Many startup employees unknowingly risk their financial future by over-investing and staking their entire financial future in their company. This approach is dangerous. Here’s why it’s a problem and how to protect yourself.
The Concentration Trap
Startup employees often:
- Earn salaries from the company
- Hold ESOPs or stock options
- Retain shares even when able to sell
This creates a dangerous scenario where both income and wealth depend on one entity. And a high proportion of net worth is in the form of employer stocks.
Risks of Overexposure
- Startup Failure: In our competitive ecosystem, failure rates are high. An employee could lose both job and savings.
- Market Volatility: Stock markets, especially in the tech sector, can be highly volatile.
- Regulatory Changes: Sudden policy shifts, like those affecting e-commerce or fintech, can impact entire sectors.
- Black Swan threats: Startups are particularly vulnerable to “black swan” events – rare, unpredictable occurrences with severe consequences. These could include sudden technological disruptions or global economic shocks. Concentrating wealth in a single startup exposes employees to the full brunt of these low-probability, high-impact events.
The Psychology of Overexposure
Several cognitive biases contribute to employees’ tendency to overinvest in their company:
- Overconfidence Bias: Employees often overestimate their company’s chances of success and their ability to predict its future.
- Familiarity Bias: The comfort of investing in a known entity (their employer) leads to neglecting unfamiliar but potentially better opportunities.
- Endowment Effect: Employees tend to overvalue their stock options simply because they own them.
- Survivorship Bias: A tendency to believe their company will be eventually as big as trillion dollar companies, while ignoring the ones that have given sub-par returns or have gone bust!
Recognizing these biases is crucial for making more rational investment decisions.
The Hidden Opportunity Cost
Employees often overlook other opportunities by heavily investing in their own company. If one looks at the listed space, multiple companies have outperformed the returns of established startups. Moreover, the liquidity in times of emergency that listed companies provide is often underappreciated. This opportunity cost can be substantial and often goes unrecognized until it’s too late.
The Power of Diversification
Diversification, a key investment principle, is often overlooked. Spreading investments across various assets can mitigate risk and potentially improve returns.
Applying Antifragility
The concept of antifragility goes beyond resilience; it describes systems that gain from disorder. Applying this to personal finance in the context of startup employment:
- Options-Based Thinking: Instead of relying solely on salary and company stock, cultivate multiple potential income streams. This could include developing side projects that could become businesses, or building a personal brand that opens up diverse opportunities.
- Skill Convexity: Develop skills that have nonlinear returns. For instance, combining technical expertise with communication skills can lead to disproportionate career opportunities, making you valuable beyond just your current role.
- Financial Barbell: Implement an extreme barbell strategy. Keep a large portion (e.g., 90%) of your wealth in extremely safe assets, while using a small portion for high-risk, high-reward investments across multiple startups or ventures.
- Positive Black Swan Exposure: Position yourself to benefit from extreme positive events. This could mean maintaining a network that exposes you to diverse opportunities, or regularly experimenting with new technologies or business models.
By embracing these antifragile strategies, you’re not just protecting yourself from downside risks, but positioning yourself to potentially benefit from volatility and uncertainty in the startup ecosystem.
Action Plan for Startup Employees
- Regular Selling: Systematically sell vested ESOPs or shares to diversify.
- Create a Selling Strategy: Plan how to reduce stock concentration over time.
- Challenge Your Biases: Regularly question your assumptions about your company’s prospects.
- Explore Other Opportunities: Actively research and consider other investments.
While startup equity offers great potential, employees must balance this with financial prudence. By understanding concentration risks, recognizing cognitive biases, and implementing diversification strategies, they can build more resilient financial futures in our dynamic and unpredictable economy.