HomeBlogIntroduction to Equity Pooling

Introduction to Equity Pooling

November 16, 2023|ByAaron Rosenson

Equity pooling is an important new tool for founders and employees to protect their wealth. It can make all the difference in how they grow and protect the value of their stock and options.

Business people are standing around circle making pie chart diagram

Equity pooling allows you to trade part of the value of your stock or option position, for ownership in many other similarly promising companies. In a way that is easy, simple, and involves no cash. It is accessible and applicable to everyone, from founders to employees.

Overview of What We Will Cover

In this article, I’ll explain:

  1. Why equity pooling is such an important and powerful wealth management solution.
    1. That’s extremely accessible and
    2. a good idea to pursue (objectively).
  2. I’ll elaborate further on one of the main benefits of equity pooling – diversification.
    1. Specifically, how equity pooling makes diversification accessible to both founders and employees
    2. And why diversification is so important.
Illustration of people sitting in an office working together

What is Wealth Management?

“Wealth management” is any activity one takes to better protect their resources and families. It’s something that we engage in all of the time (whether we want to or not).

Wealth management ranges from our spending decisions, to our investment decisions. For example,

  • The decision to rent versus buying a home.
  • The decision to allocate a budget towards food versus entertainment.

We are constantly making decisions and trade-offs about every aspect of our financial life. Yet, there is one area of our finances where we remain unable to make many decisions, despite the importance of those assets. And that is – our positions in illiquid, private market startups.

The Problem with Startup Wealth

Founders and employees often have a substantial portion of their net worth tied up in these businesses. Yet, they have limited options to manage that wealth.

  • They cannot sell their stock, except in certain cases and under limited amounts.
  • They cannot easily or efficiently move their paper wealth into other startups or assets either.
  • They must often deal with a significant lack of control and transparency.

They must sit with massive exposure to a single, speculative business. Then they must wait, hoping that this asset, which may be 80%+ of their net worth, materializes into something.

A lock is used to secure a cash load of US dollars in chains

They would be much better served by some diversification – even if they believed in the core business that they are exposed to.

That is because diversification is a critical part of any wealth management strategy.

Why Diversification Matters

One of the most important principles of wealth management is diversification. Diversification is the act of spreading one’s resources among disparate holdings. Since they are less likely to all succeed and fail in unison, one is less likely to get “wiped out”.

Diversification is the most reliable way to protect one’s equity downside and avoid the risk of total loss. And in the risky world of startups, with 92% of equity being worthless – there are few better markets to diversify.

Table with data concerning fund sequence to raise failure rate
Fund sequence to raise failure rate. Sebastian Quintera, Journal of Empirical Entrepreneurship

A closely related benefit of diversification is that it eliminates volatility.

Volatility refers to the likelihood, frequency, and degree to which a certain outcome will be different than its expected value.

Startup equity is very volatile. It may have a high value on paper. But we are well aware that its real value may very well be zero (or substantially more).

An employee with substantial startup equity would be well-served to diversify, if they could, and reduce the volatility of the paper position. Even a small portion of their holdings could be a massive benefit to their family, worth years of salary. The certainty of realizing just a portion of their paper wealth could make all the difference in the world.

Business people sitting in a circle

Yet, the current system forces them to treat things as an “all or nothing” bet.

Imagine if your concentrated stock position was in a public company, like Apple, Disney, or Microsoft. The idea of being unable to shift part of that position into another stock would seem crazy! And these businesses are much more stable than startups.

Yet, this is exactly what startup employees are forced to do. They cannot diversify or reduce the volatility of their large paper position.

But if they use equity pooling, they could protect themselves from the risk of complete loss. Similar to an insurance policy.

Private Stock and Option Holders Should Have the Freedom that Public Market Investors Enjoy

Equity pooling injects responsible management into your stock and option positions.

Let’s consider how the world of wealth management for public stock works.

A prudent financial advisor would encourage one not to make a very large gamble on a single holding – even if you had strong belief in that business. Sure, they’d recommend some outsized exposure, if you had substantial conviction. But primarily, they would guide you to invest in index funds, or at least, to a well-rounded portfolio of many strong, well-established businesses.

Illustration of people being linked to one another

In other words, in spite of any given large business being mature, there's too much volatility and uncertainty to rely on a strategy that doesn’t incorporate diversification. Especially in light of historical data that suggests that active fund managers cannot even beat a diversified portfolio of the S&P 500 index!

If public fund managers cannot beat such an index, in spite of all of the available information, expertise, and resources - why should we expect unprofessional players in the private market ecosystem to be any more successful?

We are forcing stock and option holders to engage in wealth management, in a game that favors a different sort of bet (indexes and diversification).

Pie chart of investment with different figures

What's even worse from a wealth management perspective is that employees cannot even choose the companies they want to bet on! Meanwhile, investors, who can choose from thousands of startups and yet can only pick a dozen, still have most of their bets fail!

Employees are trying to put food on the table. Optimizing for the probability of their startup equity succeeding cannot be their only consideration, like a professional investor.

Yet, the holding is meaningful enough that they should be entitled to act rationally and diversify.

This is not a good system for employees to build and manage their wealth. They are receiving substantial equity grants and being forced into a mathematically suboptimal way of harvesting their wealth, without any solid justification.

But if they use equity pooling as part of their holding, they can manage that wealth according to a conservative, data-driven approach. Without compromising on the “dream” of their equity having major upside.

What You Can Do Right Now to Protect Yourself

We've established that:

  • Wealth management is something that we engage in all the time, whether we want to or not.
  • That startup equity is a major piece of wealth for founders and employees that is relatively “unmanageable”. Compared to other assets that they have.
    • The most that someone can historically manage their startup diversification risk was to jump from startup to start up, to accumulate a diversified basket of holdings.
      • This would take many many years
      • It would still be relatively ineffective
    • Or to work in VC.
Illustration of a group of workers working on their laptop computers

Now, anyone can go from a single concentrated position to a diversified, less-volatile index.

  • They can manage their startup wealth in such a way that they are likely to see something out of their position.
  • They can have insurance for a major asset, which brings them more stability, less volatility, and peace of mind.
  • And they can do this cash-free, without harming their alignment with the company that granted them their stock and options.

Next Steps

If any of this resonates and you want to go deeper – sign up with Aption, so that we can tell you more about equity pooling and help you make the best use of this important new tool.

And share this post with any founder or employee that you know, who would want to learn about a new way to inject more security and stability in their financial life.

Isometric illustration of people working in office
Aaron Rosenson

Aaron is a Chief Investment Officer & Co-Founder at Aption and a former General Partner at Aleph, an early stage venture capital fund.