, but in options that’s not guaranteed, but it has all the upside.

14:36 – Why you need to switch to RSUs

Private companies often compete with public ones to recruit employees. RSUs can help private companies offer similar compensation as their competitors.

When you’re a $5 billion company, you’re not getting startup people that are trying to be one of the first 50 employees, right? That’s not the labor market. We’re worth 8 billion, eight and a half billion or so. Many of the people we recruit from, we’re competing with public companies, these employees work or used to work for public companies and they’re used to RSUs and not like, “Hey, I’m looking for this 100X upside.” I’m expecting some of my comp is based on stock, but I’m expecting to accrue $200,000 a year in stock plus a salary. I don’t expect to accrue zero and then maybe 200,000 if it doubles, right. I just expect to get that. And that’s what an RSU does. And so that’s why we have switched to RSUs, partly because that’s the type of financial compensation our employees now are used to.

18:15 – Employees are your investors

Henry said people have to see themselves as investors as well as employees if they choose to work for a startup, so they must be careful who they choose to work for.

One of the real challenges for employees is they have to be an investor as well as an employee. They have to pick the company that they think is going to win. But the disadvantage that employees have over investors is they only get one bet. Investors can pick a portfolio of companies, but employees can only pick one. And they usually have less information than investors do. They don’t get the financials, they don’t get the strategy decks. They don’t get access to the management team and so it is for them somewhat of a lottery. And so how does an employee know which companies are going to be the best funds? Well, one heuristic or one tell is if a company can regularly do secondaries, that means that this company has access to capital that other companies don’t. The capital markets deem this company worthy of having more investment dollars the company even needs. And that is not only a great employee benefit, but that is a very powerful signal that this is a strong company.

26:26 – The possibilities of secondary sales

There are many different types of transactions you can do in secondary sales: tender offer, reverse tender offer, and block trades.

There’s a lot of different types of transactions that you can do in secondary. So obviously tender offer is one. Reverse tender offer is another when you don’t have an existing buyer primary where you’re going to go sell the block. There’s also things like block trades, where we may just aggregate a bunch of employees that are in interest indications and then pull a block together and then sell it in a peer to peer transaction. And then there’s a handful more but the one you’re specifically referring to is our auction product, which is what if you want the market to decide the price for it? So if both tender offers, in tender offer, the investor decides. The reverse tender offer, the company decides.

28:51 – There’s no good reason to disallow secondary sales

The best companies are offering secondary sales, and there is no reason for other businesses not to follow suit.

I think at this point there isn’t a good reason. I think companies that don’t, it’s really inertia. Well, we’ve just never done it before, should we do it? I don’t think there’s a good reason. And I actually think what’s starting to happen is that the best companies are doing this and employees are starting to take notice and migrating to the companies that offer liquidity. And I think what you’re going to start to see is that the best companies are starting to do it, they’ll attract the best talent because now the offer is cash, stock options, and liquidity. And that’s more attractive than companies that are just cash and stock options. They’ll start winning the talent orders and everybody else will start to have to follow suit. That’s actually going to make it harder for the non-top-tier companies, because if you’re a non-top-tier company and you’re struggling to track capital, it makes it much harder for you to create liquidity for your employees. And this will actually create a stronger power law in venture where the best companies will win even bigger.

32:04 – Make sure your business is properly capitalized

Henry said to make sure your business is properly capitalized before you go into liquidity. Some companies have started at $200 million, though $500 million has more meaningful liquidity.

We see companies as early as $200 million in market cap starting to do tenders, relatively very small amounts, but I can totally see that starting to happen. I think 500 million is where you start to, there’s meaningful liquidity and wealth that’s been generated. I think the most important thing from a founder’s perspective is before they go into liquidity is to say, “Hey, is my business properly capitalized? Do I have enough capital? And do I have a confidence that if I needed to go raise capital in the future, I can?” And I think those two things are true. I think the company has kind of escaped the early stages that you never know if it’s going to work out but, “Hey, we have a real business here. Yes, we’ll rely on capital markets, but we’re not going away. We’re a real company,” and that’s a good time to start thinking.

33:28 – How employees can sell their shares

Henry explained what the experience of an employee trying to sell their shares would be like, from simple to complex trading strategies.

For most employees they’ll participate in a tender offer. If they were in an auction, they could actually set the price that they want to sell at. And if they have, I want to sell a hundred shares at $10, an additional 100 at 11, and they get great, very complex trading strategies. But if it’s a more simple tender offer, the experience is I have 10,000 options, the offering price is $10. I can sell between nothing, stay long, or I can sell up to 10,000 or 10% of my total state, 20% of my vested at $10. And so 10,000 times $10 is $100,000 minus the strike price. And I get that $100,000 minus the strike price back to me. And usually the whole offering will usually take 20 days. It’s a regulatory rule that tender offers have to be open for 20 days. But once that 20 days is closed, you’ll have your money, $100,000 will hit the employee bank account in about 15 minutes.

Ben Grynol (00:00):

Before getting into this episode, it’s important to note that there’s a lot of conversation around equity, and this is not meant to be investment advice. It was very much an exploratory conversation. So with that lens, here’s the episode.

Henry Ward (00:21):

The entire world runs on debt, except for Silicon Valley. We have no idea what to do with debt. We don’t know how to loan against startups. We don’t have to give loans to startups. None of it, it’s all equity based. The reason why is that in order to give somebody a loan, you need to know the duration of the loan. You need to know at what point they can pay it back, and by definition, venture duration is unknown. We have no idea when we’re going to have access to liquidity. I’ll use us as an example at Carta, where we do have committed regular liquidity. What happens now is employees, even though they have the right to sell at Carta, because they’re able to sell, they don’t have to because they can start taking loans against their stock.

Ben Grynol (01:07):

I’m Ben Grynol, part of the early startup team here at Levels. We’re building tech that helps people to understand their metabolic health. And this is your front row seat to everything we do. This is a whole new level.

Ben Grynol (01:32):

Equity at startups. It’s this black box. There are a bunch of questions if you’re a company, or if you’re a team member joining a company, what do some of these mean? Well, if you haven’t been exposed to equity before, it can be pretty overwhelming. What’s an RSU? What is an RSA? What’s an ISO? What’s an NSO? Well, those are acronyms that can sound pretty jargon-y, but what they are is different equity offerings that will have different tax implications for people receiving them. Let’s break it down quickly. An RSU, that’s a restricted stock unit. That’s different than an RSA, a restricted stock award. An ISO is an incentivized stock option, and an NSO is a non-qualified stock option. Again, all have different implications. If you’re new to equity, there are things like cliff, vesting, strike price. These are terms that a person might not know, and that’s pretty natural. They do live in the long tail of a different world.

Ben Grynol (02:31):

So Sam Corcos co-founder and CEO, and Zac Henderson, head of legal at Levels. The two of them sat down with Henry Ward co-founder and CEO of Carta, a platform that we use for managing our cap table and the equity that we grant to different team members. Sam had a ton of questions for Henry, and he was interested in understanding the difference between all different offerings, why we might want to offer different types of equity at different stages of the company as we grow and as we bring on new team members. The main takeaway is that we always want to do what’s in the best interest of the team member. We want to make sure that we’re making equity as easy as possible for people to actually receive, to grant, to get some liquidity out of in the long run, if we’re able to be successful in achieving our mission. It was a great conversation, lots of learning and an opportunity to really dig in with Henry and think through what are some of the implications of these offerings. So here’s where they kick things off.

Sam Corcos (03:35):

I have so many questions and this is for people who don’t know all of the answers. So I’m going to do my best to also define all of the terms as well, because some of these will be new to people.

Henry Ward (03:46):

Sure.

Sam Corcos (03:46):

The state of how things are now for most early stage founders or employees, they join a startup, they also get equity and that equity is generally not liquid until they IPO. Liquid meaning they get to use it for anything, it’s locked up, and IPO is when a company goes public and their shares are traded on stock exchanges. So for most early stage employees, it can end up having no liquidity for upwards of five to 10 years, I wonder why. And then there’s the concept of secondary sales, which is the ability to sell shares before a company IPOs. So I guess I would ask a simple question first, why aren’t secondaries more common?

Henry Ward (04:32):

Yeah. It’s two reasons. So one is, there’s a bit of a legal challenge where in the public world, because all these stock and securities are publicly registered, the government basically said that anybody can buy and sell these things and the company can’t put restrictions on that. In the private world, because they’re unregistered, not anybody can buy and sell these things. And the company is allowed to put, and it’s usually credit investors are allowed, it’s not everybody. But also that the company can put in restrictions preventing these things, preventing the stock from trading. And I can talk about why the world works that way, but that’s a current state of the world. So there’s never been a market that’s really developed to allow people to buy and sell private stock because there’s so much friction and that only certain people are allowed to do it. And then also there’s all these legal hurdles that you have to get through with the company to allow it to happen.

Sam Corcos (05:25):

I remember when we were talking before, there were different ways to even do secondaries. There’s a tender offer, a reverse tender offer, I think there were even other things than that. What do any of those things mean? And how are those relevant?

Henry Ward (05:40):

Sure. Well, the two most common ways, I’ll give you two formats. So one is company sanctions liquidity, where the company decides, “Hey, we’re going to do this as an employee benefit and allow employees to participate in it,” appreciate some stock and get some liquidity out of it. And then non company sponsored liquidity. So the company sponsored liquidity, there can be many forms, but the most common, most dominant form is what’s called a tender offer. How these tender offers happen, last year, just we do tender offers on behalf of companies. Last year, we did seven billion of secondary volume, be it tender offers. And the year before was two billion and the year before, that was one. So you’re really seeing this massive growth in tender offers. We do today about one tender offer every business day, 20 or so a month, and that’s how most employees today experience liquidity.

Henry Ward (06:30):

And how it happens is a company will usually raise a primary round. So they have a price in the market. The investors said we’re going to invest a hundred million at a one billion valuation to the company, but what happens is if the company only needs a hundred million, but let’s say there’s 150 million demand, 150 million that investors want to put in, what the company will up and do is say, I’ll take up hundred million out to the balance sheet for the company needs. And that additional 50 million of demand that we have excess demand, I’ll allow employees to sell their shares as secondary into that demand. And that’s a tender offer and that’s how that happens.

Henry Ward (07:10):

There’s another form of liquidity that’s less, I would say in dollar volume is less common, but it’s certainly something to address. It’s usually for very late stage companies. You don’t see this early, but in later stage companies, there are these sort of peer to peer transactions. These marketplaces that aren’t company sanctioned, where employees can work with a broker and will try to match a trade and they can sell shares. There’s a bit painful because you have to go to the company to exercise ROFR or see what the legal rules are. You don’t know who’s going to buy it on the other side. Pricing tends to be pretty opaque and predatory, but there is that other form of secondary liquidity. Most companies end up doing tender offers in part so that employees don’t go into the black, I would call it the black market of secondary trading so that the employee can kind of control the price and the experience for employees.

Sam Corcos (07:59):

Yeah. If I remember correctly, everything I’ve read about CartaX seems like it’s intended to solve this problem. Is that a fair statement?

Henry Ward (08:07):

Yeah, that’s right. And so CartaX is if tender offers, which we do on CartaX. So tender offers is sort of the purest or the most ubiquitous form of employee liquidity. CartaX attempts to solve what’s the next version of employee liquidity in the market because the tender offer’s a good instrument, but it’s a relatively prude one. Because you can only do it in conjunction really with a primary round, right? Because you already have this excess capital. You only do it in conjunction with the primary round, which might only be every 18 months. You also only do it if you have access demand. And so what if you wanted to do liquidity, but you don’t want to raise a primary? How does a company offer employee liquidity there? What if you’re doing liquidity and it’s in between a primary? You’re doing primaries 18 months apart, you’re doing something right in the middle. You shouldn’t use the same price you used nine months ago because the company is growing, employees shouldn’t sell at a lower price. We should build a good price for the secondary. So there’s all these kind of questions that come up once you say, “Well hey, what if I don’t want to just do an excess demand, tender offer as attached to a primary, but I still want to provide liquidity?” And that problem CartaX tries to solve.

Sam Corcos (09:17):

Gotcha. And I guess I’ll ask a tactical question from the founder perspective, which is in the very early days, you tend to give founders or very early employees restricted shares and that’s pretty straightforward. It’s not very complex. When the cost of buying the share is really low, it’s very easy. Then you get to this point where the cost of buying the shares is too high, you switch to ISOs. And then it seems like once you become a public company, you switch to RSUs which are restricted shares as well. So it seems like there’s this trough where you have to be given options. I assume it’s because of the 409A price versus also liquidity of the shares. It feels to me like restricted shares are better for employees because you’re actually giving them the shares as opposed to saying that you have the right to be able to purchase the shares, because they’re not free. You actually have to pay for them. So you only see benefit if they increase in value as opposed to just getting the value of the shares. So there’s a much more speculative component to that, is that a fair statement?

Henry Ward (10:24):

Yeah, that’s fair. The reason why very early employees and the founders get restricted stock is because they buy it, may remember when you first incorporate the company, you probably wrote a check for $35 or something like that, that bought you half the company because these shares were done at par. Early employees came in very, very early where the price of the stock was just pennies. You could literally just write the check and just get the shares, that was really advantageous. The problem is at some point the price of the stock becomes prohibitive where you can’t just write a check to get the shares. And so that’s where options came in, right? Because you could issue the options and there’s no cost to the employee at least right away. They can have the options, hold the options, and if the company doesn’t succeed, it’s okay, no harm, no foul.

Henry Ward (11:09):

They were never at risk. I mean, if the company exceeds they can sell the options. Problem of course with options is that at some point you do have to buy them, but it could be when you’re public, the strike price is so low relative to the public price and all of that is great. The reason why when you get into public world, you get into RSUs because the volatility is much lower, right? When you’re a private company and you come in and the company is worth $50 million and you got priced at, your option grant is worth $50 million. Really, the bet is not that the company is going to go to $75 million, right? And you’re going to 50% appreciation. It’s that it’s going to go from 50 to 5 billion. 10X, 100X. And so then the strike price is negligible, it doesn’t really matter. But if you’re now in the public markets and you’re giving out stock options where the strike price is at, the company’s worth 10 billion. Three years from now, it’s worth 15 billion.

Henry Ward (12:06):

That strike price actually matters a lot because that’s most of the value is in the strike price and the not in the upside. And so what public companies do to address that is they give restricted stock, which is effectively stock with no taxable event. That’s why it’s restricted stock unit versus restricted stock. It’s a right to have the stock versus the actual stock because if they gave you the stock right away, you have the taxable event. So they give you a unit which represents the stock that you can redeem later. And that means if I give you 100,000 dollars of RSUs, that’s now actually worth 100,000. It’s 100,000 of options where the options strike, it’s basically worth zero yet, right? You [inaudible 00:12:47] for the company. And that’s why if we work for a better company, you usually have a lot more guaranteed cash with salary plus RSUs, which is a guaranteed amount. You get the full amount of the stock value, but in options that’s not guaranteed, but it has all the upside.

Sam Corcos (13:03):

Yeah, interesting. And so I guess I would ask a tactical question. So we are still pretty early stage, our most recent round was a 300 million post in terms of valuation. We’re now at the point where this stock is too expensive to be just given. We’ve had a lot of internal conversation about whether we should do these as RSU or ISOs. I’ve listened to a lot of conversation about it, I still don’t feel like I totally understand the trade offs there. How do you manage that at Carta and how should early stage companies be thinking about these things?

Henry Ward (13:33):

Sure. Well, so part of it goes to who’s the type of person that you’re recruiting? What are you competing against? And at 300 million, most of the type of people you’re recruiting are startup people. They want to work for a startup and you’re competing against other startups for these people. When most people are looking to work for a startup is really looking for the upside and a big part of the upside to get that is to the option grant. And so it makes a lot of sense, even though the price, the stock makes it too expensive to do restricted [inaudible 00:14:02]. This is perfect for ISOs, this is exactly what ISOs were designed for. So you are very much in the ISO stage of existence or life cycle. It used to be a billion. Now, it’s maybe a two to 5 billion. When you get to say these days, $5 billion market cap, that’s about the time you really need to start thinking about RSUs.

Henry Ward (14:20):

In part, because it’s not like, oh, it’s pretty expensive to exercise your stock, it’s just 100,000 dollars. [crosstalk 00:14:29], it just doesn’t make any sense. But also the type of people that you were recruiting for, it’s a different labor market. When you’re a $5 billion company, you’re not getting startup people that are trying to be one of the first 50 employees, right? That’s not the labor market. We’re worth 8 billion, eight and a half billion or so. Many of the people we recruit from, we’re competing with public companies, these employees work or used to work for public companies and they’re used to RSUs and not like, “Hey, I’m looking for this 100X upside.” I’m expecting some of my comp is based on stock, but I’m expecting to accrue $200,000 a year in stock plus a salary. I don’t expect to accrue zero and then maybe 200,000 if it doubles, right. I just expect to get that. And that’s what an RSU does. And so that’s why we have switched to RSUs, part because that’s the type of financial compensation our employees now are used to.

Sam Corcos (15:22):

Gotcha. That’s really helpful. So I wonder, circling back on the question of secondary sales. One of the things that I have found talking to a lot of people about how they understand the value of startup equity, they often think of it as a lottery ticket and it really doesn’t mean anything to them until at some random point in the future, it can be worth a lot of money. I found that a lot of companies that I’ve talked to also use the lack of liquidity as a retention mechanism, which I think is kind of gross, that I want to make sure that we avoid. I want to better understand, is it just the complexity of doing secondary sales that prevents people from doing it more often because we’re thinking about doing regular secondary sales, maybe twice a year. I wonder how it affects things like 409A, which is the strike price, how it affects other things within the company. What are the considerations that we should be thinking about and why isn’t regular secondary sales just the industry default?

Henry Ward (16:21):

Yeah. That’s a great question. So I would say to start there’s some real hard economic and legal reasons that do create friction, secondary market. Before I go into the details, I will say that some of it’s just inertia. Historically there was the old investment, if you talk to a venture investor that’s over 35 or 40, they will tell you nobody gets liquidity until the investors get liquidity.

Sam Corcos (16:45):

Yeah.

Henry Ward (16:47):

I mean, it’s just a mindset that the old generation does. I think newer GPs under 40 are much more progressive thinking, but I do think there’s little bit, it’s the cultural mindset to get over. And I think incredibly thoughtful and progressive CEOs like you will start pushing the ball forward and the world will change. I do think that’s a trend. So I think 10 years from now, it will not seem like a weird thing to get.

Henry Ward (17:09):

I think you’ll be… People 10 years from now will go, “Can you believe people used to go work for a startup and knew they would get no liquidity until an IPO?” That will seem crazy to employees 10 years from now. They just won’t understand why we did what we did. So I think that’s worth noting. But I do think there’s a couple of things. You’re in a unique position Sam, because you have an incredible company and you have an ability to raise capital. You’re not worried about it. So one of the reasons that some companies wouldn’t want to do secondary is if they feel like this company is not strong enough to be able to raise primary capital, then they would never do secondary because now any capital that is going into buying stock for this company, they want to put it into the company, right?

Henry Ward (17:51):

So we’re all by kind of definition, venture backed companies. We’re not profitable. So we rely on capital markets. We rely on investors and I don’t want to have to compete with my own employees or my shareholders for access to capital. So that’s why the company always gets the money first. And then if there’s excess demand, it leads into this secondary market. And so I think one of the things that will shift is that to your point about for employees, it’s a lottery ticket. One of the real challenges for employees is they have to be an investor as well as an employee, right? They have to pick the company that they think is going to win. But the disadvantage that employees have over investors is they only get one bet. Investors can pick a portfolio company, but employees can only pick one. And they usually have less information than investors do.

Henry Ward (18:35):

They don’t get the financials, they don’t get the strategy decks. They don’t get access to the management team and so it is for them somewhat of a lottery. And so how does an employee know which companies are going to be the best funds? Well, one heuristic or one tell is if a company can regularly do secondaries, that means that this company has access to capital that other companies don’t. The capital markets deem this company worthy of having more investment dollars the company even needs. And that is not only a great employee benefit, but that is a very powerful signal that this is a strong company.

Sam Corcos (19:09):

Yeah. And we’re trying to think about the implications of company at our stage doing call it twice a year secondary sales. I was talking to Vinay, started Loom, and thinking about from the founder side, what would be the reasons not to do this? And there are questions around how it impacts 409A and how that reflects the value of ISO shares versus RSUs and should you switch to those earlier? What the chances are that the 409A price will converge if you do regular secondary sales, there’s also something around the compensatory implications as it relates to accounting on whether these secondary sales trigger some different accounting mechanism on how those grants are calculated and how that relates to taxes. So I assume these are things that you have thought about, because I’m kind of new to this, trying to figure it out.

Henry Ward (20:07):

Yeah, sure. So on the 409A, so I have thought a lot about this and I have this 409 conversation weekly, if not sometimes daily and I really need to write a blog post about this so people can read it.

Sam Corcos (20:18):

Saying it in a podcast now, so.

Henry Ward (20:20):

Yeah, that’s right. So hopefully everyone will listen here from the horse’s mouth, I’ll call it the 409A myth, which is that if I do secondary transactions my 409A skyrockets. It’s not true, and the reason it’s not true is when they do 409A calculations, think of it this way, right? The 409A is price on the common and how 409As are calculated, you look at the last major transaction price, usually with financing. And then you say, oh, you discount it for the common stock because it doesn’t have all the rights preferences. And that’s your strike price, your 409A price. When there’s a secondary trade that happens, they have to take into account the volume, the size of the trade, because let’s say just, you have a 300 million market company had one, there was a trade where one share changed hands. An employee sold one share for $10 to somebody else, but it was at a 500 million price.

Henry Ward (21:14):

Does that make your company worth 500 million? Well, the accounting rules say no because it’s not a real market, right? One share does not represent a market for these shares. And so the question is, okay, well what’s the size of bulk trading volume that defines it’s now a market and that’s the new price is 500 million. The answer is we don’t know. So what they do is they basically take a weighted average. So there, if 10 million of level stock trades out of a 300 million market cap, they effectively adjust the 409A price based on 10 million out of 300 million total market cap. So if you are trading 300 million of liquidity every year, yes, it will converge. But nobody does that. It’s usually two to 5% of the total market cap that trades on secondary. And so the 409A price is really, movement is really nominal. And just to give you a concrete example, we’ve done nine liquidity events and our 409A price is still at about 40% of our preferred. So it’s a myth that this stuff affects the 409A, it really doesn’t. And we can help with that.

Sam Corcos (22:20):

Yeah, that’s helpful. Zac might actually be able to be more specific around some of the accounting implications, which may be something you’ve thought about as well.

Zac Henderson (22:28):

Yeah, I’m Zac here. So moving forward with our own potential secondary sales, one thing that outside council and some of the great folks at Carta have mentioned to us is we needed to chat with an accountant to make sure that if we do regular secondary sales, as opposed to just piggybacking off of a fundraise, we need to be cognizant of how the IRS might look at that. So for example, would it actually be looked at as us finding a mechanism of compensating our employees, in which case the tax treatment might be different. And another key concern that was raised to us is the possibility that for gap accounting purposes, we might need liability accounting as a result of regular secondary sales. It would be wonderful to hear your thoughts on how much of a concern those things are for companies. Is that a real concern? Is it a false concern? How have you seen companies deal with it?

Henry Ward (23:21):

Yeah, absolutely. So that one is a real concern and there’s two parts. So one is how do you get capital gains treatment? And then what’s the accounting responsibility of the company if you get into liability accounting? The capital gain treatment that if you are running tender offers, that’s why you need a certain number of investors to participate. Because if you have the tender offer exclusively for employees, it’s deemed sort of a company compensatory event. If you include investors in the mix, it’s then considered a shareholder event. And the IRS treats if it’s just employees, it’s compensatory so they pay income tax on the sale. If you include investors, it’s considered shareholder investment and you pay long term capital gains. So whenever we structure on CartaX transactions, and if we were to help you with it, if you were to do one soon, we would say, “Hey, here’s how you use the structure, allowing employees to sell this much and investors to sell this much.”

Henry Ward (24:13):

And then we’ll make sure we have an appropriate mix, everyone gets capital gains. On the liability accounting if the company commits to a schedule of these regular tender offer events in a compensatory fashion, then they now have liability kind of thing because they’re effectively committing to this additional compensation. But as long as they’re always doing this with enough investor mix so it’s a shareholder event, not a compensatory event, it won’t trigger liability. That’s all the stuff that we could help you with CartaX is how to structure these things so that they make sense.

Sam Corcos (24:47):

Great. Gotcha, that’s super helpful. I guess one of the other things, we’re trying to think about the best way for us to structure it. And when we think about how we want to give employees liquidity would be, I think this is what you referred to as a reverse tender, which is allowing people basically call it twice a year. We ask everyone, you say, you can sell up to 10% of your ownership. How much do you want to sell? And then we come up with however many shares that is, and then we work with Carta to come up with the market for that. Is that a thing?

Henry Ward (25:19):

Yes, absolutely. And everything’s sort of exactly right Sam, I’ll throw in one extra piece you need to decide is use in a reverse tender, you set the price. So in a tender, the investor sets a price and says, “Hey, here’s the price we want a tender share at. We’re going to go buy at this price. Who’s in?” In a reverse tender, you decide, “Hey, we are going to tender. Allow employees to sell at a $500 billion market price tag. We’ll then collect all this and 10%’s invested and all the rules around it, including if investors are allowed to sell as well to get capital gains treatment, we’ll aggregate the supply into a block.” And so let’s say at a 500 million price tag that me and Zac set 30 million of supply is now available to be sold. We’ll then take that 30 million on CartaX and then we’ll syndicate it, which basically means we sell this block of 30 million of level stock to investors, and then that’s how that transaction happens.

Sam Corcos (26:16):

Gotcha. And how does this tie in? I remember seeing some documentation about Carta Cross. How does that tie into tender offer or reverse tender offer?

Henry Ward (26:25):

Yeah, so there’s a lot of different types of transactions that you can do in secondary. So obviously tender offer is one. Reverse tender offer is another when you don’t have an existing buyer primary where you’re going to go sell the block. There’s also things like block trades, where we may just aggregate a bunch of employees that are in interest indications and then pull a block together and then sell it in a peer to peer transaction. And then there’s a handful more but the one you’re specifically referring to is our auction product, which is what if you want the market to decide the price for it? So if both tender offers, in tender offer, the investor decides. The reverse tender offer the company decides.

Henry Ward (27:03):

But what if you were to say, “Look, I want you to create a competitive environment where sellers put in their limit orders.” We can look at everybody. Bob wants to sell a hundred tiers at $10. Mary wants to sell 50 shares at $11. Everybody can put in their specific price preferences on the seller side. And then on the buyer side, buyers can put in their limit orders, I want to buy 10 million at $10. I want to buy 5 million at 11 dollars.

Sam Corcos (27:31):

Cool.

Henry Ward (27:32):

And then we build an order book on both sides, and then we find a clearing price. So the investors are competing. It’s instead of continuous trading, it’s a discreet point of time that everybody puts their limit orders and then we can build a book that way. And then we can decide what the right price is for you and execute at that price. The reason you might do that is if you think I’m not interested in kind of guessing what the price is, I would like to see competitive dynamics.

Henry Ward (27:57):

Now, the trade off is a higher volatility. You are more likely to get a higher price through a competitive offering inter auction than you would be pre negotiated, like in a tender. But you also run the risk that maybe there’s not enough competition and you actually get a lower price and that’s the risk. And we at Carta, we’re at a size and scale now where we’ve moved to auction models. And so we have enough demand, but in the early days, the book usually isn’t thick enough to support an auction. So usually something we’d only do for companies sort of two billion and up.

Sam Corcos (28:28):

Gotcha. I’m wondering for call it top tier VC backed companies that are growing very quickly. What would be reasons… It feels like pretty much every company should do this if they’re in that category, no? What would be the reasons why a company would choose not to allow secondary sales?

Henry Ward (28:51):

I think at this point there isn’t a good reason. I think companies that don’t, it’s really inertia. Well, we’ve just never done it before, should we do it? I don’t think there’s a good reason. And I actually think what’s starting to happen is that the best companies are doing this and employees are starting to take notice and migrating to the companies that offer liquidity. And I think what you’re going to start to see is that the best companies are starting to do it, they’ll attract the best talent because now the offer is cash, stock options and liquidity. And that’s more attractive than companies that are just cash and stock options. They’ll start winning the talent orders and everybody else will start to have to follow suit. That’s actually going to make it harder for the non top tier companies, because if you’re a non top tier company and you’re struggling to track capital, it makes it much harder for you to create liquidity for your employees. And this will actually create a stronger power law in venture where the best companies will win even bigger.

Sam Corcos (29:45):

Yeah. And I wonder from the Carta side, because CartaX looks like it’s a platform built for this and seems like basically every early stage company uses Carta to manage their equity. How much friction is there from, let’s say there’s a [inaudible 00:30:01] backed company, they’re at a billion dollar valuation. They just decided, all right, we’re going to start doing regular secondary sales through CartaX, what’s the timeline and how much effort and how much friction is there to have to do something like that?

Henry Ward (30:15):

It’s super easy if all they’re doing is a tender offer. So let’s say they’ve already gotten investors lined up. They have insiders that want to buy it. We don’t have to find investors. We get almost, I might be slightly over simplifying, but pretty close. Push a button and they can start running tender offers. It’s super easy. If they’re in this kind of space where they’re saying, “Hey, we don’t have investors. And I as CEO, I have to run the business. I don’t want to go raise… If I have to raise money for the company, that’s my job every 18 months, but I don’t want to keep doing it every six months for liquidity, can you help us Carta?: And that’s our job, is to raise capital for you and not have you have to go do it every single time.

Henry Ward (30:53):

So we have a bunch of bankers that do this and Carta acts. That usually they sort of 30 to 45 days, because we’ll have to sort of get some basic information. We’ll have to talk to investors, sort of pre market, get some early indication interest and pricing guidance. And so we’ll work through that, but it’s a relatively low lift of you. It’s us working in the background, but then once we have the syndicate set up, then it can be really quick, right? As soon as you’re, if I came back to you Sam the next day, we have X number of… Four investors that want to buy $20 million of secondary at this price. Is that interesting to you? And you said yes. Then we get execute really quickly.

Sam Corcos (31:29):

Gotcha. This is I think another one of, you mentioned it’s more of an inertia thing, but almost every founder that I’ve talked to says that they wish they took secondary earlier. I wonder what you think is, what would be early to start doing secondary sales for a company? There’s probably some lower bound there. What in your mind is the right time for people to start offering this kind of thing?

Henry Ward (31:54):

If you just think in share of market cap and it changes based on the market, 500 million market cap today is different than what it meant.

Sam Corcos (32:02):

Yeah, totally-

Henry Ward (32:03):

Four years ago. We see companies as early as $200 million in market cap starting to do tenders, relatively very small amounts, but I can totally see that starting to happen. I think 500 million is where you start to, there’s meaningful liquidity and wealth that’s been generated. I think the most important thing from a founder’s perspective is before they go into liquidity is to say, “Hey, is my business properly capitalized? Do I have enough capital? And do I have a confidence that if I needed to go raise capital in the future, I can?” And I think those two things are true. I think the company has kind of escaped the early stages that you never know if it’s going to work out but, “Hey, we have a real business here. Yes, we’ll rely on capital markets, but we’re not going away. We’re a real company,” and that’s a good sign to start thing.

Sam Corcos (32:51):

Gotcha. That’s really helpful. And so I wonder from the employees’ perspective, because this is unusual, most companies don’t do it. I’m just trying to imagine from the employees’ perspective, let’s say you have, we’ll use an arbitrary number, 100,000 ISO options. You haven’t exercised them yet. You’ve been at the company for two years, so half of them have vested and this liquidity, the secondary sale comes about. What is my experience? Let’s say, hypothetically, the company allows me to sell up to 10,000 shares. What is my experience as an employee going through that?

Henry Ward (33:28):

Yeah, well, so for most employees they’ll participate in a tender offer. If they were in an auction, they could actually set the price that they want to sell at. And if they have, I want to sell a hundred shares at $10, an additional 100 at 11, and they get great, very complex trading strategies. But if it’s a more simple tender offer, the experience is I have 10,000 options, the offering price is $10. I can sell between nothing, stay long, or I can sell up to 10,000 or 10% of my total state, 20% of my vested at $10. And so 10,000 times $10 is 100,000 dollars minus the strike price. And I get that 100,000 dollars minus the strike price back to me. And usually the whole offering will usually take 20 days. It’s a regulatory rule that tender offers have to be open for 20 days. But once that 20 days is closed, you’ll have your money, 100,000 dollars will hit the employee bank account in about 15 minutes.

Sam Corcos (34:26):

Interesting. And I don’t know if there’s any particular hurdle in the fact that there are options as opposed to shares that you actually own. Does that add any complexity to it or is it just the strike prices gets subtracted?

Henry Ward (34:38):

It’s just the strike price gets subtracted. These are cash settled, so if the sale price is $10 and your strike price is one, you automatically get $9. So you would get $90,000. So it doesn’t matter if it’s stock or.

Sam Corcos (34:53):

Interesting. Cool. Well, Zac, I know you had a few other questions as well. I don’t know if you had any that you want to bring out?

Zac Henderson (34:59):

Yeah. And most of my questions had been answered. Just on that last point, maybe just a clarifying point for listeners. Henry, if I understand it correctly, if you’re like an ISO holder, then in order to be eligible for long term capital gains, you would actually need to hold the ISO for, let’s say a year, your vesting period hits, you’d have to exercise and then hold the underlying share for that additional year to be eligible for long term capital gains. Do I understand that right?

Henry Ward (35:26):

That’s correct. Yeah.

Zac Henderson (35:28):

So the point being, one potential disadvantage of going through a secondary sale process as an ISO holder is that if you went through it, you would actually have short term capital gains for your sale, which is roughly equivalent to I guess, ordinary income tax. So just a confusing thing with options just to flag is that to really get advantage of the long term capital gains, you have to check certain holding boxes that include not just holding the option for a period of time, but holding that underlying share for a period of time too, which is sort of a missing piece that is easy to forget about.

Henry Ward (35:58):

Yeah, that’s exactly right. And the IRS, I didn’t understand why the rule existed. It just seemed so arbitrary. The reason is the long term capital gain treatment is supposed to reward people who take risks. And so by definition, if you just have the option and you do a cash settled option sale, you’re not taking any risk because you instantly, you never actually hold the stock. But if you now buy the stock and exercise it, you have now put capital at risk on the stock. And the IRS says you have to hold it for a certain amount of time for us to give you the benefit of the discounted tax rate for taking on the risk and just MSP for a year. And so what a lot of employees do if they can’t exercise their stock is in my $1 strike price, $10 sample, they need $10,000 to exercise 10,000 shares. So what they might do is sell 1,000 shares to get 10,000 bucks and then use that to exercise the remaining 9,000 and then hold those 9,000 shares for a year and then sell those 9,000 shares in the next one.

Zac Henderson (37:00):

That’s a great insight. Yeah and Henry, while we’re on this topic, what are the sorts of considerations… The process sounds wonderfully straightforward for employees who might participate, but what are the considerations they should have on their minds? What are the kinds of questions they should be bringing to their own accountants before they decide to participate?

Henry Ward (37:17):

So I think one of the things that sneaks up on employees is the AMT. So you should definitely ask. And AMT is when you think about, let’s say my strike price is issued at $1 and the current value of the stock is $10 for 409A purposes let’s say, or maybe let’s call it $5 for 409A purposes. And when you exercise that the government treats that $4 difference between one and five as a gain and you have to pay taxes on that, which you don’t have because it’s not liquid. All you did was exercise, but they still, it’s terrible actually. We’re trying to lobby to get changed. That’s the way the world works today. So you should definitely take a look at it. That’s why, if you are going to exercise options, I’m a big believer in early exercise.

Henry Ward (38:03):

I think it’s a great benefit companies can offer employees, but if you are going to exercise, it’s great to exercise when the strike price and the 409A are the same, which is usually when you just receive them so that’s a great thing. The other thing too is if you are having regular liquidity, you now have access to debt that you didn’t have before. Silicon Valley is a very strange place. Tech is a strange place. The entire world runs on debt. Debt markets are a thousand times bigger than equity markets. The entire world runs on debt except for Silicon Valley. We have no idea what to do with debt. We don’t know how to loan against stock. We don’t have to give loans to startups. None of it, it’s all equity based. And the reason why is that in order to give somebody a loan, you need to know the duration of the loan. You need to know what point they can pay back and sort of by definition, venture duration is unknown. We have no idea what we’re going to have access to liquidity. And so you can’t get that.

Henry Ward (38:58):

But if you were a company and I’ll use us as an example at Carta, where we do have committed regular liquidity, what happens now is employees, even though they have the right to sell at Carta, because they’re able to sell, they don’t have to because they can start taking loans against their stock. And so one of the great loans that we have is employees can get a loan for the down payment of a house. So let’s say an employee at Carta wants to buy a five million house, they have to have a million dollar down payment. Instead of selling a million of Carta stock, they can borrow a million dollars, collateralize against their Carta stock because the banks are willing to underwrite because they know that there will be liquidity in the future.

Henry Ward (39:35):

And so they don’t even have to sell. But sort of this weird thing because you now offer the ability to sell, you now don’t have to sell because you have access to so nice products you have access to. Which is great for me because I love when employees get liquidity, but I also love when they can stay long. I don’t want them to have to sell, trade in this high gross and [inaudible 00:39:54] Carta stock that we think’s going to go to the moon for this investment that’s accruing 3% a year indexed to inflation.

Zac Henderson (40:02):

Yeah. That’s wonderful. And is that the sort of thing that the employees of any company offering regular secondaries would be eligible for or what would sort of need to be true for a company to make that happen? I would assume something like it’s being obvious that investors are indeed lined up to participate in the secondaries. Maybe a certain valuation, just curious what needs to be in place for that to be optional for.

Henry Ward (40:24):

Yeah. So one of the wonderful things, historically, any loans that are given to employees is an underwriting of the employee. They have to look at the employee, it’s just like going about mortgage, you go apply for [inaudible 00:40:37]. And what’s great about these stock based loans, loans collateralized for the company stock, is that you only have to underwrite the company once. And then once you underwrite the company, you can offer the same program to all employees. And so what happens if you apply for this, you apply the company, not as an employee and you say, “Hey, can we participate this stock based loan program?” We have our credit partners on the backend, but we do the underwriting and basically we will underwrite the company and we will say, “Hey, here’s what it costs. Here’s the loan to value ratio, here’s all the terms that goes into it. Is this something you can roll out?” And if you say yes, then we can just roll it out to your employees. And it’s a combination of both your liquidity, how much liquidity new and how much confidence we have, you keep driving liquidity, but also is it a good business? And what’s your growth rate? Kind of very traditional underwriting of corporate debt.