MarTech Interview with Scott Chou, CEO of ESO Fund

Scott, Could you share a bit about your professional journey and how you became involved with the ESO Fund, particularly in the context of addressing the financial aspects of employee stock options?

My VC career started in 1997 as a Kauffman Fellow. For the first 15 years, I did traditional venture capital where I invested directly in startups. During that time, I observed the key elements behind the ESO strategy. First, employee common stock is cheaper than preferred stock. It is designed that way to be an incentive for recruiting employees. But it also is that way for a good reason – the risk of losing money in startups. Over time, that risk goes down, but the stock option grants held by employees remains at the same price. Even so, employees often cannot afford the cost or risks associated with exercising which is a phenomenon I observed repeatedly as board director. This risk-value arbitrage is the basis for the Employee Stock Option Fund. The key factor is that we invest small amounts as a portfolio across many companies whereas our clients have to make relatively large bets into a single company. As such, I started The ESO Fund to help those employees harvest value without taking on any personal risk.

Option holders seek strategic flexibility. What, in your view, are the key reasons behind this, and how does the ESO Fund assist individuals in achieving this flexibility with their financial vehicles?

I’m not exactly what you would call “strategic flexibility” but let me make some assumptions. Employees negotiate option packages to be potentially life-changing if the company is successful. That requires a lot of shares. Exercising a lot of shares requires a lot of money which is something most employees either don’t think about or didn’t realize might happen. The main reason for this problem is that companies want the retention benefits of stock options, so they don’t spend a lot of effort highlighting the potential costs. The company’s perspective is, “just stick with us until the exit and you’ll get a check.” Although this is true, reality is turnover at startups is really high and leaving a company before the exit requires the exercise of the options or else the options expire worthless. Upon departure is when a lot of our clients realize for the first time that stock options are not stock but something they have to buy if they leave the company. They often feel indignant about this realization in the cases where they were laid off. The other factor behind the price shock are the taxes. If several years have gone by since the option grant and the company has increased in value, the exercise results in a lot of tax to make things even more painful. So the main reason people work with us is that they simply cannot afford the cost of the exercise and taxes. Our average transaction size is about the average annual salary of a tech employee and that might not be a coincidence. Even if they can afford it, they might not like the risk or the potentially long delay before liquidity (IPO or acquisition). Even if the risk of loss is only 1/4 (25%), a person potentially facing the loss of a year’s salary often finds this unacceptable whereas it is manageable by ESO on a portfolio basis.

Could you outline the best strategies for exercising employee stock options and leveraging equity from these investments for optimal financial outcomes?

This question is a bit broad. We have a page on our website that outlines 17 things people can do to improve their stock option related taxes, but they don’t all apply to any particular person. We typically provide free consultations for ESO clients where we’ll determine which strategies are applicable. Amongst the most powerful tax savings strategies include these 3 things: 1. Exercising stock options at a Qualified Small Business can result in a $10 million waiver of federal taxes. This essentially requires exercising really early when the company is small and high risk. That’s a particularly good reason to get help from ESO rather than using personal cash. Although ESO invests on a portfolio basis which allows for taking a few flyers, our risk appetite isn’t unlimited which means a lot of QSBS companies will be too early for us as well. 2. Founders and early employees can deposit a portion of their stock into their IRAs for tax deferred gains. They can also do Roth IRA rollovers while that stock has tiny value. By paying the tiny tax now, the Roth will give them tax free profits at the back end. Facebook made the benefits of a Roth IRA legendary, but Congress has put some limitations on it as a result. 3. Unlike NSOs and RSUs where taxes are high and hard to mitigate, Alternative Minimum Tax on the exercise of ISOs have wiggle room. We spend most of our consultation time dealing with AMT. ISO holders can exercise a certain number of options each year without owing AMT. This is a great tax efficient strategy to exercising options.

For holders of options looking to regain control of their investment future, what are the proper steps they can take, and how does the ESO Fund support individuals in this process?

I’m not exactly sure what you mean by “regain control of their investment future” but I’ll take a crack at it. Rather than investing a large portion of their life savings in a single stock, ESO will fund the exercise for them. That allows them to participate in unlimited future upside without taking any financial risk. Even if they have the appetite for risk, they can take the money they would have tied up in this one company’s stock and diversify it into other investments that are just as promising but not as risky or illiquid.

What are the significant upsides for individuals in exercising their employee stock options, and how can this contribute to their overall financial well-being?

Exercising stock options is essentially investing in a startup company. They can potentially make a killing which is why the VCs are investing in the same company at an even higher share price. Option packages are often negotiated based on size relative to annual salary. So if a person got a package of options equal to one time their annual salary and the company may eventually be worth 20x what it is worth today, then this person stands to make 20 years of salary all at once.

Employee stock options involve risks. What strategies or advice would you provide to individuals for managing and mitigating the risks associated with these financial instruments?

Our main angle is suggesting that they let ESO make the investment on their behalf rather than doing it themselves. Of course, ESO will own a percentage of the future by doing so and they would own 100% of the future if they did it on their own. For those who can actually afford to invest on their own, we encourage them to first consider what other investments they can be making instead. By letting us invest, they might still have access to about 70% of the future benefit of this stock but now they also have 100% of this other investment. The sum of the 70% plus 100% of the other investment is usually larger than simply having 100% of this one company. At a minimum, they’ll be more diversified and more liquid.

How have you observed market trends evolving in terms of employee stock options, and what implications do these trends have for individuals navigating their financial strategies?

I wouldn’t call it a trend but certain terms come and go with the circumstances. One is switching from options to RSUs. This usually happens when the company stock share price has a Fair Market Value that is too high to be an incentive. The law/IRS requires that the option exercise price be at least as high as the FMV. The high FMV diminishes the perception that employees are getting a significant discount and increases the financial risk associated with an expensive exercise. RSUs don’t place any cost requirements on the employee, but you don’t get as many either. RSU’s are also subject to higher tax rates and unlike stock, can expire. However, you can say that unicorn valuations and the stock market funk together form a trend by keeping companies private longer. As such, RSUs will appear more commonplace than stock options. Internal liquidity events to appease long time stock and stock option holders will also increase to deal with this trend. A related issue is the use of NSO extensions to replace ISOs and their mandatory 90 day expirations. However, this practice has been going on for a long time and is typically used to prevent an employee exodus rather than being a new trend. It goes against the interests of the company and investors so it isn’t an automatic privilege but granted only as needed.

Tax implications are crucial when exercising options. Can you elaborate on how the ESO Fund guides individuals in understanding and managing tax considerations related to their stock options?

This question is mostly addressed (3) and other comments above. But I’ll take this opportunity to say more about mitigating Alternative Minimum Tax. Wealthy people trying to minimize tax impacts have long employed complex strategies such as constructive sales that defer capital gains taxes by spreading them out over a long period of time. This allows the capital from the gain to be used in other investments rather than going straight to taxes. We accomplish something similar by being a legitimate third party financial transactor for an AMT disqualifying disposition. This is a cookie cutter service that ESO can do at small scale unlike those complex Deferred Sale Trust vehicles that only the wealthy can set up.

As CEO of the ESO Fund, what personal advice do you have for individuals navigating the complexities of employee stock options and their associated financial decisions?

To at least engage with us for a free consultation. We’ll get you thinking about tax mitigation and diversification considerations. We also aggregate the insights from many other employees from the same company in most instances. This can be helpful in deciding when to sell or hold. This especially true several years down the road when a client has long left a company and knows very little about what might be happening.

Any final thoughts or insights you would like to share with our audience regarding the future landscape of employee stock options and the role of the ESO Fund in this domain?

We are in a nuclear winter for liquidity. IPOs are few and far between which means that good M&A is also hard. Many companies that received capital in 2021 at high valuations are about to run out and raise capital under harsher terms. Now is probably the most important time in a generation to consider the use of third party capital such as the ESO Fund.

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