Startup Stock and Option Holders Have a BIG Problem
There’s something broken about equity compensation.
A founder or an employee could have a stock or option position worth a substantial amount of money. It could be $300,000, it could be $6,000,000. The company can be promising and well-funded, a truly valuable business.
Yet, when they sit around the kitchen table with their partner to make important life planning decisions – they must act as though the money wasn’t there. Even if buying a car, moving school districts, or fixing something in the house was a tiny fraction of the value of their options – it’s irrelevant. They hold a single, speculative, concentrated position, and they are powerless to “lock-in” even a small portion of its value, unless they were one of the rare few that could sell secondary.
Meanwhile, these startups can be illiquid for well over a decade. One’s children could be born and on the verge of leaving the house, before an exit event that may have changed one’s home and family life for the better was even realized.
In light of the longer illiquidity horizons of startups, coupled with their risky nature and macroeconomic headwinds, we need a better way for equity holders to preserve and grow their wealth. To make it more reliable, sooner, for the good of themselves and their families.
Finally, there is a solution. It’s equity pooling, from Aption.
How does equity pooling solve the problem?
By pooling a portion of your holdings with other similarly-promising companies, it becomes extremely likely that you will realize at least some of the value of your paper wealth. And that you will realize it sooner, rather than later.
Consider this analogy. Imagine that you wanted to buy a slice of pizza, but the restaurant was only selling whole pies, and through a lottery system. Where you gamble the cost of a slice to try and win a whole pizza.
The current startup ecosystem is like that store: “Take a bet! Enter the cost of one slice, and you have a 1/8 chance of winning a big prize – a whole pizza!”.
A whole pizza would be much better than a slice. But seeing as you’re hungry, you’re mostly concerned with getting something to eat.
Equity pooling is similar to getting together with 7 friends and everyone putting in the cost of one slice. There’s a 66% chance (1-(⅞)^8) that you will end up with at least one slice and a fair chance you end up with two.
For most people, having confidence that they could walk away from their startup with $200,000 or $400,000 is even greater than the small chance that they might earn $3,000,000.
But what’s even better about equity pooling is that “you can have your pizza and eat it too”. You can pool a % of your holdings, to better lock-in that paper wealth, while simultaneously “betting” the rest of your holdings by continuing to retain them.
With equity pooling, you can access greater personalization, balance, and downside protection. You can access better wellbeing. In other words – more “utility”.
Equity pooling enhances your expected wellbeing (or “utility”)
Equity pooling is the wise decision for anyone who owns shares or options in private companies. This is because it optimizes their wellbeing, or “utility”.
In other words – when choosing to join an equity pool, shareholders and option holders are most likely to be “best off”. Their wellbeing from this decision is far higher than if they had not entered an equity pool.
How can one be certain that this is true? If one does not know whether their financial outcome will be greater or smaller, with or without equity pooling – how can they be certain that equity pooling is the “high utility” decision?
To better understand this, let’s explore
- What exactly is equity pooling?
- What is this “utility” or wellbeing that we are solving for?
- Why should we believe that equity pooling optimizes utility, over staying concentrated in one or two positions?
Together, the answers to these questions contain powerful and important lessons for how we should be managing risk, building wealth, and protecting our families.
One caveat – the world of startups and equity is inherently risky and opaque – it’s hard to create consistent rules for what one should do with any given stock or option position.
Nonetheless, we can find surprisingly reliable frameworks for approaching these questions, if we dig deeper into just what equity pooling does and how it can contribute to our wellbeing.
What is equity pooling and how does it work?
Equity pooling is a mechanism by which a stock or option can be used like a currency – to freely trade and exchange. A stock or option holder can freely exchange part of the economics of their position for those of another business (or many other businesses).
For example, let's say you had $50,000, $500,000, or even $5,000,000 worth of stock in a promising company like Discord or Databricks. With equity pooling, you could take some % of that paper wealth and trade it for that of other promising businesses. It would cost you no cash, trigger no new taxes, and be simple to execute.
With a few signatures, an equity pooling customer goes from a single, concentrated position into the holder of a more diversified “pool” of equally promising businesses.
Equity pooling has been around for a long time, conceptually. And in practice, there have been a few localized attempts into diversifying concentrated positions. But until Aption, there has never been a universal platform for easily and effectively pooling any sort of interest, with any level of customization and flexibility.
What are some other benefits of equity pooling?
Equity pooling carries a number of distinct benefits:
- Enhanced psychological wellbeing; greater feeling of security, supported by math
- Users are more likely to see sooner and more frequent liquidity events.
- Even if an equity pool led to someone making the same amount of money or less money – if they saw a small amount of their money years before their exit were to occur, it could make all the difference in their family’s life.
- Users lock in their wealth and have less risk of a total loss event
- Users have a more balanced and secure financial life, which leads to more happiness and less stress.
- Users build alliances and networks with operators and founders at other companies that they pool with
- Makes them wealthier – they enjoy the newfound buying power of their stock, which now acts as fiat currency.
- Does not involve cash
- Does not require approvals, disclosures, or changes to the cap table or voting rights
- Customization and flexibility as to how one wants to pool and with which companies
What is “utility”? And why should an equity pool reliably enhance it?
Utility is a measure of measure worth, value, or well-being.
The term initially gained usage as a measure of pleasure or happiness. It evolved to include one’s preferences and benefits.
Importantly – utility is a more complete, holistic, and inclusive measure of well-being than a financial outcome. Because ultimately, a financial outcome is just an input into utility (as important as it may be).
Relatedly, “marginal utility” refers to the additional benefit that one would gain, by having more of any utility-bestowing thing.
For example, if one was very hungry – the marginal utility of a bite of a favorite food would be relatively high, in comparison to a situation of greater satiety. Whereas if one was very full, the marginal utility of an additional bite of food would be relatively low (or even negative).
This above dynamic is best shown through a utility function graph. In many cases, these graphs assume a logarithmic shape. Simply put, as one receives more of something, it becomes less marginally valuable.
The concept of marginal utility applies to start-up exit outcomes as well
This concept of marginal utility applies neatly to a consideration of startup exits. It can be used to illustrate why equity pooling is such a wise decision for most shareholders.
Again – this is not because they will necessarily have a better financial outcome (though we would expect the vast majority of those participating in an equity pool to make more money than they would have otherwise made – due to to the “power law” rule of outcomes and the likelihood that any given participant is not a possessor of said outlier company), but because they will have a much higher expected utility.
In other words, they will get more money in the situations that will really matter, for their wellbeing.
Let's say someone has $1,000,000 stake in a Series B startup. They take 10% of that and submit it to an equity pool. With a simple KYC and a few signatures, they use $100,000 of their economics to acquire $100,000 of 2-20 similarly promising businesses.
Let's assume that their startup is relatively successful from here. To the tune of 5x so.
Let's also assume that the 10% that they put into an equity pool is only moderately successful. Let's call it 2x in aggregate.
If the user had not put shares into an equity pool at all – they would end up with $5,000,000. If they did indeed participate in an equity pool, they would end up with $4,700,000.
$5M is meaningfully more than $4.7M, but in terms of what it would afford someone in terms of their overall buying power and well-being, the difference is not so great. Furthermore, the real utility difference of these two outcome amounts are further reduced, by the fact that the user a) had a smoother stream of income from the $200k equity pool component (e.g. maybe they had an exit 5 years before their major outcome that allowed them to really improve their life, during that period of time) and b) they had psychological well being from having less highly-concentrated risk.
In other words, the marginal utility of that $300,000 difference is quite low, because it is a relatively low “marginal amount”, in comparison to the successful outcome that occurred.
In contrast, let's imagine someone pulls 10% of a $1,000,000 dollar position into an equity pool and their business fails. (Which is very reasonable, seeing as 92% of equity is worthless and the vast majority of companies do not succeed, even promising ones that have raised meaningful amounts of venture capital.)
And let’s assume that once more, their equity pool produces a 2X.
In that case, they ended up with $200,000, instead of $0.
In other words – by entering an equity pool, a user sets themselves up to capture substantially more utility in a situation where they are in the most need, if anything but a fantastic outcome were to occur. And in the case of a fantastic outcome – their overall utility and happiness remains relatively unchanged.
Equity pooling thereby acts as a highly effective insurance policy, ensuring substantial utility persists for the customer, across a variety of situations.
But doesn’t this stop making sense if I believe in my company?
You might believe in the company, yet it may be a huge portion of your overall net worth. It does not make sense to carry such heavy exposure, even to a company you believe in.
If you had $5M – would you invest it into a single stock, even if you thought that Apple/Microsoft/etc was the best company in the world and was undervalued?
You almost certainly would not.
Indeed, if someone told you that they had even just half of their net worth in Apple, Alphabet, or Microsoft, one would likely think to themselves “that is a lot of concentration! That feels unnecessarily risky”. If the number was 80 or 90%, one might be alarmed.
Yet, this is exactly what equity holders in successful companies are forced to live with on a daily basis. Sure, they may believe strongly in their vertical SaaS business or infrastructure monitoring business, or their consumer-facing operation. But as the business achieves third party validation of its progress and the implied valuation of their stake grows – they often end up with 50-90%+ of their net worth in a single business.
Not only is this a huge concentration, but it is illiquid. They don’t have full control over the operation, nor do they have full alignment with the investors or founders.
Even with massive conviction, it logically makes sense to move anywhere from 5-20% of their concentrated stock/option position into other similarly promising businesses, to the extent that any given position is constituting the lion’s share of their net worth.
They will still maintain massive exposure to that business and this will not detract from the substantial economic impact of an exit, nor should it impact their motivation.
And with equity pooling, you can do this without paying any cash or taxes and with no change in your tax treatment. You can do this without any company approvals and it can be done discreetly. It is robust and reliable, with strong legal opinions and legal protections.
Do right by yourself and your family – explore equity pooling with Aption
Equity pooling supports a utility-optimizing allocation of resources, relative to a variety of outcomes.
As such, equity pooling is thoughtful and responsible personal finance management. It doesn't matter whether you believe in your company or not – the same reasoning will likely apply.
And while it is very likely to be a financially optimal outcome as well, for most users – it is almost certainly the right decision from the perspective of happiness and well-being optimization.
Equity pooling with Aption offers flexibility to pool in whatever way best serves your needs. Some equity pool users select an Aption index fund, others prefer to hand select the businesses that they pool with.
And yet others choose to do both.
Ultimately, equity pooling allows people who work in startups to easily increase their expected utility / well-being and reduce their risk, in a way that is simple, reliable, and effective. This protects working families, at a time in the world that we need it most.
Aaron is a Chief Investment Officer & Co-Founder at Aption. He's a long-time VC, having invested for Insight Partners and most recently, as a General Partner of Aleph.