What comes to mind when you hear the word startup?
If it’s a grungy basement in the heart of Silicon Valley, you’re not alone. A lot of people think of startups as a shoestring team of five people with one common thread: a high threshold for chaos. Many are surprised to find out even a five-year old company can still be considered a startup. According to Forbes, a startup can graduate to a larger company by being acquired, opening more than one office, generating revenues greater than $20 million, or even having more than 80 employees. These employees work for entrepreneurs who believe their ideas could skyrocket by creating a startup. Well, that’s the dream, right?
So, what happens if you find yourself working for a startup? Maybe you’re the CEO or a member of the founding team. How does this role fit into your financial journey, both now and over the next five to ten years?
Well, the reality when it comes to working for a startup is you’re vulnerable to risk — and likely more than you could imagine. A 2021 Failory study found that only 10% of startups are successful each year. Yikes!
To help you navigate this potentially turbulent journey in the context of your personal finances, we’ve developed five financial moves you should make while working for your startup — moves to help your financial future remain on track, regardless of the startup boom or bust.
1. Start with your Emergency Fund
Working for a startup can be exciting. With your idea, you and fellow founding members have the opportunity to change the world. The seemingly limitless potential of this venture does come with great risk. According to Failory, 20% of startups fail in the first year of operations with 90% of startups ultimately closing shop. Are you prepared for this disruption to your paycheck? Do you see yourself being able to quickly secure a new gig should this one go belly up? Of course you do!
To ease the stress from a job loss (or any other curveball thrown your way), establishing an emergency fund is a critical first step to help steady your financial ship between startup ventures. At minimum, a reserve of three months of spending is standard. For those in single-income households with dependents, a six-month reserve may be more appropriate as an added buffer.
To establish an emergency fund, we’re assuming you know how much you spend each month. Need help on that front? Try using a tool like Mint or You Need A Budget (two of our favorites!) to automate monthly tracking.
Once you’re ready to set aside money in your emergency fund, consider opening an account at an online bank. We’ve had success with our startup clients opening accounts at Marcus or Ally to hold their funds. Remember, the goal is to have quick access to the money, but not too quick. This account is for emergency expenses only!
Once you hit your emergency fund target, either via a lump sum contribution or consistent saving, stop. You do not want to be hoarding too much cash. Why? The opportunity cost. You want to retain your ability to reach other goals, such as starting a family, purchasing a home, or retirement.
2. Protect Your Legacy and Earning Potential
If COVID-19 has taught us anything, it’s that no one is immune from life delivering surprises. To ensure you are prepared, there are a few steps you can take.
First, protect your legacy by ensuring your wishes are properly documented. This includes having the following documentation in place:
- Will: States how your possessions will be distributed and managed once you have passed.
- Power of Attorney: Authorizes an individual to step into your shoes and act on your behalf.
- Advance Health Care Directive: Expresses your critical care wishes should you be unable to speak for yourself.
For some, protecting their legacy may also include establishing a Trust. To learn more on this topic, check out Your Complete Estate Planning Checklist.
The second step you can take is to use insurance to protect yourself from unforeseen circumstances. Common policies you may need include:
- Home/Renters Insurance
- Auto Insurance
- Disability Insurance
- Life Insurance
- Umbrella Insurance
Speaking with an advisor can be a great way to understand how each of these insurances play a key role in your risk management plan.
3. Prioritize Retirement Savings
You may be envisioning that your startup is your retirement plan. We’ve all seen those images of founders ringing the bell at the New York Stock Exchange as confetti rains from the sky to mark their company’s IPO. Years of tireless work have finally come to an inflection point where the equity built can now be converted into substantial wealth. For a select few, this could be how their retirement plan plays out. For most, a more measured approach to financial independence will be required.
It’s unlikely if you’re employed by an early-stage startup (Seed Stage or Series A) that you will have access to a company-sponsored retirement plan, such as a 401(k). Many young startups are starved for cashflow, so offering this perk can siphon critical funds needed to grow and scale the business. As a result, you will need to make use of the Traditional IRA or Roth IRA to save for retirement.
Traditional IRAs let you set aside pre-tax dollars for retirement that grow tax deferred. At retirement, funds withdrawn from a Traditional IRA are taxed at your ordinary income tax rate. The Roth IRA allows you to contribute post-tax dollars that also grow tax deferred. Once retirement arrives, you can withdraw funds from your Roth IRA tax free. Both the Traditional and Roth IRAs have a contribution limit of $6,000 for the 2021 tax year. If you are 50 or older, you can make an additional catchup contribution of $1,000 annually.
If you happen to work for a startup that does offer a company sponsored retirement plan, take full advantage of it! With a 401(k), you can contribute up to $19,500 annually with pre-tax contributions. This is three times greater than what you can set aside for retirement via an IRA.
Maxing out your 401(k) over 10 years can result in about $280,000 set aside for retirement, if invested in a globally diversified equity portfolio. When comparing this to someone who doesn’t have a 401(k) plan available at work and who can only contribute via an IRA, their figure would be much smaller at around $87,000.
These numbers showcase how critical it can be to prioritize retirement savings, especially if you have a company sponsored plan available. Should the business also offer a company match, take full advantage of this benefit! This is basically earning free money.
By prioritizing retirement savings early, you allow market growth and compounded investment returns to serve as major tailwinds in having work be optional at an earlier date.
4. Invest Broadly to Minimize Risks
Much of our work as financial planners is geared towards mitigating or minimizing risks to your financial plan. Working for a startup is the ultimate risk-reward scenario. You’re likely assuming years of reduced earnings augmented with large equity positions in the business that can only be realized by meeting vesting requirements or through a future liquidity event. In short, there is no guarantee these equity positions will ever be realized.
To limit some of the fundamental risk associated with your startup role, be sure to invest broadly across your investment portfolios, such as your taxable or retirement accounts. This also includes exercising and selling stock options strategically to re-invest the proceeds with your portfolio assets. Diversification can help reduce risks that currently do not have an expected return (such as your founder’s equity). At Abacus, we work with clients to implement investment strategies anchored in global diversification to broaden their investment universe.
By investing broadly outside of your startup, you can begin to mitigate some of the risk in your financial portrait that is inherent to your career path.
5. Be Proactive with Tax Preparations
We cannot stress the importance of being on top of your tax situation while working for a startup. This is especially true if you find yourself facing a liquidity event or have just experienced one.
We’ve seen countless stories of employees who went through an IPO and immediately earmarked the proceeds for a housing purchase. In these instances, the problem arises when employees forget about Uncle Sam. Fast-forward to tax season the following April and they’re facing a six-figure tax bill with little to no funds to pay for it. Now what do you do?
For early-stage employees (think founding members), be aware of the 83(b) election. This often-missed tax item has the potential to greatly reduce your future tax liability should you experience an exit in your business. Urgency is key as you only have 30 days to file your 83(b) election with the IRS once your shares have been granted. Unsure if filing the 83(b) election is for you? Speaking with an advisor is a great first step!
Another important tax consideration is equity compensation, which can be a large part of your benefits package when working at a startup. Restricted Stock Units (RSUs), Incentive Stock Options (ISOs), and Non-Qualified Stock Options (NQSOs) all have different tax implications. It’s important that you understand these differences. Some key considerations for equity compensation include:
- Equity Type: Are they RSUs, ISOs or NQSOs?
- Vesting Schedule: Is it graded or cliff vesting?
- Taxation Timing: Am I taxed when vesting requirements are met, when I exercise the options, or when the options are sold?
Understanding the answers to these questions is key to having a handle on your upcoming tax situation. Check out our blog What to Do with Your Employee Stock Options to learn more.
To help prepare for upcoming tax bills, we often encourage our startup clients to establish a ‘tax set aside’ account. The sole purpose of this account is to proactively stash proceeds from any stock options to cover future tax bills. No one likes to see money go out the door to pay Uncle Sam, especially when the figure has more than a handful of digits to it. What do people hate more than that? Having to raid their hard invested portfolios to cover the bill because they didn’t properly prepare for it.
By not allocating in advance for taxes, you could be setting yourself back when it comes to meeting other financial goals. Don’t make that mistake!
Taking the Next Step in Your Startup Journey
Find yourself working for a startup? We’re here to help! Schedule a call with an advisor to understand how your startup journey can help you reach your financial goals, regardless of the boom or bust.
