Deciding Whether to Exercise ISOs by Considering the Health of Your Startup

Making money is art, and working is art, and good business is the best art.

-Andy Warhol

If you work in a start-up in San Francisco and have received Incentive Stock Options (ISOs) you may now be considering your best course of action. Should you exercise now, while the tax consequences are minimal, or wait until the company is successful? Do you prefer the risk of a high tax bill or the risk of exercising and then watching the value of your illiquid stock implode? There’s very little firm guidance on this, because everyone’s personal situation, risk tolerance, and start-up business model are different. The decision is hyper-specific to you.

I previously discussed the potential tax ramifications of holding and exercising ISOs. However, the single most important factor in considering if and when to exercise your options is their underlying value when they reach full liquidity – either through being acquired, following an initial public offering (IPO), or when the team closes shop. The fundamental question is, ‘will my startup succeed?’

As an employee, or even co-founder leading your team, you have a unique view of the company. You see the day to day stressors and big wins. The honesty and integrity of your team’s leadership provides a fundamental baseline for whether you make the decision to exercise.

253 Startup Deaths Explored

Let’s flip the success question on its head, asking not whether your start-up will succeed, but what exactly causes start-ups in general to fail? Fortunately, the research is in. Over the course of the last 4+ years, research and consulting firm CB Insights investigated 253 start-up shut downs and analyzed their founder’s goodbye letters, employee comments, and investor postmortems to compile their knowledge base.

12 Reasons For Failure

The top twelve reasons for failure on their list follow. Note that more than one issue could be attributed to failure, and thus percentages do not add up to 100%.

1.      No Market Need 42%

2.      Ran Out of Cash 29%

3.      Not the Right Team 23%

4.      Get Outcompeted 19%

5.      Pricing / Cost Issues 18%

6.      User Un-Friendly Product 17%

7.      Product without a business model

8.      Poor Marketing 14%

9.      Ignore Customers 14%

10.   Product Mistimed 13%

11.   Lose Focus 13%

12.   Disharmony Among Team/Investors 13%

I find it striking that almost one half of companies found that they failed because they were not solving a felt need of their target customers. Items 1, 6, and 9 speak to this. Secondly, the quality of the team matters, as items 3, 11, and 12 indicate. Before exercising options you may want to ask, “am I confident in the team around me to meet a felt need of our target audience, and will I enjoy the process of getting there with them?” I highly encourage you to spend more time with the CB Insights research drawing your own conclusions. They’ve put together a very digestible resource here.

Assessing Your Company Health

Working off this list of the top twelve, you may want to consider giving your current start-up a score on the following questions corresponding to the above categories. Adapt them as applicable to your industry.

1.      Are we solving a felt need for a large group of people? When our target client understands our product are they excited? Are there enough of them to support this business?

2.      Do I know our current burn rate and our current runway? If not, why not? If yes, is the team comfortable with where we stand?

3.      Does the team get along? Are the founders trustworthy, and do they make the hard decisions about hiring and firing staff when needed?

4.      Are there similar products out there that are better than ours, or companies building what we are building more quickly or effectively?

5.      Is pricing a major hurdle for product adoption? Is our product scalable?

6.      Do we hear that our product is hard to adopt, or frustrating to use?

7.      When the funding runs out, can I envision what we are building driving enough revenue to keep us running?

8.      Is our marketing team driving adoption, or do they seem stymied and frustrated?

9.      Does our company culture encourage consistently make decisions by asking what is best for our customers?

10.   Are we too far ahead of our customers? Will what we’re making fit into their lives or workflows easily?

11.   Do I, or does my team, feel sidetracked by projects that aren’t crucial to our core offering?

12.   Are the co-founders on the same page for big decisions? Are they often at odds with our investors or staff?

Whether you take the time to score your start-up in each category or not, I hope this exercise provides value as you consider exercising your ISOs. As a bearer of options, you get to choose whether or not you want to be an owner of the company for which you work. Does taking the pulse of your startup lead you to want to dive further in, wait and see, or even begin the job search? Give us a call, we’d be happy to discuss further with you and help you understand the potential alternative minimum tax implications of exercising.