Financial Planning Case Study: A complex asset-allocation decision

Published: March 6, 2022 at 6:00 am

Last Updated on March 18, 2022 at 5:52 pm

The top three personal finance blunders are, not saving enough for retirement; making too high an allocation to equity; and using high-fee financial products/services. Case studies help to illustrate how difficult these decisions are.

About the author:  Avinash Luthria is Founder, Hourly-Fee Financial Planner & SEBI Registered Investment Adviser (RIA) at Fiduciaries. He was previously a Private Equity & Venture Capital investor for 12 years and has a flagship-course MBA in Finance from IIM Bangalore. His articles about Financial Planning & Investing have appeared at Business Standard, Mint and The Ken. An article in Business Standard last year explained why you should avoid Bitcoin, Smallcase and IPOs.

I previously wrote a case study in Mint about how much one should spend during retirement. That case study provided a solution. And the presence of a solution made it seem like it is very easy to identify the right decision.

So, the case study that follows does not provide a solution for two reasons. First, while the case study that follows has some good and bad solutions, it does not have an objectively correct solution. Second, since the case study that follows does not provide a solution, it is more likely that the reader will put themselves in the shoes of the client and the RIA and thus grapple with how difficult such decisions are. 

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This is a hypothetical simplified discussion between a client and a competent Hourly-Fee/Fixed-Fee SEBI Registered Investment Adviser (RIA). This is because, as I have written in Mint, it would be irrational for a client to ask an RIA that charges 1% of Assets Under Management per annum, for an unbiased evaluation of an option that would lead to a 40% reduction in annual fees of the RIA.

Client: I have put in my resignation at the start-up where I was the very first employee and I have been working for ten years. And the new job is in a tearing hurry for me to join in one month. You might remember some of this but to recap, firstly my entire financial interest in the start-up is in the form of stock options. 

Second, my salary at the start-up was very low, due to the hope that the options would eventually compensate for it. My salary at the new job is double the salary at the start-up. Third, the last venture capital fund-raising round two years back happened at a valuation that is double the exercise price of these options. 

The start-up is still far from becoming profitable and the last two years have not been good, so my wild guess is that the fair valuation today is the same as it was two years back. 

Fourth, the stock options policy of the start-up says that because I am leaving, I can no longer defer exercising my options. So, I have to either exercise the options and pay for the shares before I leave the start-up or let the options expire. 

RIA: We should look through the start-up’s financial performance together. But even after we do that, it will be very difficult to guess what ballpark the fair valuation is in. Based on the calculations in the shared spreadsheet, if you let the options expire, then during retirement you will most likely have to move from central Mumbai to the outskirts of Mumbai. 

Since all your friends/relatives are in central Mumbai, this will not be ideal, but it will be bearable. If instead, you pay for the shares, then it will consume 40% of your current net worth (in which we had treated the options as having zero value). 

For simplicity, let’s say that there are two scenarios. In the first scenario, since the company’s valuation is not sufficient for an IPO even in India, if the start-up later gets acquired at a valuation that is in the ballpark of the last fundraising round, then during retirement, you are likely to be able to continue to live in central Mumbai. 

Naturally, such an outcome is ideal for you. In the second scenario, if the value of the shares later goes to zero, then during retirement you are likely to have to shift from central Mumbai to the outskirts of Pune. This is a very bad outcome in your case. 

Client: Letting the options expire, would feel like I have wasted the last ten years of my career. And if the start-up later gets acquired at a valuation that is close to the last fundraising round, then I will feel a lot of regret. On the other hand, if I exercise the options, then the possibility of having to retire in the outskirts of Pune does scare me. I realize that it is my decision, but what is your recommendation — should I exercise the options?

To the reader: Should the client exercise the options and what is your rationale for your recommendation? And only after you have answered that a more technical and hence optional question is: what critically important aspect of the valuation of a venture capital-backed unlisted company have the client and the RIA completely missed discussing?

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