Start-Up Equity Is a Great Retirement Plan, if You Can Pull It Off

Nearly two years ago, Trevor Ford left a job at LendingTree that gave him a 401(k) plan and a generous employer match to work at Yotta, an online banking app.

When Mr. Ford began working there, Yotta, like many early-stage start-ups, didn’t offer its employees a 401(k) plan. Instead, Mr. Ford received equity compensation in the form of incentive stock options, which give him the right to buy shares of company stock at a discounted price. He believes that owning early-stage equity provides a better opportunity to accumulate wealth than an employer-sponsored 401(k) plan with matching contributions.

“The equity could be worth well into the seven figures, hopefully, and maybe more,” said Mr. Ford, who is 33 and lives in Austin, Texas. “That’s more than enough to retire on.” But Mr. Ford’s equity will have value only if Yotta becomes a successful public company. (Yotta recently gave employees access to a 401(k) but doesn’t match their contributions; Mr. Ford makes a small contribution.)

Trading in a corporate job with a traditional 401(k) plan for a job at a start-up that offers equity gives employees a rare opportunity to receive a large payout at a young age. While the potential payoff can be far greater than with a traditional retirement plan, the equity is worthless until someone buys it or the company goes public.

“In terms of building wealth, investing in a 401(k) is like running a marathon, whereas investing in company equity is like a running a sprint,” said Jake Northrup, a certified financial planner at Experience Your Wealth in Bristol, R.I., who specializes in helping millennials manage their equity compensation. “If a start-up hits a home run, you may be able to achieve financial independence at a very early age via your company equity,” Mr. Northrup added. He estimates that about 20 percent of his clients have received some type of payout from equity.

Mr. Ford is banking on equity in part because he witnessed his friend Andy Josuweit, the founder and chief executive of Student Loan Hero, receive a huge payout when LendingTree acquired the start-up for $60 million in cash in 2018. “At age 31, he walked away with a life-changing amount of money,” Mr. Ford said.

Not every start-up is successful, of course. An analysis conducted this year by CB Insights, a firm that studies venture capital and start-ups, found that 70 percent of start-ups fail.

“You have to keep in mind that it might not work out,” said Chris Chen, a certified financial planner at Insight Financial Strategists in Lincoln, Mass. “When you’re in your 20s or 30s and work at a start-up, it looks like time is infinite, but, at one point or another, you will have to retire,” Mr. Chen said.

Annie Fennewald was among the first dozen employees of a fast-growing tech company in Missouri, and she worked there for almost seven years. In May, after she sold her stock through a private equity sale, Ms. Fennewald, 44, was able to retire about eight years earlier than she had planned.

Although she received a seven-figure payout, Ms. Fennewald said she didn’t rely on her equity as her only retirement plan.

“I always treated stock as a lottery ticket,” she said. “It could be valuable, but I didn’t really bank my retirement on it.” When the company began to offer a 401(k) plan four years ago, she contributed the maximum amount. Often, as start-ups move out of early-stage funding and grow to 50 or more employees, they will offer a 401(k).

But not everyone is able to sell their equity.

Danielle Harrison, a certified financial planner in Columbia, Mo., has a client who wants to retire but is waiting for her company to go public so she can cash in almost $2 million in equity. “To be completely reliant on something like that is tough,” said Ms. Harrison, owner of Harrison Financial Planning.

If you’re a start-up employee considering giving up a more traditional route to retirement savings in favor of relying on equity, here is what you need to know.

Employees with equity compensation are typically granted several thousand shares of stock that they can buy at a discounted price before the company goes public. If they leave the company, they typically have 90 days to buy their options. For instance, one of Mr. Northrup’s clients worked at a start-up and had 65,000 stock options that were granted at 13 cents per share. His client paid $8,450 to exercise those options.

The company’s stock is now valued at more than $25, making those shares worth $1,625,000, if the company has an initial public offering or is acquired, Mr. Northrup said.

“The option you have when you leave is to buy the equity and hope that at any given point, something will happen,” said Jessica Little, 32. She and her husband, Matt Little, 40, have worked at several early-stage start-ups and typically buy their equity when they leave. That investment has paid off for them several times, Ms. Little said.

However, exercising equity and buying stock isn’t risk free. There is no guarantee you will ever see that money again or receive a payoff from your investment, and the value of the stock can fluctuate.

Exercising options also has tax implications. “One of the reasons people don’t exercise their options is because it could cost millions of dollars in taxes,” said Jordan Gonen, the co-founder and chief executive of Compound, a wealth management platform that helps people with company equity manage their long-term financial health. Those taxes need to be paid even before earnings are realized from the investment, Mr. Gonen said.

The need to have cash to buy stock options and to pay taxes on that purchase is why many people who work at start-ups are reluctant to tie up their money in traditional retirement vehicles such as a 401(k) or Roth I.R.A. — neither of which can be fully accessed without penalties until later in life, Mr. Northrup said.

The mistake that some people make is becoming so attached to the company they’re working for and its stock that they don’t want to give up their equity, fearing they’ll miss a large payout, Mr. Chen said. “When you have equity and your salary is tied to the same company, you already have too many eggs in one basket,” Ms. Fennewald said. For some, this concern has taken on new urgency, given the recent plunge in start-up sales and initial public offerings, which dropped more than 80 percent in the first half of this year, according to figures released this week.

Both Mr. Chen and Ms. Harrison recommend saving money in multiple accounts, including a Roth I.R.A. and a health savings account.

A lot of start-ups have high-deductible health care plans, so opening a H.S.A. is a great way to have a triple tax advantage, Ms. Harrison said. The money is contributed to the account tax-free. Money held there is not taxed, and when you take money out to pay for a health care expense, it’s not taxed, either.

After employees max out a Roth I.R.A. and a H.S.A., Mr. Chen and Ms. Harrison recommend that they open a taxable brokerage account that allows them to invest in stocks and bonds.

“If you’re young and have 20 to 30 years before you will need that money, you can invest in the stock market,” Mr. Chen said. A brokerage account might be a better investment plan if you’re young, he said, because if you take money out of a 401(k) or Roth I.R.A. before age 59½, it will be taxed as income (with some exceptions). But if you put money in an S&P 500 index fund and take the money out after a year or more, it will be taxed as capital gains, which, at a rate of 15 percent, is generally lower than the income tax rate, he said.

Mr. Ford was working at Student Loan Hero when it was acquired in 2018, and, because he had equity, he received nearly $200,000. After paying off his student loans and opening a Roth I.R.A., he opened a brokerage account.

After Ms. Little and her husband used some of their equity to pay off student loans, they spent the rest to buy property, including a lake house in Maine. “We see it as a retirement investment that we’re actively enjoying today,” said Ms. Little, who is the chief of staff at Catch, an app that helps users save for retirement by depositing a percentage of their income into an I.R.A. “The return on those investments will be significantly more valuable in the long run than us having funds wrapped up in a 401(k),” Ms. Little said. Her husband also works at Catch, and both contribute to the 401(k) Catch offers — though they don’t want all their money there until retirement.

“Most young folks aren’t thinking about retirement or benefits the same way their parents and grandparents did,” Ms. Little said. Mr. Ford admitted that he didn’t often think about retirement and that most of the people he interviews for jobs at Yotta didn’t either. “Retirement benefits are not a deal breaker,” he said.

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