Helping Startup Employees Navigate Stock Options with Dave Thornton

Speaker A: We're looking at a company's financing trajectory, which is a fairly obvious thing. So is it, is it going up and to the right as it raises progressive rounds and you need two points to make a line. Therefore, we can only invest in companies that have had two, uh, institutional prior rounds, which means we kind of start at series A enough. Like we one day could build models that go deeper. But like, if that's an important data point, then we are restricted to series A enough. So with those two qualifications aside, it's kind of an everything fund. The best performing companies do tend to look like the market as a whole. We're just taking like the top slice of it.

Speaker B: Welcome to Alternative Universe. This is a show for financial advisers, alternative fund managers, and those who want to navigate the diverse landscape of alternative investments and explore opportunities that lie beyond the conventional. Today, I want to start with a question. How many of our audience has had options from an employer that they couldn't afford to exercise when they left their job? Um, well, that's exactly what's at the heart of the discussion today and the passion behind vested. And today, uh, I'd like to welcome its co founder and CEO, Dave Thornton. Dave has spent time as an innovator, an operator and a student. Uh, he holds degrees from the University of Pennsylvania and, and Georgetown University Law Center. He's been a founder and has an incredibly deep understanding of employee stock options. Dave, welcome to Alternative Universe.

Speaker A: Thank you. Glad to be here. And actually, I know it was rhetorical, but the answer to your question about what portion of your audience has had stock options that were expiring that they couldn't find the money to exercise if it's limited to the portion that actually were granted stock options at a prior job. The most recent print from carta is that 76% of people abandon their expiry stock options. Wow, 76% is a disgusting number.

Speaker B: Wow, that's incredible. I wonder on the flip side, or inverse to that, how many of them decided on that employment opportunity when they took the job based on those stock options?

Speaker A: I would just intuitively go with a lot because nobody gets paid market comp at a startup. Like you don't get cash that makes you want to join a startup, so.

Speaker B: Right, exactly.

Speaker A: It's some combination of liking the work and the stock options.

Speaker B: Yeah. Wow, that's incredible, man. I'm looking at your, your resume, you've done a lot of remarkable things. And so getting to a place where you're so interested in stock options, like how did we end up here? I Mean, I'm looking at your, even just your education, you started in computer science.

Speaker A: Whole track of my twenties was just a lot of figuring out what I wasn't going to do up until I got into the startup world post law school, I would say I was just progressively crossing things off the list. Not on purpose, but by trying the next thing that I thought I might like to do and then meandering, discovering whether I did or didn't like it. Um, startup stuff is where I have decided I want to be for a while. But, um, the answer to your question on how Vested came about and what part of my background relates to Vested. So it's two things, I guess, one is general and one is specific. The general thing is I've now been in the startup world either receiving or granting as a founder of stock options to employees for the last 12 years. And so there's just a lot of general familiarity, familiarity with the uh, upside of potential pitfalls. And then the specific thing that pointed directly at Vested was in my last company we were acquired by, uh, one of our data vendors who was a private company at the time. And it was a part cash and it was in part stock deal, which is one of the more complicated configurations of acquisition. And I ended up giving one of my employees accidentally terrible advice about how to participate on the stock side of the acquisition. So he had the opportunity to go anywhere from 0 to 100% stock. I did, I was, I was, I was a key person in the documents and my parts were prescribed, but all of my employees got the chance to go 0 to 100% at their own discretion and he wanted to go 100% in part because he knew people at the acquiring company and he was very bullish on them. I made the offhanded comments that fine, that would be tax free. If you want to roll the dice that hard, go for it. At least private for private stock on the same basis should be a tax free transaction. And it turns out that I was wrong. Not because the thing that I was thinking when I said that was wrong, but because I had forgotten that at the time that I was making the comment, he actually held stock options, not stock. Implicit in the acquisition mechanics, as the first step to the stock part was a quiet automatic exercise of stock options for anyone who held them. And the stock option exercise is a taxable event. So basically I forgot about that part entirely and I told them that the stock for stock part would be tax free, which was true, and assumed therefore that the entire thing would be tax free. And I was wrong and it created a ton of scar tissue. And although he is just fine now, and although the company that acquired us went public at higher multiples, meaning like proportionally he did better than anybody else. It was a wake up call for me. Uh, yeah, the general thought was if somebody with my background is screwing up giving advice on startup equity, your average startup employee probably doesn't have a chance. So. Oh man.

Speaker B: No, no doubt. It's so true. How many people come into this and make a decision on employment because of stock options and then you ask them about the waterfall and they don't know what you're talking about. A salt and pepper song.

Speaker A: Yeah. Yeah, I thought you talked about Don't Go Chasing Waterfalls, which was not a song ever. So. Oh my God. Uh, I'll remember my music from the 90s later. I think most of them don't know any of the terms. I mean, nobody reads their docs and I don't think that's a startup employee specific dynamic. But I think just most people assume things are going to be fine, tell themselves the story that they want to believe, and then, you know, go to work at the place they want to work. And it's particularly bad to do that in a startup context because most of your comp, or at least a meaningful portion or the biggest meaningful possibility of upside lives in your stock options.

Speaker B: I mean, this is a great intro. Uh, tell us about Vested. Let's set the stage.

Speaker A: Yeah, Vested originally began as a company that was intended to help startup employees just understand their equity. So, uh, the first version of Vested was a website with some free content. For example, uh, the difference between stock and stock options, which is the thing that I implicitly screwed up in giving my advice to my old employee. The difference between incentive stock options and non qualified stock options, which has major tax ramifications. What is early exercise and should you care? All the way down the complexity stack. There was also free tools, so there was uh, an option grant fairness calculator, so that if you're staring at the equity comp part of a job offer and deciding whether you want to negotiate, it can tell you whether you're within reason or not. An outcome simulator, an equity dashboard that helps you track your equity over time. So that was the first version of Vested and it was just intended to help people get from zero to one in terms of knowledge around their equity. And then from the first year, year and a half's worth of user base that we put together, Vested, we started to get inbound demand from our own users for money around their equity. And it's not as crazy as that sounds. Like we weren't even conceptualizing of ourselves as a capital provider. So it was definitely surprising. But looking back, we were these people's Sherpa, uh, into the world of startup equity. So it was natural after they asked us their first knowledge based questions like what is this? To then come to us again when it was time to do something with money around their equity. And when we looked at the use case for the capital that was being requested of us that we didn't have at the time, we saw that it was almost entirely funding for a post termination stock option exercise. And so just for your listeners who may or may not be steeped in the world of venture backed startups, this is an incredibly common, I would ballpark it at upwards of 95% of companies issue where you get cash comp that is less than market. Because you're working at a young cash strapped startup, you make up the difference in equity, typically stock options, because the granting of stock options doesn't create tax ramifications for you. Now on the day of the grant and then in your employee stock option plan there is a provision that says when you leave for whatever reason, it doesn't matter whether you're going to business school, getting poached by Google, going to another startup for a higher title, getting fired, just like all the reasons that you might leave, you have 90 days after you leave within which you have to exercise your best in stock options or else they go up in smoke. And it creates this brutal cycle of very predictable, very like structural to the labor flows of the startup market type of distress where because you've been under cash comps for the last on average three years, which is like a usual startup employee tenure, you don't have the $70,000 hanging out waiting for a rainy day to exercise your stock options. And so now the majority of your comp is actually at risk. And that was the nature of the inbound demand coming to us from our own user base. And when we started to look at the market that we assumed had to exist around this problem, because this is what I'm describing Now is like mid 2020 stock options and post termination stock option exercise windows have existed for decades. Prior to that we saw that there was a market, but it was mostly populated by people who wanted to help senior employees leaving very late stage companies. And so kind of after doing our market research, what we saw was that the part of the employee base coming to us from, you know, represented within our own User base was the other 99% of startup employees. So like rank and file startup employees across the entire stage and sector spectrum and then anybody leaving early and mid stage companies.

Speaker B: That's super interesting. So you're getting these kind of inbound requests for capital. No one has any cash. So what was the process for you guys? Kind of exploring, well, how can we meet this demand? Obviously, is there a business here? You know, we know where you ended up now, but um, can you walk us through a little bit of that process on how you evaluated the opportunity?

Speaker A: Yeah, the first thing we did was we got stuck maybe in the wrong mental place, but it forced us to do some analysis that unlocked the answer to your question. So the first thing we did was we, we noticed that all versions of stock option funding and there are many transactional flavors, but they all have the common thread that you are getting some exposure to the employee's common stock that you're helping the employee to unlock. And so effectively you're uh, a VC secondaries investor of some sort. And where we got stuck initially was we were like, all right, if we're going to live in the VC market, whether primary or secondary, we need to be picking winners because this is vc. And unfortunately, if we're going to try to serve the unserved part of the market, which is the very long tail of rank file employees leaving like tens of thousands of VC backed startups, we have to meet tens of thousands of management teams and look them in the eyes and read their souls and pick our winners like VCs do. And that's a clear impossibility. So we started working to understand some basic stuff about the potential trade that we could put on. The most important question that we didn't know the answer to at the time was if we're getting exposure to common stock, which is at the very, very bottom of the capitalization stack of a private company. Debtors first and then all the preferred stockholders next, and then common gets paid last. What's common stock actually worth? And so we did an analysis where we randomly selected some round from a historically exited company, in other words, a company that had gone to zero or been acquired or had an ipo. And we tweaked the discount at which we would have to buy common stock contemporaneous with that preferred round to track preferred returns. And what we saw was that common stock usually is worth maybe a uh, 20 to 30% discount from preferred stock. But the opportunity that we had to get our exposure to that common stock using the only prices that are available for all companies which are the common stock fair market values usually are at higher discounts than that, at higher implicit discounts than that. And so the big unlock for us was the only reasonable price to use actually gave us a decent amount of price buffer to enter as an entry point in owning the equity of these companies. And so all of a sudden we were like, oh, maybe we don't need to pick winners. Maybe we can do the next most tractable thing at ah, scale, which is use data to get rid of losers, which there are plenty still of losers. But it's a lot easier to find a loser than uh, to know for sure this is going to be a winner. So for example, if you see a company that just laid off 70% of the workfor which is very visible, they are probably a loser. So we built a fund around the idea that we were getting rid of losers. And then with the remainder of the asset class, call it the top 10 or the top 25% of companies, we're buying kind of everything diversified and unconcentrated and with that extra discount buffer to give us some cushion. So that's the fund product that we ended up building was uh, think of it as almost like a proto VC index, uh, with a discount built in.

Speaker B: Yeah, absolutely. And is it only common or do you guys come across opportunities to buy preferred? And will you.

Speaker A: A very interesting thing about our business is we're occupying a large but very specific niche of like rank and file employees, 50 to 100 grand at a time, common stock exposure. But nobody that needs potentially some money around their equity has any idea that that's the nature of the business model that we're focused on. And so we see all kinds of random deal flow. We even see the people that need $10 million leaving Stripe every so often. And we see angels and early stage investors that have preferred and want liquidity. And you know, at the moment we're pretty focused on building out our fairly wealth management and retail focused VC index fund at a discount concept. So at the moment we're not servicing them, but there's no reason that we couldn't overtime.

Speaker B: Yeah, I mean I think it's all just the data. Right. So kind of like the way that this fund came to fruition is you get in this inbound and so why not? Um, even if it's set up a different fund or a new opportunity.

Speaker A: Yeah, yeah, yeah. Basically as soon as we're at scale and in steady state with the current fund strategy, then we should absolutely explore the other like 15 types of opportunities that have randomly come inbound because we're doing this thing first.

Speaker B: Before we jumped on the podcast we were talking a little bit about ah, a quote I read earlier today. It's no secret there's a pent up amount of companies who have not gone public. The going public market has, has been on a downward spiral. Companies are staying private which is obviously creating more and more of these pent up liquidity events that employees are, are hoping for. Employees that haven't obviously exercised their options yet or those that have have partnered with someone like vested to exercise those options. So what comments do you have about that? It's obviously a trend that's gone on I think along a little longer than most people expected.

Speaker A: The lens through which we see that problem is the employee problem. I'm sure investors who have been in companies for 10 and 12 and more years would also like to see the IPO market completely unlocked and finally get their returns. But the we, we see things through the employee lens and the most acute thing that we saw is that there were a bunch of employees who made fairly large life decisions out of the assumption that markets would continue to function in their normal way as they had in like 19 and 2021. And arguably that was not normal at all but the market the way that they had gotten used to at least and they did things like buy houses and take out big mortgages and start to enroll kids in private schools. And all of a sudden the IPO market ground to an absolute halt and there was like an acute need for liquidity that was unexpected and then slightly less acute than that. And so I'm describing now like mid to late 2022. It's just a bunch of people that have been working at startups and can't seem to get their cash out even though they are paper rich enough to start doing the next thing that they want to do, um, which is a lot of the promise of stock options in the first place. So you have seen really late stage companies cater to their employee base and these are companies that have sufficient internal resources to actually run a liquidity program just to make their employees happy. But it's those companies are few and far between. Most of the companies that we're talking about are still scrapping it out and moving from high revenue growth to tighten things up to profitability. And they haven't yet put the legal and the equity teams around something like this. And so like for the most part companies don't do liquidity programs because it's hard.

Speaker B: No, I Mean, you just dropped so many little knowledge bonds there. But you know, the ripple effect of uh, the changes in the economy and the expectations, it's, it's not just like those individual employee decisions, right? It goes all the way up through, I mean literally job descriptions and the entire infrastructure that teams have been built on. And especially when we think of these venture backed companies which generally are. I saw a quote recently on LinkedIn which I love, which is no venture company is interested in backing your mediocre growth company. No one's interested. We're looking at like massive scale. We're looking for big, big, big multiples in growth. And that growth at all cost mindset, uh, is totally being reversed and that upsets the entire infrastructure of how startups have been built and hired and, and trained their teams and brought on salespeople. So it's a big, it's a big upset.

Speaker A: You know the funny thing is both the initial dynamic, which is growth at all costs, and then the arguably current dynamic, which is reasonable profitable growth, they both require a level of focus from a company's management team at a minimum and hopefully the entire company that precludes thinking of cool things like employee liquidity programs. So like in all cases, regardless of the regime, like a, ah, startup's first job is to do one of those top level things, right? And then like priority number 17 is building a liquidity program for your employees to be happy.

Speaker B: Right? And again, like back to our conversation before the call, setting up a liquidation program is a lot, it's challenging and there are some things that startups just really shouldn't be using capital to do. And this might fall in that camp, right?

Speaker A: Which is, well, yeah, using your own balance sheet is tough. And then, yeah, uh, if you're not using your own balance sheet, sourcing investors for their capital to allow your employees to do a little bit of liquidity production is just a hassle.

Speaker B: Right, well, let's talk, let's dig into that a little bit. I mean, so a liquidation plan, obviously that can be a great way of, I think instilling trust in your employee base and providing confidence. Why don't you click into that a little bit and tell me a little bit more around the benefits, the pros and cons. And obviously this is a, ah, need and um, you're there to fill that. So.

Speaker A: Yeah, well the pros are big. You've got a bunch of people whose equity compensation is effectively a paper lottery ticket unless such a program can exist. And it's nice to actually get comped and See the value of your equity grow and then be able to sell a couple shares and buy a car or make a down payment on a house or something like that. And so the pros at a company level are recruiting and retention. You're gonna, you're gonna everything else equal. You're gonna uh, get that 10x engineer. If they're between you and a startup that does not provide an equity plan or like a liquidity plan around their equity, you're going to keep your people relative to that hypothetical competitive startup more often than not when you are giving them the chance to turn their equity into cash periodically. The cons are that it's a hassle. You're not going to buy back shares with your balance sheet if you're a startup because that's money that's supposed to be going towards depending on what market regime you're in, uh, either growth at all costs or profitable growth. And in any case the main levers, supporting the main levers in business is what that capital was for. And so you need to find investors and investors need to show up with a collective dollar amount and a general price range that'll make your employees happy. And then you need to coordinate amongst your employees and make sure that there's like a market clearing price at which many of them would sell their common. And then you need to give them the opportunity to participate and hopefully you're even handed and everybody gets to participate equally. But you might want to reward your earlier employees first and your, There's a lot of considerations there. And then finally, even if you've got the capital and the employee supply lined up, you actually have to do all the transactions, deal with the tax consequences, settle things, retitle shares and um, it's just one big pain. Doesn't necessarily have to be a big pain, but it's. Even if you could create great plumbing for the middle part, you still have to coordinate with your employees and find investors. And that's not easy.

Speaker B: Yeah, exactly. And you had given a little bit of framework around kind of the due diligence of weaning out the losers that were obvious based on data, uh, is there any particular sector things that you're looking at that kind of boil to the top for you or uh, although

Speaker A: there are no particular definitely do or definitely don't sectors that are kind of prescribed in our lpa, we do have a bunch of data and the nature of the data that we have to make the decisions on who makes the cut actually does have at least a small effect on sectors and Stages and what ends up being in the fund. So the most important data set that we have is financial performance data for private companies, which is not a common data set. For example top line revenue growth or net income as like a major set of uh, financial metrics on how a private company is doing. And the issue with using that data is that there's a class of companies that don't make money until they exit. So biotech companies for example, that like raise capital to get past the FDA hurdle 1 and 2 and 3 and then they sell to Medtronic or Pfizer. We are guaranteed to be underweight in those companies. I'll give you another example of like a database limitation that has ramifications for the characteristics of our portfolio. We're looking at a company's financing trajectory, which is a fairly obvious thing. So is it, is it going up into the right as it raises progressive rounds and you need two points to make a line. And therefore we can only invest in companies that have had two, uh, institutional prior rounds, which means we kind of start at series A and up. Like we one day could build models that go deeper. But like if that's an important data point, then we are restricted to series A enough. So with those two qualifications aside, it's kind of an everything fund. And the best performing companies do tend to look like the market as a whole. We're just taking like the top slice of it.

Speaker B: I like that and couldn't be put more simpler. But you need 2, 2 points to make a line and how often. Yeah, the early stage stuff, it's uh, I've had conversations with founders several times especially we work in this, in this alts world and we're trying to kind of blend for wealth management firms how they include and incorporate private market investments for their clients into the, all the public market work that they've done such a great job at. And there's so much infrastructure around and, and it comes to like portfolio analysis and risk assessment and all this stuff where they're like, oh, I just want to blend it all together and why can't we have more transparency around data?

Speaker A: Oh my God.

Speaker B: Uh, you need two points to make a line and so you can have all the transparency you want. But if there's only been one event where it's repriced, there's only been one event where it'S been repriced. So you know, it's an important factor I think when you're getting into that world. And again you, you put it very simply, but it's A very, there's a lot of depth there to that comment.

Speaker A: There are all kinds of database limitations in this world. The reason that there are secondary markets for like a couple hundred private companies and not 30,000 is because there's no data on the other 29,800. It's just like, it's uh, I mean, I don't know if your listener base is going to be familiar with the secondary markets that exist for private shares, but you know, you got forage and equities and the NASDAQ private markets and Setter Capital and a handful of names. And across all of them you still, even during the Good Times adventure, you only saw three or four hundred names trading.

Speaker B: Yeah, it's incredible, right?

Speaker A: Which is 1%. 1% of the market during the heyday of the market is what actually traded.

Speaker B: Yeah. And I can only, I'm guessing, but I imagine that there was some privileged information that really drove them to start to build out the secondary markets. Right. It's uh, not necessarily like literally getting access to some data where it's like, hey, we can make a better informed decision here.

Speaker A: Yeah.

Speaker B: This is not widely known.

Speaker A: And I mean that's the reason that a lot of our predecessors in the stock option funding market focused on the late stage companies is because they were outsiders trying to do diligence on a company that they didn't necessarily know that well. And so the only companies that you can even think of trying to diligence as an outsider are the latest stage companies about which there is the maximum

Speaker B: amount of information going back to our, our days in college. I studied finance and you know, you hear about these analysts. An analyst job used to be go meet the managers and walk around the plant and examine the business. And if they were the ones who had the leg up, they had the information. They have boots on the ground.

Speaker A: One day. One day there will be more data.

Speaker B: One day. Dave, it's been a pleasure, man. Is there anything that you want to leave with our audience around vested, maybe how to get in touch with you? Um, the direction that you're going, the

Speaker A: general direction that we're going is to, at least from an investor's perspective and from the perspective of like an advisor thinking of their clients and what they can put them into within the alternatives world. VC has been notoriously hard to access for a couple different reasons. One is to get into the best brand name VCs, you usually need to be able to write a really big ticket, like a $10 million ticket. And that's if the uh, VC is even still open for subscription and haven't been closed for the last however many years like Sequoia. The other is even for people who can get access to venture capital managers that they like, VC is known to be a pretty high octane asset class. And despite the fact that VC is the best asset class as it relates to if you, if you were a top quartile manager in your last vintage, you are most likely to be a top quartile manager in your next vintage. That proportion that actually transitions from good to good is still only 49%. So it's like as sticky as it is. You're worse than a coin flip if that guy tells you he did well in his last vintage. Like you need to worry about regression to the mean. So single fund manager, single vintage Risk is the other reason that people tend to be nervous about vc. If you are an investor who has your money managed by a financial advisor listening or if you're a financial advisor that lives within a platform that has some resources that do like fund manager sourcing and diligence, have the folks at the top of the platform get in touch with either Vested at our website, which is Vested co investor or, or me or my team. My email is DaveInvested Co and we'll kind of walk you guys through what the offering is.

Speaker B: Awesome man. You know we have inside the mammoth platform we have some information up about Vested and you can read more about it there. We will add this stuff to the show notes Dave. So the link to your website and I really encourage everybody, even you know, I work with a lot of financial advisors who work with high earning employees. A lot of them are sitting in these shoes and just because they're high earning doesn't mean they have liquid liquidity. And so a financial advisor can play a massive role if you can step in and, and try and help those clients when it comes time to maybe changing careers, there's some good opportunities out there. And so having our ear to the ground is a great way for us to provide value and deepen those relationships. So Dave, it's, it's good work that you're doing man. We are really happy to have you on the show today.

Speaker A: No, I appreciate you having us on. Thanks Steve.

Speaker B: Awesome. Thank you. And everybody, thank you so much for listening to this episode of Alternative Universe. Uh, this podcast is brought to you by Mammoth Technology, produced by Turncast. If you like the show, consider sharing it with a friend and you could subscribe on wherever you're listening to the podcast right now for more information about Mammoth Technology and Alternative Universe, visit us@mammoth technology.com. M. Everything discussed on this podcast is for informational purposes only and should not be considered advice. The participants may have financial interest in the companies discussed on the podcast.