Startup equity can be a great retirement plan

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 Ford began working there, Yotta, like many early-stage startups, didn’t offer its employees a 401(k) plan. Instead, 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.

Ford 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 Ford, who is 33 and lives in Austin, Texas. “That’s more than enough to retire on.”

But Ford’s equity will have value only if Yotta becomes a successful public company.

Trading a corporate job with a traditional 401(k) plan for a job at a startup that offers equity gives employees a rare opportunity to receive a large payout at a young age. But 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, Rhode Island, who specializes in helping millennials manage their equity compensation.

“If a startup hits a home run, you may be able to achieve financial independence at a very early age via your company equity,” Northrup added.

“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, Massachusetts.

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, Fennewald, 44, retired about eight years earlier than she had planned.

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 offered a 401(k) plan four years ago, she contributed the maximum amount.

How equity compensation works

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 usually have 90 days to buy their options.

One of Northrup’s clients had 65,000 stock options 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, Northrup 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, and the value of the stock can fluctuate.

There are also 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. Those taxes need to be paid even before earnings are realized, he said.

Diversify your investments

Some people become 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, Chen said.

“When you have equity and your salary is tied to the same company, you already have too many eggs in one basket,” Fennewald said.

Both Chen and Harrison recommend saving money in multiple accounts, including a Roth IRA and a health savings account. After maxing out those accounts, Chen and Harrison recommend opening a taxable brokerage account that allows investment in stocks and bonds.