How to Accomplish a Techxit: Part 1

By AJ Ayers, CFP, EA, CEP

If I had a dollar for every time one of my clients told me they just want to work their high-paying tech job for a few more years before leaving to do something more fulfilling and better for the world (usually it’s the environment), well, I’d have about $100 and a very successful financial planning business. Har har har. I’m being cheeky and mean because I’ve heard the same thing over and over. It’s a worthy goal for sure and one that I spend a lot of my waking hours helping my clients achieve. I’ve heard this narrative so many times that I’ve decided to give it a name:

The Techxit (like Brexit). In other words: work at a high-paying tech job earning a high salary with a generous equity package and then quit after a few years, once that equity has vested and there’s a liquidity event (your company is acquired or goes public). Then the plan is usually to use the incredibly valuable skills learned in the fast-paced, high-growth environment for good: to help an environmentally conscious start-up or a non-profit who could really use those skills but can’t afford to pay competitive salaries to lure talent away from the Googles or Facebooks of the world.

In the paragraphs that follow I’m going to teach you the recipe for financial freedom if you happen to have one of these well-paying jobs and work at a company that experiences a liquidity event. Most of our clients work in tech but I’ve also seen this done in retail, advertising, and other areas. This strategy assumes a ton of risk and can only work if things go your way: a disastrous IPO or a recession can easily throw this plan out of whack. At the end of the day, the amount of wealth being created for rank and file employees by innovative companies is unprecedented and if you happen to find yourself in this position, I’m going to show you a case study of how to accomplish financial independence.

When we talk about equity compensation we have to talk about a lot of confusing concepts and advanced tax law. I’ll do my best to stop for definitions when I think it’s necessary. I hope by the end of this you will feel excited by the possibility of financial Independence or at least have a firm grasp on how your equity compensation works. At the end of the day, it’s exactly what it sounds like: compensation (value exchanged for service) given in the form of equity (ownership in a company). I’m presenting a case study in a vacuum to illustrate my point but it is very much grounded in reality. I have real clients that have experienced a version of this scenario at companies like Spotify, Etsy, Datadog, Palantir, Asana, and more.

Caveats, disclaimers, and general warnings: First of all, this is not tax or investment advice. This is a case study presented for your entertainment and perhaps to spark your curiosity. Second of all, this strategy is neat but the stars have to align for this to work. Third of all, this strategy goes against what I often recommend to my clients which is to diversify out of a concentrated position as fast as possible in the most tax-efficient way. This isn’t a science, it’s an art: balancing the risk of holding shares longer with the tax consequences of selling sooner.

Finally, if you have equity compensation, especially Incentive Stock Options (ISOs), you MUST go to an accountant that is familiar with this space. As you’ll see later, ISOs generate a multi-year complicated tax wormhole and my colleagues and I have found and corrected DOZENS of mistakes by other accountants. It doesn’t make them bad accountants, it just means they don’t specialize in this niche. If you want to know if your financial adviser or tax adviser knows their stuff ask them about form 3921 - that’s the tax form that reports your ISO exercises to the IRS.

Ingredients to Accomplish a Techxit

Many things have to go right in order to pull this off.

1. A six-figure salary at a young private company that allows you to save at least 20% of your income for the future (retirement) PLUS the cash you’ll need to exercise your options and pay the tax bill.

2. Incentive Stock Options (or ISOs) with a very low strike price.

3. A liquidity event like an acquisition or IPO.

4. Additional equity grants in the form of RSUs or Non-Qualified Stock Options. Not essential, but they speed up the process.

Steps to Accomplish a Techxit

Step 1: Exercise your Incentive Stock Options when the fair market value of the stock is close to your exercise price. This way, your out-of-pocket cost is low and you avoid paying significant Alternative Minimum Tax.

Step 2: Wait for a liquidity event.

Step 3: Stick around for another year or so and immediately sell any new equity awards.

Step 4: Start earning that AMT credit back.

Step 5: Quit your job, earn very little income for the next few years and move to a state with no capital gains tax to sell your stock at 0%-15% capital gains.

Step 6: Invest your proceeds in a diversified portfolio and take advantage of compound interest. You’re financially independent and ready for the next exciting thing. Your semi-annual meetings with Brooklyn FI now take place from exotic locations throughout the world.

Let’s begin.

Step 1: Exercise your incentive stock options when the fair market value of the stock is close to your exercise price.

Companies are generally required to grant stock options at the fair market value on the day of the grant. This number (the fair market value or FMV) is often called the 409(a) valuation. Smaller companies that aren’t public yet will have to outside experts to arrive at their 409(a) valuation. Often, the price of each share doesn’t get updated until they need to raise more capital so if there’s no need to raise additional funds the 409(a) could be static for years. Sure would be great if you could just exercise all your options on the day you get them, right? Sometimes companies will allow an early exercise but most of the time you have to wait for them to vest. Stock options are granted as incentives to keep you employed at the company so most of the time they come with a vesting schedule of 3-4 years. The word exercise just means you’re exercising your right to hold the shares, in other words: you’re buying them and holding them.

Fun fact: most young companies issue ISOs to employees instead of Non Qualified Options (NQOs) because they don’t have the infrastructure and finance teams to monitor the mandatory tax withholding required for NQOs at exercise. There’s no withholding on an ISO exercise (we’ll get into why in a moment) so it’s just EASIER from an accounting perspective. Accountants make the world go round…did you know that?

To pull off a Techxit you should exercise your options as soon as they vest while the fair market value (FMV) of the stock price is close to your exercise price. In other words, you want to experience the taxable event of exercising your shares as early as possible before the stock gets expensive. (Sir Caveat here: remember this is super risky as MOST stock options at young companies never actually have value because the companies DON’T IPO and you don’t get the money back). By exercising your options early on, you likely won’t have to pay a lot of Alternative Minimum Tax or AMT, the nasty alternative tax that catches so many unsuspecting ISO exercisers.

The Alternative Minimum Tax is a parallel tax system that is designed to make sure wealthy people who use complex investments to defer income actually pay their fair share of taxes. In “regular” tax land, you get to deduct things like state and local income taxes, a standard deduction, certain medical expenses but in “AMT” tax land these items all get added back to your taxable income. Most regular folks don’t have to worry about AMT because they pay enough regular tax. But, it just so happens that Incentive Stock Options are one of the items that get added to your income in the parallel tax system, along with oil drilling partnerships and other shady things rich people own to avoid paying taxes.

How will I know if I owe AMT? Well, my friends, this is the point at which I say you should probably hire a financial planner that specializes in the taxation of equity compensation (hi, hallo, have we met?). The AMT is complicated and hard to explain but I’ll give it a go. First, we need to talk about what’s causing the AMT. The difference between your exercise price (doesn’t change, is listed on your grant paperwork) of the shares and the fair market value is called the spread or “bargain element.” The bargain element is the part that generates taxes. Now if you have regular old Non-Qualified Stock Options (NSOs or NQOs), the bargain element is TAXABLE INCOME to you. Gross. But if you have Incentive Stock Options (ISOs), the bargain element is ONLY counted as an “AMT Preference Item” and increases your Alternative Minimum Taxable Income which means you MIGHT owe additional tax but it’s dependent on about 100 other factors on your tax return: your income, your other stock sales, your spouse, your spouse’s income, you got kids? Own any mines or oil drills?

You can read about the AMT in-depth elsewhere but simply: if you exercise enough ISOs, your taxable income in the Alternative Minimum Tax parallel universe goes up and if that AMT taxable income is HIGHER than your regular taxable income, then you owe additional tax. The actual extra tax you’ll owe is the difference between regular tax you owe on your salary and the Tentative tax calculated when the bargain element from your ISOs got added in. Sir Caveat again: I’m simplifying the AMT for clarity, there are lots of other factors and calculations that a tax preparer can help you with.

The closer the fair market value on the day you exercise to your exercise price, the less AMT you owe. If your exercise price is the same as the FMV, you’ll owe $0 AMT. Some companies will allow you to early exercise shares and elect to pay the taxes in the year of the grant. This is called an 83(b) election. Note: You MUST make the 83(b) election within 30 days of the grant, no exceptions. The election requires writing a letter to the IRS. Seriously, there’s no form you just write a letter. Big fan of her, the 83(b) election.

Let’s look at a case study.

Example 1

So let’s say your exercise price is $1 and your grant of 10,000 shares vests over three years. It’s been three years, your company is growing rapidly and the founders start dressing better and you year whispers of IPO on the Slack channels. You’re ready to exercise. Let’s assume the company is slow to grow and the valuation hasn’t changed which means that the company’s shares are still worth $1 per share. Any new employees receiving grants will have the same exercise price as you did three years ago.

Cost to exercise shares: $1 x $10,000 = $10,000

Bargain element for AMT purposes: FMV - exercise price x # of shares exercised. $1 - $1 x 10,000 = $0

So you only have to come up with the $10,000 cash to exercise and you will pay no additional taxes. Easy, right?

Example 2

Same scenario as Example 1 except that now your ISOs have vested after three years but the company just went through two rounds of fundraising and an expert valuations company puts the fair market value (or the 409(a)) at $10.

Cost to exercise shares: $1 x $10,000 = $10,000 (same as above)

Bargain element for AMT purposes: FMV - exercise price x # of shares exercised. $10 - $1 x 10,000 = $90,000

So, you have to come up with the $10,000 cash to exercise PLUS any alternative minimum tax generated by the $90,000 bargain element.

Let’s look at how that works because you don’t automatically owe $90,000 but if you want to do some very quick back of the napkin math, the AMT tax rate is 26% or 28% depending on your income. Here’s how it breaks down.

Sir Caveat here again: we’re using 2015 tax numbers for the example but tax laws have changed so your AMT calculation for other years will be different.

So, you had come up with $10,000 to exercise the shares and $20,000 to pay the AMT bill. That’s not too bad if you had that saved somewhere and $30,000 is less than 10% of your net worth (remember, you don’t want ALL of your net worth concentrated in one company). But most folks early in their career don’t have this kind of cash! This scenario looks at a small 10,000 share grant. If you’re a key early employee your grant likely to be six figures meaning your cost to exercise plus AMT could be hundreds of thousands of dollars. Sir Caveat here: I almost never recommend this strategy to my clients unless they have a large diversified portfolio elsewhere because it’s incredibly risky and we want to avoid putting all our eggs in one basket. If there isn’t ever a liquidity event, these options will be worthless unless the company wants to buy them back from you. Remember, the worthless stock scenario is what is most likely going to happen since around 90% of startups fail. For most people, that exercise cost plus AMT due is impossible to achieve without help from a wealthy relative. There ARE other options to explore, like a third-party partner (EquityZen, ESO Fund) who will front you the cash to exercise and pay the AMT but will take something like 20-30% of your eventual exit at a liquidity event. So if $150,000 is your life’s savings as it is for most folks in their 20s, this strategy doesn’t work and is just too risky. You can hope for a miracle IPO, but sorry kid, it’s probably not going to happen.

Here’s why exercising early is advantageous IF and only IF your company starts to do well. Because when you hold onto shares with such a low exercise price, the bargain element starts to get really big. We’ve helped some folks at companies like Spotify who have an exercise price of less than $5 when the fair market value of the stock is over $250. Let’s take a look at an example when the stock price shoots up to $100. Yikes, we now owe more than a quarter of a million dollars in Alternative Minimum Tax. I just thew up in my mouth a bit.

Example 3

The same scenario as Example 2 except the company just went through explosive growth and raised a ton of capital. The 409(a) is now $100!!

Cost to exercise shares: $1 x $10,000 = $10,000 (same as above)

Bargain element for AMT purposes: FMV - exercise price x # of shares exercised. $100 - $1 x 10,000 = $990,000

So, you have to come up with the $10,000 cash to exercise PLUS any alternative minimum tax generated by the $990,000 bargain element.

Let’s look at how that works because you don’t automatically owe $990,000 but if you want to do some very quick back of the napkin math, the AMT tax rate is 26% or 28% depending on your income. Here’s how it breaks down.

That looks pretty scary but honestly, that’s what USUALLY happens. A lot of clients will come to Brooklyn FI just weeks ahead of an IPO with tons of unexercised shares. There are many strategies we can implement at that point as well but that’s a post for another day.

Let’s keep moving with Example 2 with the cost of $1 and the fair market value at exercise of $10.