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Intro

So you’re leaving Startup Co.

You’ve worked there long enough to hit your “cliff” and have the option to exercise some incentive stock options totaling some dollar amount.

Startup Co. is doing well and growing fast, but it’s not yet clear if a purchase of its stock will turn into an investment generating Facebook IPO-like returns.

Since you’ve probably got 90 days or less to make a decision around exercising your options, here’s a simple framework to consider when deciding how much of your options to exercise.

Tax disclaimer

This example does not take any tax implications into account - it’s simply a framework for asset rebalancing. Regardless of whether your startup’s valuation has increased exponentially from the time you joined or not, it’s important to chat with a CPA or CFA before exercising your options.

This is an opinion and an untested framework. I’m sharing it to document my current thinking around startup options in the context of the macro economy in November 2015.

My take

I propose that after the personal decision to purchase some percentage of options in Startup Co. has been made, the question of “How much should I buy?” should be answered by examining and then modifying between 25%-50% of the “alternatives” section of the investor’s existing investment portfolio.

Although it could be argued that exercised options, which are stock holdings in a private company, should be grouped under a section of a portfolio alongside other small-cap US stocks, the volatility of privately-held startup stock makes it an alternative investment in my mind.

Therefore, holdings of private startup stock are best grouped with REITs, hedge funds, precious metals, and other alternatives to the stock market.

A practical example of divesting and re-allocating a portion of a portfolio to accept the infusion of private startup stock is below.

Investor Profile:

Mid-20’s investor
Startup job in the Bay Area
$150k annual salary
Long-term investing horizon

Initial allocation of a $100,000 example portfolio:

Investment Allocation (%) Allocation ($)
Cash 0.5% $500
International Bonds 0.8% $800
US Bonds 2.2% $2,200
International Stocks 25.8% $25,800
US Stocks 60.2% $60,200
Alternatives 10.5% $10,500

Total exercise cost of all available options:

$10,000

For this example, let’s choose to sell 30% ($3,150) worth of equities from the portfolio’s current alternatives allocation and re-allocate the proceeds towards the purchase price of our Startup Co. options.

Following the sale and exercise transactions, the portfolio has gained some increased diversification, and the investor has their ticket punched for the startup lottery in the form of a $3,150 ownership stake in their former company.

Hopefully, this framework can help to provide some investment discipline to what is often an emotional and gut-based decision.