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My brother-in-law is leaving a private tech company. He has $100,000 in stock options (fully vested) which he must either purchase, or abandon completely upon his exit.

This is not a startup — the company has been around almost 15 years. They are not big enough to IPO, but they are currently shopping the company hard for a buyout.

Word around the office (from the higher ups) is that the currently issued options will be worth 4x-6x when (if) the company is bought out.

He does not have the funds to exercise his options, so he is offering the opportunity to me.

  • First question: How do I evaluate risk vs. reward on this deal? And is there any "insider trading" problem here?

  • Second question: How could I structure the deal with him? I would like to spread out some of the risk to him, but have no idea how to do this.

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First, you mentioned your brother-in-law has "$100,000 in stock options (fully vested)". Do you mean his exercise cost would be $100,000, i.e. what he'd need to pay to buy the shares? If so, then what might be the estimated value of the shares acquired? Options having vested doesn't necessarily mean they possess value, merely that they may be exercised. Or did you mean the estimated intrinsic value of those options (estimated value less exercise cost) is $100,000?

Speaking from my own experience, I'd like to address just the first part of your question:

Have you treated this as you would a serious investment in any other company? That is, have you or your brother-in-law reviewed the company's financial statements for the last few years? Other than hearing from people with a vested interest (quite literally!) to pump up the stock with talk around the office, how do you know the company is:

  • Valuable?   Is the balance sheet healthy? How many shares & issued options are there?
  • Not heavily indebted?   Are there significant loans or credit facilities that have been drawn down?
    Might there be a potential credit event around the corner?
  • Profitable?   What does the income statement look like? Are margins healthy?
  • Solvent?   Do they realize enough profit as cash to cover current liabilities and then some, or are they profitable on an accounting basis but not generating ample cash?
  • Growing?   How do revenue, profit, etc. look compared to previous years?
  • Free from significant conflict-of-interest?   Have any owners / officers disclose material transactions with the company? Do such arrangements appear within reason, or cause for concern?

BTW, as an option holder only, your brother-in-law's rights to financial information may be limited. Will the company share these details anyway? Or, if he exercised at least one option to become a bona-fide shareholder, I believe he'd have rights to request the financial statements – but company bylaws vary, and different jurisdictions say different things about what can be restricted.

Beyond the financial statements, here are some more things to consider:

  • Is there a shareholder agreement? Many private companies use these. How would the agreement bind you? How might it restrict a future share sale or transfer? Could a sale to another shareholder / employee be vetoed, or just subject to a right of first refusal?
  • Is there even such a private market? Has anybody sold their shares to another shareholder? What were prices for recent deals? Financial statements may inform your own share valuation, but are shareholders valuing the shares — through transacting – above the option's exercise price?
  • Beyond the founding owners, are there other stakeholders, e.g. venture capital or venture debt, with special rights? What are these rights and how might they impact your investment?
  • Is there any intellectual property? e.g. are there patents that are valuable but not accounted for? Is the company involved in any ongoing IP litigation (or other legal issues)?
  • How dependent is this company on one (or a few) large customers? Say, is there one client that constitutes 50+% of revenue? What if that client goes away? How do the financials change?

The worst-case risk you'd need to accept is zero liquidity and complete loss: If there's no eventual buy-out or IPO, the shares may (effectively) be worthless. Even if there is a private market, willing buyers may quickly dry up if company fortunes decline. Contrast this to public stock markets, where there's usually an opportunity to witness deterioration, exit at a loss, and preserve some capital.

Of course, with great risk may come great reward. Do your own due diligence and convince yourself through a rigorous analysis — not hopes & dreams — that the investment might be worth the risk.

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    The exercise cost would be $100k. He hasn't exercised any options before, so you are right, he is not yet an actual shareholder. Thank you for taking the time to list out all the question I should be able to answer before I make a decision. You make a great general point, that I shouldn't treat this any differently than any other investment (just because it's an "insiders" deal, and I have a relationship which allows me this opportunity). – EkoostikMartin Jan 15 '14 at 18:56
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    You're welcome. And, FWIW, I would treat it differently from any typical investment: I'd approach investment in a private opportunity with even more caution than a publicly-traded company, since the inherent illiquidity would make it near impossible to get out if it were to head towards zero. But yes, I'd start by looking at the fundamentals. – Chris W. Rea Jan 15 '14 at 21:04
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    Good point, since there is a reasonable risk for complete loss here. Thanks again. – EkoostikMartin Jan 15 '14 at 22:11
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The company may not permit a transfer of these options. If they do permit it, you simply give him the money and he has them issue the options in your name.

As a non-public company, they may have a condition where an exiting employee has to buy the shares or let them expire.

If non-employees are allowed to own shares, you give him the money to exercise the options and he takes possession of the stock and transfers it to you.

Either way, it seems you really need a lawyer to handle this. Whenever this kind of money is in motion, get a lawyer.

By the way, the options are his. You mean he must purchase the shares, correct?

  • He must purchase the shares within 90 days of his exit, or lose the options. Good point about the lawyer, I need to make sure I am legally able to take possession of the shares after he buys them with my money! – EkoostikMartin Jan 15 '14 at 18:58
  • @EkoostikMartin Even if he's not permitted to transfer ownership of the shares, there may be other legal means for you to benefit while keeping the shares in his name. However, there'd be other risks, and a shareholder agreement might not permit pledging or assigning the shares in any way, let alone sale/transfer. A lawyer can advise you of the various options with respect to the shares, the debt, etc. For instance, if you loaned the money, perhaps interest and forgiveness could be tied to share performance, subject to limits. Just one idea. Yet, I am not a lawyer. Seek professional help. – Chris W. Rea Jan 15 '14 at 21:09

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