Startup Stock Option Changes(medium.com)
medium.com
Startup Stock Option Changes
https://medium.com/@beninato/startup-stock-option-changes-5df706da0317
11 comments
Based upon the comments, I added some additions to the end of the post. Thanks for raising those issues!
Definitely needs to change.
Backloaded vesting seems like a terrible idea. It puts the employee in a really vulnerable position. As a company grows, the absolute value that a given person generates should decrease relative to everyone else. The function (relative value created this month / stock vested) decreases even more quickly. This may create an incentive to fire (or at least not try to retain) an employee after the first or second years. The founders may not need to increase this person's salary because of the perceived value to come, so this person may end up making less money than later employees.
I would not even think of proposing a backloaded vesting schedule to an employee. There's nothing wrong with an even vesting schedule in terms of employee alignment. If you cannot retain an early employee after year 1 or 2 you have other problems.
I would not even think of proposing a backloaded vesting schedule to an employee. There's nothing wrong with an even vesting schedule in terms of employee alignment. If you cannot retain an early employee after year 1 or 2 you have other problems.
I agree. I came across this once, and ran the following model. Assume you assess the expected value of the equity grant to be, let's say, $100k over 4 years. Then this means your total comp will rise by $10k a year, which probably is comparable to your natural gain in market value. Thus this is equivalent to taking a similar offer except with $40k in equity with linear vesting, and either getting a raise or switching companies to get the $10k/year raise.
What this analysis omits is that the expected value calculation ignores the fact that the equity far exceeding the expected value is correlated with a desire to stay at the company, which makes the backloaded vesting irrelevant.
If you interpolate a bit to account for that correlation, I personally started concluding the $100k offer became more like $50-60k, which dropped the offer below market rate and I walked.
What this analysis omits is that the expected value calculation ignores the fact that the equity far exceeding the expected value is correlated with a desire to stay at the company, which makes the backloaded vesting irrelevant.
If you interpolate a bit to account for that correlation, I personally started concluding the $100k offer became more like $50-60k, which dropped the offer below market rate and I walked.
The reason I brought this up is that there are some founders who believe if you only stick around a year or two, you aren't loyal so you shouldn't get any stock. Some companies have repurchase rights. I was trying to suggest a way for employees who leave after a year or two to keep what they've vested and appease those founders who take a hard line about buy backs. I think this norm will be difficult to change although Sam Altman also discussed it in a post in recent years.
My thinking as well. Heck, early employees are already vulnerable enough with linear vesting.
Frontloaded vesting would make the most sense, but that could be tricky to get right.
Frontloaded vesting would make the most sense, but that could be tricky to get right.
A lot of great suggestions.
I'd consider lack of #1 and #2 as dealbreakers. Any company that doesn't allow early exercise is being unfair to early employees for no reason, and not providing basic cap table information makes stock options numbers impossible to value.
#3 is great, but it is much more progressive. I'd value a company's offer more highly if they offered this, but it wouldn't be a dealbreaker if the company didn't.
As for number #4, I think 10/20/30/40 vesting is way too bottom heavy. The problem is the employer can always fire you if they want, and if the company blows way up in value in 2-3 years, they might prefer to fire you than give you so much stock. This reportedly happened at Zynga so it isn't unheard of. You'd hope to never join a company with this type of leadership, but as an employee you don't have much power so it is good to be defensive about it. Maybe I wouldn't mind a minor tweak like 20%/25%/25%/30%, but I'd prefer 25%/25%/25%/25% with a culture of refresher grants to high performers (which accomplishes the same thing).
The difference between founder stock and employee stock options is already so large, I don't think option holders really need to make any concessions (like bottom heavy vesting) to get some common sense benefits to stock options.
It also is important to educate people about these differences. I hope that companies that do #1, #2 and #3 have a nice guide on their offer letters explaining why this is beneficial to potential employees.
I'd consider lack of #1 and #2 as dealbreakers. Any company that doesn't allow early exercise is being unfair to early employees for no reason, and not providing basic cap table information makes stock options numbers impossible to value.
#3 is great, but it is much more progressive. I'd value a company's offer more highly if they offered this, but it wouldn't be a dealbreaker if the company didn't.
As for number #4, I think 10/20/30/40 vesting is way too bottom heavy. The problem is the employer can always fire you if they want, and if the company blows way up in value in 2-3 years, they might prefer to fire you than give you so much stock. This reportedly happened at Zynga so it isn't unheard of. You'd hope to never join a company with this type of leadership, but as an employee you don't have much power so it is good to be defensive about it. Maybe I wouldn't mind a minor tweak like 20%/25%/25%/30%, but I'd prefer 25%/25%/25%/25% with a culture of refresher grants to high performers (which accomplishes the same thing).
The difference between founder stock and employee stock options is already so large, I don't think option holders really need to make any concessions (like bottom heavy vesting) to get some common sense benefits to stock options.
It also is important to educate people about these differences. I hope that companies that do #1, #2 and #3 have a nice guide on their offer letters explaining why this is beneficial to potential employees.
The problem with refresher grants (and the thing that people don't understand) is that they tend to be near worthless due to the strike price. If the company is doing well, and you've stuck around for several year, the price on the options is probably so high you're unlikely to make much money off of it.
In comparison to an early grant a refresher grant will be smaller and worth less, but that doesn't make it "near" worthless.
First, if you have 7 years to decide if you want to exercise it, then every stock option has risk-free upside regardless of the strike price. Without the 7-year rule then the upside isn't so clear cut, but that doesn't mean they are near worthless at all.
Second, companies really don't grow that quickly. Over a 1 or 2 year time horizon, even a really successful company will 2x-4x in value (and the common stock might grow even less than this). If the strike price was low on the original grant, the strike price will also probably be pretty low on the refresher grant. Especially at early stages of a company's life when the options are priced at essentially zero, even if you 5 or 10x the value, the strike price will still be very low.
When you have more established companies and higher strikes prices, it is less of an issue because there might be a shorter term path to liquidity which takes away risk of exercising without being able to sell the stock.
First, if you have 7 years to decide if you want to exercise it, then every stock option has risk-free upside regardless of the strike price. Without the 7-year rule then the upside isn't so clear cut, but that doesn't mean they are near worthless at all.
Second, companies really don't grow that quickly. Over a 1 or 2 year time horizon, even a really successful company will 2x-4x in value (and the common stock might grow even less than this). If the strike price was low on the original grant, the strike price will also probably be pretty low on the refresher grant. Especially at early stages of a company's life when the options are priced at essentially zero, even if you 5 or 10x the value, the strike price will still be very low.
When you have more established companies and higher strikes prices, it is less of an issue because there might be a shorter term path to liquidity which takes away risk of exercising without being able to sell the stock.
The dramatic difference in price is really between pre-funding to post-funding. e.g. I know many companies where options were granted at 1c a piece, even as seed notes and safes were given out, but as soon as the Series A equity round hits, the 409A & thus options grant went up to $0.50+. That's a huge difference.
That said, your point about having 7 years to decide is entirely fair, and mostly negates that downside.
That said, your point about having 7 years to decide is entirely fair, and mostly negates that downside.
"Near worthless" is an entirely overblown characterization. The central factor is not the strike price, but the spread between your strike price and what you can eventually sell at (which should hopefully be higher than any strike price set at the last 409A). If you get an initial grant at $1/share, and then a later grant of the same number of options at $5/share, then is the later grant worth 1/5 of the initial one? No - if you end up selling for $15/share, then it's a difference between getting $14/share and $10/share pre-tax. It only ends up being a much worse deal if the strike price of the later grant is very close to what you later sell at, in which case your company is flatlining.
The real problem comes from the fact that any amount of stock that would generate significant return becomes prohibitively expensive to exercise. If you're granted 100k shares at $5/share, and they could eventually sell at $15/share; it does you very little good, because there's no way you can swing the half a million bucks it'll take to exercise in order to make your uncertain $1M profit.
On the other hand, if it's an amount of options you can afford to exercise (e.g. 1k shares @ $5 = $5k… most people could scrap together the funds for that.), your profit is unlikely to be more that 2-5x, which likely would return $10k, and at the most $25k on your $5k investment. A lot of risk and trouble to go through for very little gain…
That said, with a 7+ year time period to exercise after leaving the company, it's not an issue
On the other hand, if it's an amount of options you can afford to exercise (e.g. 1k shares @ $5 = $5k… most people could scrap together the funds for that.), your profit is unlikely to be more that 2-5x, which likely would return $10k, and at the most $25k on your $5k investment. A lot of risk and trouble to go through for very little gain…
That said, with a 7+ year time period to exercise after leaving the company, it's not an issue
I don't really think it's 10/20/30/40, one year cliff means they get 25% after a year but then the schedule is monthly. See it as a salary: you get some every month, it stops when you get fired.
Great points!
Here are some of Sam Altman's thoughts http://blog.samaltman.com/employee-equity
My retention equity grant after an acquisition was 10/20/30/40. I just left after 2 years partially because I realized that the schedule was insulting and I had barely vested a small slice of the pie.
I have a 2 year cliff (which I would hit 2 June 2016) on 4 year vest. I would not recommend this to anyone on either side of any transaction.
I've never seen a 2 year cliff. Can you say what company?
Not standard at the company. Unique as part of acquisition.
Yeah, the only way I would go along with something like that would be if I received a higher percentage than what is currently standard. I would expect something like double the percentage associated with a 4/1 deal.
I think what Sam Altman suggested was give more stock but have it backloaded on the vesting.
When a company refuses to disclose the fully diluted number of shares, what do you do? Assume it is the number of shares authorized (which you can find for $20 at https://delecorp.delaware.gov/tin/GINameSearch.jsp)?
You walk. You don't want to work with a founder/company that isn't forthcoming and truthful.
That is the upper bound that is generally much higher than the fully diluted count, so not a good proxy. However, it would be a fair assumption on your part since you are not given the right level of transparency. At any rate, probably best to be firm about the ask and just walk away if you dont get it, since it is not a good sign for things to come. Unless, of course, you would be okay to work there if they dont disclose you a salary (salary? dont worry about it...)
Is it an absolute upper bound? Is there a legal prohibition against creating derivative instruments (options, contracts secured by issuance of stock, etc.) in excess of authorized-at-time-of-execution?
in practice, it is set very high to cover all conversions and future capital needs and then some. however, it can be increased if needed, with a sharedholder vote.
Authorized shares is a pretty much irrelevant number. Companies typically have millions more shares of common stock authorized than they have actually issued to anyone. The relevant number is the number of shares actually issued and outstanding. You might also care about how many options have been issued and could in theory become outstanding shares, so in that case you'd want what is called the total fully diluted number of shares.
You don't want to work for someone like that. If they won't tell you that, what else are they hiding?
As others have said, walk away. Also, if convertible debt is involved, ask for the total number of outstanding shares after the debt converts.
Why do we give out options instead of stock in the first place?
Tax reasons and complications with having >500 shareholders (and shareholder information, etc. rights in general), plus administrative costs.
Early on, you issue founder grants if you want, at common stock price, paid in cash. A company is worth $100 in total, so you can buy 10% of it for $10.
Common and preferred can run separately in terms of price (although there's some relationship between the two; more enforced now than in the past.)
After Series A, 1% of the company would be a real amount of money -- maybe a $10mm valuation, so 1% would cost your engineer $100k at hiring. That's a lot of cash for an employee to invest.
Early on, you issue founder grants if you want, at common stock price, paid in cash. A company is worth $100 in total, so you can buy 10% of it for $10.
Common and preferred can run separately in terms of price (although there's some relationship between the two; more enforced now than in the past.)
After Series A, 1% of the company would be a real amount of money -- maybe a $10mm valuation, so 1% would cost your engineer $100k at hiring. That's a lot of cash for an employee to invest.
Taxes. Stock is a capital gain, an option is only potential.
To expand on this, if you give an employee stock rather than options, then they'd have to pay taxes on the stock value. It would suck to pay thousands in taxes for stock that ends up being worth nothing when the startup fails. With stock options, the tax issues are deferred and only come into play if the company succeeds and you want to exercise+sell.
The employee can make an 83b election upon grant, pay for the stock up front, and not get hit with a tax bill upon vest.
If the company is public (either via acquisition or IPO), the company will sell part of your vested stock to cover taxes.
If the company is public (either via acquisition or IPO), the company will sell part of your vested stock to cover taxes.
I think parent is addressing the situation where the company is giving the employee the stock for free, trying to avoid there being an out-of-pocket cost for the employee. In that case, the value paid is 0 and the entire value of the stock is taxable income to the employee. An 83(b) doesn't solve the problem here because it just makes the IRS calculate the spread on the day of the purchase, rather than at the time of each vesting event, but there is still a taxable spread on the day of purchase.
Even with the 83b, you'd still have to pay taxes on the current value. This is practical if the stock still has negligible value (i.e. you joined pre-funding), but otherwise you face being taxed on monopoly money.
My understanding is that you pay taxes not on the current value, but on the difference between the value of the stock and the price you paid for it. It's essentially treated as income.
That's correct. But if you're buying shares at non-negligible value then you're basically an investor at that point. No employee is going to do that.
More likely, the company might give away shares to an employee in lieu of salary, but then the employee has to pay taxes on the value.
In other words, there's no way to obtain stock in a private company without facing some kind of expense. You're either paying money directly for shares, or paying taxes on the gift of shares.
The only way to avoid any of this is:
1) Be there at the very beginning, when shares have negligible value and can be bought easily. OR 2) Be granted stock options instead of real stock.
More likely, the company might give away shares to an employee in lieu of salary, but then the employee has to pay taxes on the value.
In other words, there's no way to obtain stock in a private company without facing some kind of expense. You're either paying money directly for shares, or paying taxes on the gift of shares.
The only way to avoid any of this is:
1) Be there at the very beginning, when shares have negligible value and can be bought easily. OR 2) Be granted stock options instead of real stock.
That's not how an 83b election works. Your grant price is the current value, so your taxable gain is 0 upon election. You only have to come up with the money for the stock. Also, you can make a partial election if you don't have enough to buy all of your stock. Many people mess this up.
Honestly, 4 year vesting schedules give me almost zero incentive to work harder.
The reason is this: These days, founders are more likely to try to make their companies look attractive as acquisition targets than try to grow their businesses long-term. Therefore, except for rare companies with exceptional growth potential, an employee can expect the company to either fail quickly or get acquired. So, rarely do typical startups last 4 years.
Further, since it's up to the board and the acquiring company to trigger full vesting on acquisition, and since boards and acquiring companies have no incentive to do so, most employees are left with much less than 4 years of vested options.
The reason is this: These days, founders are more likely to try to make their companies look attractive as acquisition targets than try to grow their businesses long-term. Therefore, except for rare companies with exceptional growth potential, an employee can expect the company to either fail quickly or get acquired. So, rarely do typical startups last 4 years.
Further, since it's up to the board and the acquiring company to trigger full vesting on acquisition, and since boards and acquiring companies have no incentive to do so, most employees are left with much less than 4 years of vested options.
Any stock option worth anything will take 5-10 years to return. You'll know early on if it fails, but any acquisition within the first couple years won't return much to the rank and file.
generally you would have a double trigger, so as long as you stay with the acquirer you would fully vest over time, which is a fair proposition. depending on the terms of the deal and acquirer's stock you may have no optionality (all cash), some optionality (some stock, but low growth), or a lot more optionality (acquirer has a better growth story). there have been cases from the days of the 2000's bubble where gains post-acquisition were 10x. Much less likely today, but certanly possible.
I feel like this hardly touches on the main issues. It really doesn't matter what % of the company you are given, there are tons of other factors (such as the class of stock) that can effect your future dilution, as well as the value of the options independent of dilution (for instance if there is a right to repurchase your options are worth significantly less because there is a huge risk component added to them). TLDR: it's your responsibility to understand the agreement you are signing. If you can't, you need to give it to someone impartial who does and can advise you.
Also, re: #3 after 90 days (3 months technically) the SEC eliminates many tax benefits you get from your options being classified as ISOs, so while extending the time you have to purchase is helpful, it's not like it's as simple as giving you more time to exercise. Many things change after those 90 days that have nothing to do with your company's policy.
Also, re: #3 after 90 days (3 months technically) the SEC eliminates many tax benefits you get from your options being classified as ISOs, so while extending the time you have to purchase is helpful, it's not like it's as simple as giving you more time to exercise. Many things change after those 90 days that have nothing to do with your company's policy.
Not sure what you mean about class of stock. Almost all employee options are common stock. Good point about repurchase rights. I should probably add a section on that. On the 90 day issue, usually those ISOs are converted to NQSOs after 90 days.
Possible downside to 10/20/30/40: does this make employees less mobile? From the company perspective, if we all start imposing this schedule, it might harm the recruiting pipeline. While startups all want committed employees, to what degree are they depending on the fact that, in the case of success, they can poach heavily from employees that have 1-2 years of tenure at their existing jobs?
Side effects are always important to consider. The "law of unintended consequences" is powerful.
Side effects are always important to consider. The "law of unintended consequences" is powerful.
This may be country-specific, but can options be put in tax-free accounts like TFSAs (Canada), (N)ISAs (UK), or (I think) IRAs (US)? Wouldn't that mitigate the capital gains tax issues?
In the US, with enough foresight, they can be purchased through a Roth IRA, which would prevent any tax from being applied. The (major) caveats are three-fold:
1) The money cannot be touched until retirement. So… if it turns out to be Uber and worth hundreds of millions, you can't touch any of it! It's probably a good idea to only put 25-50% of your stock in the account.
2) You can only contribute a tiny amount yearly to an IRA ($6k I think). So, the options strike price must be dirt-cheap for this to make sense.
3) Actually doing it is quite complex, and requires a third-party account custodian. If you're accepting a random startup offer pre-funding (the only time you'd have essentially free options, allowing #2 above not to be an issue), you're unlikely to go through that trouble.
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The huge benefit, however, is that if you do succeed in hitting in big with something that way, you'll have a gigantic Roth IRA balance, tax-free, and you'll be able to use it to make other investments, whose cost basis and profits will all be tax-free.
https://www.google.com/?q=max+levchin+paypal+roth+ira
1) The money cannot be touched until retirement. So… if it turns out to be Uber and worth hundreds of millions, you can't touch any of it! It's probably a good idea to only put 25-50% of your stock in the account.
2) You can only contribute a tiny amount yearly to an IRA ($6k I think). So, the options strike price must be dirt-cheap for this to make sense.
3) Actually doing it is quite complex, and requires a third-party account custodian. If you're accepting a random startup offer pre-funding (the only time you'd have essentially free options, allowing #2 above not to be an issue), you're unlikely to go through that trouble.
--
The huge benefit, however, is that if you do succeed in hitting in big with something that way, you'll have a gigantic Roth IRA balance, tax-free, and you'll be able to use it to make other investments, whose cost basis and profits will all be tax-free.
https://www.google.com/?q=max+levchin+paypal+roth+ira
Are you talking about a "ROBS" (Rollover As Business Startup) thing? The IRS hates them, but I believe they're technically legal.
I wasn't sure if you could do it with a Roth IRA vs. with a (non-Roth) 401k, though.
I wasn't sure if you could do it with a Roth IRA vs. with a (non-Roth) 401k, though.