Building Your Wealth at a Startup
Understanding Your Compensation
© 2022 Brightworth. All Rights Reserved.
Beginning something new is exciting, especially when you are doing it with like-minded, energetic people. Building a company from scratch requires a lot of sweat equity, and for many, the hope and plan is an eventual sale of the company to a group who appreciates the value of what you’ve built. And a sale with a large price tag.
Should sudden wealth come your way, congratulations! We’ll address how to plan for and execute a sudden wealth strategy later in this paper. But first, how do you ensure your personal financial situation will continue to march forward even in the early stages of working for a startup?
Here are a number of important questions to address:
- What can you do now with your compensation and benefits plans at your startup company to ensure you will be able to meet your financial goals, such as:
- Living comfortably in retirement
- Sending your children to college
- Paying off your mortgage
- Buying a vacation home
- Building a reserve fund so you can weather the twists and turns of life
- How should you invest your retirement accounts and other investments today to build wealth? What if your startup company does not offer a 401(k) plan?
- How much of your overall portfolio should be invested in your startup company?
- If offered equity, when is the best time to exercise your stock options?
- Are you taking full advantage of tax savings strategies available to you?
- What can you do today to prepare for sudden wealth, if your startup company is eventually sold for millions?
Brightworth specializes in helping busy professionals build and maintain a financial strategy to address their retirement planning, college funding, taxes, cash flow, investments, risk management, estate planning, and philanthropic objectives. One of the most common themes we’ve heard when speaking with professionals during their working years can best be summed up in a quote: “I am so busy with my career and family life that I have no time to focus on my finances.” Yet your personal finances are so critical to your future. It is the means to reach many of your life’s goals such as paying for your children’s college, retiring and moving to the beach, or making a sizable contribution to your favorite charity. Achieving your financial goals is like putting together a puzzle; each piece must fit together in order to complete the whole picture. If you want to make sure the pieces of your financial puzzle fit together, we can help.
Below are some highlights of how Brightworth approaches coordinating a client’s overall financial picture.
Early Stages of Working for a Startup
The key to financial success while working for a startup is to make sure you aren’t reliant on the startup in order to hit your financial goals. Your financial plan and trajectory should not be solely dependent on your company’s success. Cash flow planning is key, especially if you are taking a pay cut to work for this company. While the future rewards can be great, if it doesn’t work out, you don’t want your existing balance sheet to be jeopardized.
While you are waiting for your big payday to arrive, keep your head above water so to speak. Do not spend more than you are making each month, or have a predetermined amount of cash in the bank that you are willing to dip into, without it materially jeopardizing your future. Most people should target a three to six-month cash reserve during their working years; if you are taking a pay cut to work for a startup, you may want to plan for a twelve-month or longer cash reserve. This will help avoid going into debt to maintain your lifestyle. Make your lifestyle work within the boundaries of what you currently have.
When rumors start popping up that a buyer may be interested in your company, don’t start spending your potential windfall, and don’t make mental plans for a new and bigger lifestyle. Deals get delayed or fall apart all the time, even at the eleventh hour. Keeping a level head and being patient is so important when big dollar signs may be flashing in
your not-too-distant future. Again, do not depend on the company’s success for your personal success.
Manage risks in other areas of your financial life, including having the right amount and kind of insurance policies. Many startups don’t offer lucrative benefits packages, and if you are moving from a large employer to a startup, you could have sticker shock at how much more you are paying for health and welfare benefits. Health insurance premiums alone could be double or more of what you were used to paying if you had worked at a larger employer in the past. Startups may not offer enough life or disability insurance policies to cover your family’s needs, so buying this coverage outside your employer could be a wise move.
Personal liability, also known as umbrella coverage, needs to be in place and keep pace with your growing balance sheet. Check with your home or auto insurance agent to review the level of liability coverage every few years or whenever you have a major personal or financial change.
And, regardless of your employment situation, always have an updated estate plan. This includes a will, financial power of attorney, and healthcare power of attorney documents. Life insurance and retirement plans should have beneficiary designations on file to align with your estate plan. These documents should be reviewed every few years as well, or whenever you have a major personal or financial change in circumstances.
Here are more fundamental financial planning elements to consider as it relates to your startup company.
Many professionals working in corporate America use their 401(k) plan as their primary savings vehicle. It’s convenient, you may get a company matching contribution, and the money you save is automatically deducted from your paycheck. You will be amazed at how quickly you can build a nest egg for retirement within your 401(k) plan because of these features. As such, you should consider setting up automatic monthly savings with all of your investment accounts! It is a great way to build wealth systematically and keep your lifestyle in check. If your startup company does not offer a 401(k) plan, be sure to establish your own Individual Retirement Account (IRA) or Roth IRA.
Every working professional should strive to put the maximum amount into their 401(k) plan each year. For those under age 50, in 2022 this deferral amount is $20,500. For those ages 50 or above in 2022, the maximum deferral amount is $27,000 (including a $6,500 catch-up contribution). Oftentimes you need to make a separate election for the catch-up contribution, so don’t overlook this administrative detail when reviewing your 401(k). Once you are regularly maximum funding your 401(k) plan each year, try to never reduce your savings election.
Your 401(k) plan often offers a number of other investment choices which should be coordinated with your overall investment strategy. Typically, the younger you are, the more equity funds you should have since you are most likely in accumulation mode. As you approach retirement, adding in a few more bonds, real estate, or alternatives funds makes sense. Brightworth provides our clients with specific investment recommendations for their 401(k) plan based upon their personal situation.
If your startup company does not offer a 401(k) plan as mentioned above, plan to fund an IRA or Roth IRA each year. The maximum deposit to these accounts is $6,000 if you are under age 50, or $7,000 if you are age 50 or older in 2022. There are rules as to whether the contribution to the IRA is deductible or not, depending upon your or your spouse’s access to other retirement accounts. Also, there are income limitations on eligibility to fund a Roth IRA. In 2022, if you are single and make less than $129,000 you can contribute the full amount to a Roth IRA; this limit is $204,000 for married couples.
Unlike 401(k) plans which tend to have a more limited selection of investment choices, IRAs and Roth IRAs have essentially unlimited investment options. You can open an account at most financial institutions and will want to set up automatic monthly withdrawals from your bank account to your IRA or Roth IRA so you stay on track with your savings plan.
Finally, be sure you have an updated beneficiary designation on file with your 401(k) plan or IRA plan administrator. Especially if your plan administrator changes over time, be sure you’ve re-entered your beneficiary elections every time the plan administrator changes, even if you’ve been told your elections will carry over. We’ve seen many instances where they do not. Make sure your beneficiary designations are properly coordinated and integrated with your overall estate plan. For example, if you have created a trust in your will to hold assets for minor children, but your 401(k) beneficiary designation still shows your child’s names individually as the ultimate beneficiaries, none of the 401(k) money will land in the trust created in your will. This is one of the most common mistakes we see people make with their 401(k) plans – not having their beneficiary designations updated and coordinated with their estate plan.
A common compensation element for those working for a startup is a grant of stock options. This gives you the ability to participate like an equity owner in the event your company has a meaningful valuation, without having to make a personal cash investment in the company. In many cases, there is no opportunity to cash out of your stock options until there is a buyout of your company, or your company goes public (aka IPO or initial public offering). At that time, a change in control in your company can mean thousands of unvested shares of common stock will now be fully vested. The gain in your stock options may become the largest asset on your balance sheet. This also means a large part of your overall net worth is tied to one company stock.
Any stock option exercise strategy will likely be impacted as a result of an IPO or company buyout, as your time frame to exercise is forced upon you or quickly shortens. The acquiring company may require you to exercise the stock options within three to six months of the acquisition. This could cause your income to skyrocket for the current tax year.
Since stock option proceeds are subject to income tax upon exercise, part of your exercise strategy should include income tax planning. For example, perhaps you can exercise a portion of your options this year and a portion early next year, while staying just under the top marginal tax rate. If you have any chance of staying out of the top tax bracket when you exercise options, this also saves taxes on other parts of your financial picture such as dividends, interest, and capital gains from your brokerage accounts. Also, don’t forget to ask whether income taxes will be withheld from stock options – in particular, if they are non-qualified stock options. (Read your grant agreement to know what kind of options you were granted). If taxes will not be withheld, you’ll need to plan on making an estimated tax payment(s) or setting aside a large amount of cash to pay the bill due when you file your tax return.
Incentive stock options are taxed differently than non-qualified stock options and subject to the Alternative Minimum Tax calculation. Income taxes are not withheld upon exercise
of an incentive stock option, however, be sure to consult with a tax professional to understand your tax liability when you file your tax return that year or need to make an estimated tax payment(s).
Restricted stock units are shares of company stock that vest after a period of time and are released to you, dependent upon meeting certain criteria laid out in the plan. The criteria could include being employed for a period of time with your employer, or a combination of an employment time period and company performance.
Upon issuance of the restricted stock grant, your company may offer you the opportunity to make an 83(b) election. This is essentially an election to report the value of the restricted stock as income on your tax return today, and it is based on the fair market value of the stock when the award was granted to you. For startups, this amount is typically negligible. If the stock rises in value over time, the 83(b) election can mean you pay less tax on the stock as it vests and is liquidated than if you had not filed the 83(b) election. If these shares are sold for a profit, capital gain taxes apply to the gain which is typically a lower tax rate than ordinary income tax. Conversely, if the company’s valuation declines from the time you made the 83(b) election, then you will have paid more tax than if you had not filed the 83(b) election. Consult a tax advisor prior to determining whether you should make this election.
A company buyout or IPO may require any shares of restricted stock to immediately vest. If so, there can be a significant impact on income taxes due because you are receiving this income earlier than expected, and all at once.
If your vested company stock converts to shares in the new organization, be sure to track any adjustments to cost basis as this will have an impact on your taxes when you sell the stock. There may be a one-for-two conversion of old stock into the new stock, with cash received from fractional shares. Determine your cost basis for each share of stock you own before the change in control, and write down any adjustments to cost basis for your new stock. Depending upon how long you’ve held your company stock, the gain will be taxed as either a short-term capital gain at your top marginal tax bracket (currently as high as 40.8% for federal tax including the current 3.8% Medicare surtax) or a long-term capital gain up to a 23.8% rate. And don’t forget about state income taxes.
Finally, if you are staying with the new company, the new restricted stock plans could be very different. For example, stock plans based on performance may have different measures compared to your startup company. This may also affect provisions around retirement, death, disability, and vesting periods.
Personal Cash Investment in your Company
You may have the ability to make a personal cash investment into your startup company in exchange for individual phantom stock shares. These shares typically don’t have marketable value until your company is sold, but at that time, you could experience a significant capital gain on your investment. Capital gains are taxed differently than stock options – often at a lower tax rate (see above) – so be sure to consult a tax professional to understand how a buyout impacts your capital gain tax bill on personally owned shares.
If you are forced to liquidate stock options or restricted stock, your concentration of stock held in just one company will suddenly decrease. This could have an impact on your overall investment strategy as your allocation to stock has declined, and your allocation to cash has ballooned.
We are often asked, “How much of my net worth should I hold in a concentrated stock position?” We typically recommend that clients have enough diversified assets by the time they are entering the “withdrawal phase” of their life to cover their core living expenses and taxes. Above this core level, concentration in a single stock position does not pose as much risk to your financial strategy. We recommend always having a predetermined strategy for when your stock options or restricted stock vests or are exercised, as it can provide confidence and peace of mind to make critical financial decisions.
Equity in your startup company can play a significant role in your wealth accumulation and cash flow strategy. It’s important to have a plan in place especially if you have a limited window to make big decisions surrounding your equity.
When your company is sold, it often results in an acceleration of income due to stock plans paying out, and in some cases deferred compensation being liquidated as well as severance pay. Your company 401(k) plan may need to move too. Here are some key steps to take to minimize your taxes.
If you think your company may get bought, or your job may be at risk, contribute the maximum amount to your 401(k) retirement savings plan early in the year. This move will help reduce income taxes in the year of the merger or acquisition as you’ll ensure you can take advantage of this before-tax savings. For 2022, people younger than 50 can contribute up to $20,500 and those 50 and over can contribute $27,000. If you cannot contribute the maximum amount under the “old” employer’s plan, make certain to contribute the maximum amount when you combine plans with the new employer.
If you participate in a Health Savings Account, contribute the maximum amount if you choose a high-deductible plan. Contributions can be made until April 15 of the following year for the prior tax year. This means you don’t need to make all of these contributions before leaving the job or before the end of the year. If you are not in a high-deductible plan for the entire year, your contribution limit will be pro-rated.
Defer taking capital gains in your taxable investment portfolio in the same year you’re receiving large stock payouts or severance payments, and harvest capital losses to offset gains you incurred earlier in the year.
Review opportunities to qualify for state tax credits for special programs. For example, in Georgia, executives can purchase film credits to help reduce the state income tax burden.
For executives who make charitable contributions, consider setting up a Donor Advised Fund. This fund enables a person to contribute a large amount of money in one year to fund charitable gifts for several years. You can deduct the entire amount given to charity in the year it is made, which will reduce your tax bill. Appreciated company stock is often a great tool to fund the donor-advised fund, as when the stock is liquidated inside the donor-advised fund account, no capital gain taxes are due.
If your financial condition is sound – especially after receiving stock options and other payouts -- it may be a good time to help out family members in need. Any person can make a gift up to $16,000 -- $32,000 if you are a married couple -- to an unlimited number of people each year and not file a gift tax return. Another favorable gifting strategy is to pay someone else’s medical or tuition bills directly to that institution. The law allows any person to contribute an unlimited amount of money under the gift tax law.
Contribute to your child’s or grandchild’s 529 college education savings plan, which may result in a break on state taxes. These plans offer tax-free growth if the money is used for qualified education expenses and could be a good use of cash.
Finally, work with a tax professional to have a tax projection run in the year you experience large liquidity. Be sure to set aside enough cash to pay for extra taxes due either through quarterly tax payments or when you file that year’s tax return.
A sound investment strategy is the cornerstone to building and preserving wealth. It should be designed to meet your specific cash flow needs, time horizon, growth requirements, tax objectives, and risk tolerance. Successful investing requires a long-term perspective and discipline to avoid making short-term emotional mistakes. Having a coordinated and comprehensive strategic asset allocation is the foundation for your entire portfolio.
If it looks promising that your company will be bought, and the dollar signs are flashing brightly, it can be very tempting to mentally start spending your new wealth. However, a strong word of caution is in order! Deals come and go and can fall apart at the last minute. Be sure to not make any big financial commitments before the cash is in your bank account. It’s equally important to keep your emotions in check, as you don’t want to experience disappointment if the deal doesn’t go through, and now have to pull yourself out of that mental funk.
However, it is smart to map out a financial strategy in anticipation of a windfall coming one day. Consider your financial priorities. Do you want to pay off your mortgage? Fund children’s college accounts? Make sure you have enough in retirement and can stop working by your desired deadline? Think about family member support as well charities you’d like to donate to. Put dollar amounts or percentages on paper or in a spreadsheet and determine how you’d like to allocate proceeds coming your way from the sale of your company.
Once your important short- and long-term goals are earmarked, then consider fun uses of the extra cash such as a nice family vacation, purchase of a beach house (don’t forget what this does to your future cash flow and expense budget), or buying that new car you always wanted. These extra expenses should not be the priority when it comes to receiving sudden wealth. They should be secondary to your important financial priorities in life.
It’s equally as dangerous to immediately upgrade your lifestyle when liquidity comes to you. Give it time – at least several months – before you decide to buy a bigger house, put the children in private school, break ground on a pool in the backyard, etc. One of the best financial moves you can make is to keep your lifestyle in check even when you can afford to upgrade it.
Once your balance sheet does balloon, you’ll want to review your insurance coverages. Do you need as much life insurance now that you have more assets? Are your umbrella policy limits high enough to match your new net worth? Is now the time to purchase a single premium hybrid life insurance/long-term care insurance product? Insurance planning should evolve over time as your wealth evolves, and experiencing sudden wealth is a key time to revisit risk management plans.
In addition, your estate plan may need to be updated. If your balance sheet is suddenly immensely higher than when your will was last updated, there may be new tools and techniques you now need to consider. Do you need certain trusts? How do you want your new wealth distributed among family members should you pass away? Are there resources you now want to allocate to charities, especially if that helps to lower your taxable estate? Meet with an estate planning lawyer to review your balance sheet, goals for your legacy, and wealth distribution once you pass away. Regardless of receiving sudden wealth, reviewing your estate plan is important to do every few years or when there is a major change in your life’s circumstances. Don’t forget to coordinate insurance and retirement plan beneficiary designations with your updated estate plan.
Building a company from the ground up can be a fun and rewarding adventure. While you are building the company, keep focused on building your personal wealth dollar by dollar, each day. If sudden wealth comes your way, be sure to have a plan in place for how to allocate the proceeds focusing on important priorities such as retirement and college education funding. Treat yourself to something nice, just don’t squander the possible once-in-a-lifetime opportunity that sudden wealth can bring your way. Our team of financial professionals is ready to help you navigate this important transition in your life. Reach out to us for expert advice! Schedule a conversation today.
This information is provided as a guide to assist you in your financial planning. The examples are provided for illustrative purposes only and are not intended to be specific financial planning recommendations or tax advice. Please consult with a professional for specific questions regarding your particular situation.
© 2022 Brightworth. All Rights Reserved.