In my experience most people at startups who leave end up not exercising their options due to the cost of exercising them coupled with the fact that they may be underpaid due to the assumption that their options may end up quite valuable. So basically they pay somebody 90k/year then give them ~20k/year in options. Then they quit after 2 years and have 90 days to buy like 50k worth of stock at the strike price they were promised.
So they end up paying 50k to buy some common shares (not preferred). An investor who paid 50k to invest in the company most likely got preferred shares, so the young guy who paid 50k who probably can barely afford that is now taking way more risk for a much smaller percentage of the company. If the company goes under the preferred shareholders have a chance to get their money back during a firesale of assets or IP or whatever, but the common shares are screwed.
So I tell virtually everybody unless there is a well established secondary market to sell your shares of your particular company, then don't take the options.
I honestly think the 90 day exercise is totally ludicrous in the startup world. I think that should be a major negotiation point with anybody who is joining a startup. They should just insist on it no matter what.
> I honestly think the 90 day exercise is totally ludicrous in the startup world. I think that should be a major negotiation point with anybody who is joining a startup. They should just insist on it no matter what.
Unfortunately, while the number of options, salary, holiday, etc are relatively easy for a company to change, I think changing the contracts around exercising for a single employee is a change large and complicated enough that companies are unlikely to do it.
Yea I'll have to find some term sheets laying around, but I can't remember seeing the 90 day exercise being explicitly written into most term sheets. I only have seen it written into people's offer letters. Does anybody know where that language would be written actually otherwise? Some sort of bylaws or something -- seems like that could be relatively easily changed to read something like "exercise period of employee stock options is 90 days after termination of employment unless otherwise stated in employee offer letter and should not be greater than 10 years."
It's usually in the underlying option plan I believe. I think the challenge with changing the 90 day window is that you run the risk of the option not qualifying as an ISO. If that's the case, it would instead be classified as a non-qualified stock option and the holder would lose the capital gains benefits and be subject to ordinary income tax (IANAL though, so could be way off base).
This is roughly correct. The 90-day exercise window isn't just something made up out of thin air to handcuff employees and keep them from leaving.
It's explicitly written into the tax code that an option must be exercised within 90 days of leaving a company if the option is to be treated as an ISO. ISOs are arguably more advantageous than NSOs, which is why this is the default.
A workaround is to convert ISOs to NSOs after 90 days. Quora adopted that policy a while ago and a lot of companies followed suit (Square and Pintrest to name a few). Sam A now recommends that approach - http://blog.samaltman.com/employee-equity
That sounds suspect to me. The company I work for gives 90 days + 1 month for every 1 month over a year you work there (so work there 2 years and you have 1 year, 90 days to exercise after leaving).
Do they keep you employed for that month? It's fairly common to extend your termination date for health insurance and visa reasons. If you aren't actually terminated, the 90 days wouldn't have started.
The sentence was slightly hard to parse so you may have missed that you get an extra month for each month you are employed over 1 year. So the stated example of a 2 year tenure gives 1 year and 90 days to purchase the options.
This language appears in your stock option grant agreement (or some other very similarly named document). It's probably about 10 pages. You probably signed one when you received your stock option grant. It's full of legalese so a lot of people don't read it very carefully.
Eh, worked at one where there was a departmental exodus while the company was expected to IPO within the year (and it did). Plenty of people left due to political reasons or after full vest, exercised their options, and made out well. Anecdotes.
> An investor who paid 50k to invest in the company most likely got preferred shares, so the young guy who paid 50k who probably can barely afford that is now taking way more risk for a much smaller percentage of the company.
The common shares cost less than preferred shares as they lack the preferences. So when the employee leaves, her 50K will buy a larger percentage of the company than your hypothetical investor. She may of course still be taking a larger risk as she probably has a smaller asset base than the investor and his customers (err, LPs).
> Then they quit after 2 years and have 90 days to buy like 50k worth of stock at the strike price they were promised.
This is missing the key point of the article which is that there are also taxes to pay, not just the strike price. What you're saying is valid -- even the strike price can be a lot for someone to afford on their way out without any liquidity. But it is very important to understand that it's much worse than that at "successful" startups that have increased in value substantially over those 2 years. You also have to pay AMT (28%) on much of that gain in value, which could end up costing even more than the strike price itself.
To add a counter-anecdote, I left a startup while still having a good amount of faith in the company. Left after finishing work on a couple of their products because I wanted a lifestyle change and had an opportunity to strike out on my own venture. The product was great, but engineering culture was a death march, partially due to the seasonal industry (hardware/toys) and partially due to management.
Oddly enough, a bunch of other engineers also left shortly after -- after all the hard work was done. Company is profitable now due to increased sales, but also cutting salary costs. Strike price was still low when I left, so I bought my options.
Just playing devil's advocate here: So they are leaving because they have low faith in the company, but still expect to be able to collect rewards on other peoples' work years later if the company happens to succeed?
If they didn't have a high degree of confidence in the company, the safe bet would always be to not exercise.
This mentality is dangerous and pernicious. We have vesting schedules for a reason. They'd be reaping the rewards of their past work, not other people's future work.
Curious about this, what "distinction" are you referring to here exactly? My understand is that the whole point of preferred vs. common shares is that there's a distinction: preferred shares get, well, preference in a liquidity event. This ensures investors recoup their losses if things go awry.
We are talking about the exact same distinction and the exact same scenario only from different POVs. To be clear, I'm not at all saying that investors who put up real money for startups shouldn't get preferred stock as compared with employees' common.
What I am saying is that if+when an employee leaves a startup and has say 90 days to buy any accrued options then that employee should utterly pass if they think the company looks at all dicey. If it looks dicey then the distinction between preferred and common is very real and hella pass.
Most startups fail and this employee is leaving that company for some reason. Now if the employee is early and the options are cheap and there's little taxes then maybe it's a lottery ticket. The details are always more complex.
I'm just looking at it from an employee's POV. You're probably looking at it from a VC's POV. Would you voluntarily sign a pay to play agreement late in the game? No. You'd stare cold and hard at the facts on the table. You sure wouldn't throw good money after bad. You should expect the same from a rational employee.
employees don't currently have the transparency to make this objective decision.
founders and board members are very opaque about this information, the prevalence and the covenants of preferred shares.
the state of delaware has created greater transparency requirements for securities holders of private companies. fortuantely it is still trendy for companies to incorporate in that state despite the 55+ distinct jurisdictions under the federal umbrella. unfortunately, employees have found themselves in legal battles with their own companies for attempting to leverage these regulations.
At this point, anybody offering those terms is well-aware it's not in the employee's best interest. And they don't give a shit. I agree, 90 days is totally ridiculous.
A 90-day window might be better for you if you want to stick around at a company for a while and there were other people that came before you, but left. "Dead equity" of startup employees who have left but not exercised means that they can let you do all of the work while they dilute the available equity pool (i.e., take money directly out of your pocket). This a16z article goes into this: http://a16z.com/2016/06/23/options-timing/ (Though I'm not saying I agree 100% with their naturally biased position)
An extended exercise window is not an end-all-be-all solution. Other solutions that don't have the dead equity problem include:
1. Actually pay startup employees reasonable salaries and don't pretend their equity is 100% certain to lead to great riches since it is a risk
2. IRS / Congress could fix tax treatment in this situation, since it is not serving the purpose it was intended to (avoid rich people dodging taxes)
3. Startups actually IPO / get liquid faster instead of contributing to our existing private equity bubble where liquidity events are delayed indefinitely, rendering equity useless. More liquid cash flying around is generally better for everyone as long as it's not a dotcom-era bubble.
Employees have just as much of a responsibility to learn this stuff as their employers do to act generally ethically. They're your employer, not your parents.
"Dead equity" could also be used in reference to most of a company's investors.
That is of course, tongue in cheek. Why should employees have their investment of time and energy taken away from them when investors' one-time cash investment earns preference? Another industry double-standard.
It's not really a double standard. A share of stock and an option to buy such share of stock are two distinct products, priced differently.
E.g. MSFT share price today is $64.27, a contract allowing you to buy a share of MSFT on March 17, 2017 for $64 is 83c.
Investors buy their shares in full, cash-on-delivery, so to speak. Would investors like to be able to buy call options in the companies at pre-specified valuations for just 1.5% of the price and complete freedom to exercise (as well as forfeit) those options four years down the road? You betcha.
Not only do they need to pay significantly less to participate, they can spread those bets around and cover roughly 60x more companies, if they choose. Or double or triple down on this one specific company. Or just sell their option down the road in case it's the next FB or Uber without ever needing to put up cash.
Both investors and employees get to buy their shares for cash. Employees though do get the luxury of time, and can not only benefit immensely from stock's rise, but also save their hard-earned money in case of a dud. Investors do not get the latter option. Therefore they seek compensation elsewhere, usually in the liquidation preference department (which is moot anyways if the liquidation value is $0).
I don't think you're really justifying why employees and investors ought to have different terms. To the extend that investors need extra compensation, they can always be compensated with additional shares, regardless of those shares' terms.
I think in an ideal world, investors would normally receive common stock (and more of it), but there are some practical reasons why that isn't the case:
- Selling preferred stock lets a company declare a more lofty valuation.
- If a company sold common stock to investors, they'd have to use the more realistic fundraising valuation when pricing options, rather than a (typically) more conservative 409a price.
- Employees tend to not have access to the cap table, or not understand it, so there's not much disadvantage to giving them less favorable terms.
The basic reason that investor capital has a liquidation preference is that if it didn't, the founders could raise $X million on day N, then since they hold the majority of voting rights, declare bankruptcy on day N+1, and split the majority of the invested capital among each other.
There are ways around this, such as giving the investor a veto on bankruptcies and reorganizations, but the time-honored solution is a 1x liquidation preference where the investor gets their capital back in a bankruptcy.
I'd go with Occam's razor on this - investors always want preferred, the more preferences the merrier, companies always want to sell common, and if they could go sub-common (by stripping the shares of voting rights or dividend participation) they would.
Whoever has the most leverage in the transaction tends to win.
Yeah, but you still have to buy the shares at strike price. So not only are you getting paid below market rate, but you have to spend some of that pay exercise cost and taxes to have proper equity. So it's not so simple.
What did you mean then by "much prefer to have shares over options"? I assumed this implied equal footing with the investors, and shares distributed in exchange for the check. If you have the means and are willing to tolerate the risk, shares are a better deal. If at least one of those components is missing, call options are a better deal.
Because the investors' cash is the thing that enables high growth companies to survive and be, well, high growth (who do you think pays said employees' salaries?). Not saying they don't often make out much better than employees, but no one forces you to accept a term sheet you don't want to, and you should understand the implications of the equity you're getting walking in.
That's possibly the most bullshit argument I've ever heard.
Any founder will tell you employees are more important than investors. It's possible to build a successful company without VC—it's impossible to build one without quality employees.
I don't buy that argument for a second. The employees actual work, causing the startup to be able to actually do something or sell something, is what allows the company to survive.
IMO there's no point in arguing about the relative importance of investors versus employees, because everyone should be in favor of more flexible equity terms.
The 90 day rule creates a lot of risk for employees who lack the capital for early exercise. If employees are rational and well-informed, they'll heavily discount the value of any options with a 90 day expiration. By offering more flexible terms (like Quora's), companies should be able to hire the same candidates while giving away less equity.
Granted, some employees don't ask about the equity terms in their offers, or don't carefully consider the risks. But I think this is improving, and eventually more flexible terms will become standard. I've personally declined a few offers based on the equity terms.
Employees are effectively making an investment in the company in the form of work instead of cash. If a startup chose not to give out stock options, they'd likely have to pay their employees more, and they may have to raise another round to get cash to do so. The dilution from that round would never come back to the original stockholders under any circumstances.
When employees accepted the options in lieu of cash, they were taking a risk in exchange for a potential future reward. The work they put in often makes that success happen, whether or not they're actually working for the company at the time a liquidation event occurs.
I liken the scheme a16z proposes to something like using a loophole to buy back all of your investors' stock at their original valuation, just because you got to profitability. At that point you no longer _need_ their money, so why do investors deserve to reap the rewards?
This a16z article states that some options not returning to option pool is a bad thing, because option pool has to be extended faster than expected. As I read it, this means that some employees granted stock options are expected not to exercise, or in other words, option pools are overcommitted (more options are scheduled than expected to be excercised).
To my mind, this is a very dangerous mindset, driving actual option value even lower, because for every 100 options vested, only say 90 are expected to be exercised, meaning that upon liquidity event options are expected to be diluted to at least 90% of their value. Amount of options offered therefore must be discounted for this. Sadly a prospective employee has no idea what is the expected option pool commit ratio adding one more variable to the equation and tipping the scales towards hard cash compensation.
"Dead Equity" has some advantages as well. You align the long-term incentives of the company with those of employees who are moving on earlier. If you know that you'll never have to deal with a scaling issue, why would you spend the effort dealing with it? Getting employees invested in long-term outcomes helps with principle-agent problems like this, which can help company performance more than the cost of "Dead Equity".
I see your point but don't really agree with your argument -- in my experience engineers who consciously know what a good or a bad engineering decision for the future is will make the good decisions regardless -- it's the terrible engineers who don't know any better you need to worry about.
In either case, given an extended exercise window both are sitting around collecting value indefinitely after leaving. They don't need to contribute anything to the next "generation" of work but they still collect the rewards. I'd expect that in most high-growth companies the impact of individual contributors quickly gets washed away after they leave.
If you think that former early employees don't contribute to future "generations" of work, then the ethical thing to do is to offer better cash compensations and less equity. It's not really ethical to offer equity compensation that looks like it could be valuable but has significant hidden barriers to actually being used.
> the ethical thing to do is to offer better cash compensations and less equity
That's one of my main points: Employees have the power to refuse employers that offer equity in lieu of fair salary. But my experience has been that people keep falling for the equity carrot again and again, and as long as they keep falling for it, employers will keep doing it.
>I'd expect that in most high-growth companies the impact of individual contributors quickly gets washed away after they leave
I'd argue it's the opposite. Early employees often have an outsized impact on the trajectory of a company and get it to a point where additional hiring is possible. Future generations of workers tend to iterate on the existing (unless there's a significant pivot) and come on board in a more de-risked situation often with salaries much closer to market.
Most start-ups also present equity as a form of compensation for work performed (trading cash for illiquid options). To take away that earned and vested compensation component because an employee doesn't have the money to exercise within the 90 day is not only arbitrarily absurd but also grossly unfair in my opinion.
> Early employees often have an outsized impact on the trajectory of a company
Mmm... I think we'll have to agree to disagree there... Seems to me that the bulk of the work adding value in a company, even if it's "just maintenance", is in the marathon and not the sprint. The initial engineers who contributed to Google Search no doubt contributed value but it's the folks who kept it going strong (and changing for the better) for many years afterwards that are the real company heroes.
And if someone is really such a special snowflake, I don't see why they'd bother working for someone else instead of founding their own company. If they expect to get paid proportionally that is.
> get it to a point where additional hiring is possible
Usually investors do this by injecting cash, at least in your traditional high growth "startup".
> To take away that earned and vested compensation ... is ... grossly unfair
How is it unfair if the employee agrees to the terms walking in?
If Joe Vendor down the street sells something to you at a loss, do you feel bad about buying it anyway? Likely not, since he happily signed it over to you for a reduced price.
If a company really believes that, they're free to back-load their grants and vesting. The reason they generally don't do this is because "dead equity" isn't a real problem. I'm nearly certain most employee options go unexercised. For one thing, most employees don't vest their full grant before they move on. And those that do often can't afford to buy it anyway.
The one exception might be the handful of employees that joined before the first big round, who might still be able to exercise at a negligible strike price. Again, I don't think it's a real problem in the grand scheme of things.
Good point. My thought is that to compensate the people who stick around you have to combine two things: 1) vesting period (already happening for virtually everybody), and 2) a predefined plan to give people increasing amount of options for staying longer. So basically get 20k options in year 1, 30k options in year 2, 50 options in year 3, 70k options in year 4, or something like that.. so if you leave after 1 year and have the 10 year vesting period, you end up missing out on multiple option granting periods. The dead equity often is a small portion of around 10-15% of total equity in the company. So assuming that there are maybe 5 employees floating out there in the wild with this "dead equity", they probably are comprising a tiny portion of the equity in the company -- most likely around 1% of the company equity max. If that 1% of dead equity is having any kind of real effect on the companies day to day situation or ability to raise funding, I would be thinking the company is in some serious shit.. Yea definitely agree with the IRS trying to fix this. Think of it this way, in one case the founders get a ton of money during the IPO event. They have tons of resources and time to figure out how to avoid paying as much taxes as possible. Versus if you have a ton of people who now get relatively large payouts of stock options worth say 300k or so, those people will likely end up paying 20-30% tax or more on that since they have less ways they can try to reclassify the capital gains -- and maybe will just opt to sell everything short term and pay maximum capital gains. But the rich guy who just did the IPO is like, "eh, I already got like 10 million in the bank, so lets see.. if I just say that my stock is worth 0.1 cents per share, then put into my Roth IRA, then I can cash it out in 20 years with a 1 million X gain with no taxes.."
"A 90-day window might be better for you if you want to stick around at a company for a while"
I don't know many people that go into a job not wanting to stick around for a while. But that's at the beginning of the relationship, when everything is rosy. After the honeymoon, if it turns out that the company is toxic, things change.
"They're your employer, not your parents."
This statement makes no sense. That doesn't mean they aren't obligated to act ethically.
I can't help but feel the system is highly rigged in favour of investors.
Many countries have tax incentives for investors, but when it comes to people actually joining startups, investing their time and effort, then all you get is a tax bill - and mostly at a highly inconvenient time to pay it!
It very much feels like the system is designed to keep the rich rich, and to put the working (wo)man in their place.
Our perspective depends on the relative value/scarcity of capital.
If capital is scarce and valuable, it makes sense for a system to be designed to reward and protect capital risk.
But the "standard terms" haven't changed much since the 80's and capital is definitely more abundant today than it was before. Valuations for early companies are ~10x what they used to be decades ago. Founders give up a fraction of ownership compared to what they used to.
The question is where the right balance point is given current parameters.
Also, wages have never been higher for tech employees. I'm happy to have a 2x wage level conspared to 15 years ago rather than have the same wage but 2x equity (obviously a simplification), so something's at least working well here wrt labor gaining some ground on capital.
There are two different things going on here though - one is whether we offer incentives for investors.
The other is how the tax system works when people receive options / equity.
The problem with 'receiving' equity is that 1) Current laws treat equity as if it was cash - but it's not. 2) Whether employees should be compensated and recognised for their potential opportunity costs - essentially given a similar deal to investors.
Keep in mind that many startups will offer equity in lieu of the salary that they would otherwise command.
Also, if you're offered a significant portion of equity in a startup, then taxes currently make a large disincentive for people to accept and join the startup.
on 2) I think if investors are rewarded for the risk they take, then other stock holders should also be rewarded for the opportunity cost they've sacrificed. So specifically, in terms of 'a similar deal' I'm talking about tax incentives.
At the very least, I think tax shouldn't apply until you cash out - this just makes sense.
Perhaps the system could also offer a tax incentive for lower returns for non-investor shareholders to recognise sacrificed opportunity cost as well.
Some countries let you pay taxes on liquidation, others demand to be paid on receiving something, despite it being impossible to liquidate. The USA is the second kind of country with AMT, and that is the fundamental problem.
The US is probably the worst in this respect, and I heard Canada is quite bad, but most of European tax systems follow the "pay taxes only when money comes your way" principle, which puts all investors on equal footing.
On the other hand, if you are lucky enough to work somewhere in the UK that grants options, those options are likely void the moment you leave the company so this entire discussion wouldn't even take place.
I've been granted options twice, both times essentially designed to stop people leaving during a rough period. Given how few UK startups float it wasn't much of an incentive!
That doesn't sound right. It should be when you exercise the options or when you sell the stocks:
> Basic taxation of stock options depends on whether they are qualified stocks or unqualified stocks. The qualified stock option is not subject to Japanese income tax until it is sold, on the other hand the unqualified stock option is subject to Japanese income tax when it is exercised and sold.
Taxes on income (share value - option strike price) become owing on option exercise.
If the company is not a CCPC (Canadian-controlled private corporation) and the option strike price was less than the share value at grant-time, you may qualify for a 50% deduction (bringing it in line with capital gains), subject to some conditions (arms-length dealing, etc).
If the company is a CCPC, you can defer the taxes until the shares are sold. If sold within 2 years, you pay full income tax. If sold after 2 years of holding, a 50% deduction applies bringing it in line with capital gains. CCPC status of options are grandfathered in so if the company loses CCPC status (e.g. bringing in US investors), your options continue to qualify.
Keep in mind that going bankrupt/company sale are forced sales of your shares, which could hit you with a big tax bill and since that tax bill is income (not cap gains), the capital losses of the sale cannot be used to offset it! If you find yourself in this position, you should contact the CRA. They have forgiven these kinds of errors in the past (Nortel employees, JDS Uniphase) with a special treatment of the gains/losses. No guarantees though.
CCPC employees should also look at the lifetime capital gains exemption (LCGE) of $750000 to reduce taxes on the capital gains following exercise, and the allowable business investment loss (ABIL) which can be used to halve the tax owing in the downside case. In theory, the 50% deductions mentioned above and the ABIL stack to reduce the tax owed to 0. The ABIL can only be claimed if the company is a CCPC when it is wound up; so it's possible to lose the ability to claim the ABIL if e.g. US investors come on board later and get a majority of the company.
All these rules make perfect sense assuming there is easy liquidity, but it's a mess for illiquid shares.
The main trap I'm aware of is that exercising a stock option is considered employment income of the difference between strike and exercise price, but selling shares is considered capital gains/losses on the change in value.
So, if you exercise some options, it'll trigger a tax bill on the income. No problem, at tax time you can either pay cash or sell shares to cover. But if in the meantime the company tanks and the stock drops to zero, that's capital losses and doesn't cancel out the tax bill on the income.
Basically you want to exercise only when you're able to sell right away.
After working at 4 different startups over the past 10 years I can tell you with a very high certainty that the only people who will make much $$$ from options are founders and investors.
Early Employees generally are shafted. Don't think your 20-200 basis points will be worth anything at the end of it. Make a decent salary and avoid companies that work you to death. Take it as a learning experience and look at the options as pure monopoly money.
EVERYTHING is skewed towards founders and investors.
Do you have voice and power in future negotiations about the direction and equity breakdown of the company? If so, the promises are worth something. If not, they likely are only worth enough to convince you to not sue about it, because that's what the actual incentives are in future capital negotiations.
Stock options are not complicated. Most people who look into the details of them will find them very plain and actually quite simple. The issue is you don't often deal with this area of finance so it looks foreign until you spend some time looking into the terms.
Your options are a contract between you and the company for you to buy shares at a given price.
If the value of the shares is worth more then you pay, the difference is income. "Value" is a 409a valuation ask your CFO what it when you execute.
Enter the accountant who will tell you how much your liability is for that income ( it varies no more then a dozen other factors affecting your yearly taxes )
Your shares are illiquid, and likely worthless. VC's and other institutional investors have contracts with the company that means they will get paid well before and much better then you. This should really be the first point since you should have known this when accepting your compensation package.
> If the value of the shares is worth more then you pay, the difference is income.
This turns out to be true, but I think it overlooks hidden complexity.
1) You'll find a bunch of stuff online that says you don't have to pay tax on that difference if you're getting ISOs. Options newbies who believe that ISOs have no tax burden, newbies who don't know that AMT is a thing, are going to have a bad time.
2) Since AMT is a thing, it's difficult ("complex") to use options safely, if only in the sense that it requires making a prediction about the future. Exercise early and you could lose your investment if the company fails. Exercise late but pre-IPO and you can find yourself in huge trouble, on the hook for hundreds of thousands in taxes with no way to sell your stock to pay your taxes. If you exercise post-IPO and sell on day one and you'll more tax than you would if you hold for a year. Making the right choice here can be difficult.
Agreed. Takes maybe a few hours to understand the terms.
BUT, most technical folks are very uninformed about investing and finance in general. Many brilliant engineers at my previous employers were utterly confused about their options as well as their decision making after IPO.
So I think the difficulty also stems from a lack of development in financial acumen generally.
+1 for development of financial acumen. We can often point to people taking out 18% APY car loans, or going to Payday loan vendors and say how silly they are for not understanding finance, but we turn a blind eye when its the finance that effects us ( even though one could argue that compounding interest on a payday loan is probably more complex then your basic stock option grant )
Just a bit off topic: I'm from Brazil, working as a contractor for a company in the US. They offered me stock options and I'm totally lost about this. Not only because this isn't normal in Brazil, but, the majority of the articles in the wild only focus in the US scene. I want to know more about how this works when you're not in the same country as the company. Will I be double taxed (in US and Brazil)? On what rules I'll be able to exercise my options?
Regarding stock options expiring 3 months after leaving the company, it doesn't have to be this way and a lot of startups are moving in the direction of 10 year exercise periods.
As somebody who has personally experienced every aspect of the stock option lifecycle (which fortunately worked out for me), I would never take a job at a company [1] if they didn't have an extended exercise window. The 90 day expiration period creates a massive gap between the risk/reward of equity for founders and the risk/reward of equity for employees, when the whole point of giving equity is to align those.
1: Assuming it was the type of company that compensated people with stock options
I'm not sure about "a lot of startups", I'm personally only aware of a very few that are doing this. Word on the street that I hear is that maaaaybe your current employer might do this for employees they like, but not as a consistent policy. Many board members, founders, etc... feel they will take a retention hit if they were to implement something like this.
I personally think the status quo is insane, and I will never take another role with a options component of the package that does not have a policy like this.
Good for you all (not sarcastic!) but as someone who did a job search recently, the number of startups that offer this is much much closer to 0% than 100%.
A late edit: and you will get pushback for even asking. Apparently we're all supposed to pretend that we're never going to leave the company / we owe them our undying loyalty. I've previously taken the honest route when asked why I was leaving a job and said the ceo didn't deliver on her promises (growth, revenue), so why would I stay? That approach does not necessarily work well =P
> Apparently we're all supposed to pretend that we're never going to leave the company / we owe them our undying loyalty. I've previously taken the honest route when asked why I was leaving a job and said the ceo didn't deliver on her promises (growth, revenue), so why would I stay?
I mean, part of getting promoted and learning how to rise politically in your career is learning how to lie.
Why did you expect honesty to work? You have to learn how to play the game, say the right things that people want to hear.
Oh I know there are more than a few these days. My point was the majority of startups I'm aware of are still very hesitant to do this. From the conversations I've had its less that the founders of these firms are morally opposed to the idea, but that their VCs really don't like the idea as a global policy.
> Regarding stock options expiring 3 months after leaving the company, it doesn't have to be this way and a lot of startups are moving in the direction of 10 year exercise periods.
This requires converting all options to NSOs, and the tax implications of NSOs are not pretty. (From a tax perspective, ISOs aren't great[0], but they're much better for employees, by design).
[0] You have to pay AMT on the spread between the option price and current value at the time you exercise, whether or not the equity is liquid, so you could end up paying a large tax bill only to find that the company goes bankrupt before you have the opportunity to ever sell your equity.
The kicker here is that the option life is 10 years, even if you have left the company. So you can avoid tax by not exercising until you plan to sell. It becomes a personal choice between 1) do i want the option still, even if i quit, and 2) do i plan to have ownership in the company for a period longer than a year before i sell. Typically most people would prefer 1 over 2.
Keep in mind for someone reading this comment, this is about private companies.
The other thing to keep in mind is that stock options (especially those given to employees) tend to be much less protected than shares.
If you exercised, and another shareholder got unfair preferential treatment, you have reason to seek compensation or sue. If you haven't exercised yet, .... well ... not so much.
Also, many option contracts give you the right to buy X shares at price Y and do not make special consideration for stock splits - e.g. a 2:1 split would likely make your options worthless by halving the share price, and by halving the percentage of the company that X represents.
So, waiting to exercise until you sell is a very good strategy, except when it isn't - not very common, but you rarely get notified about these issues beforehand, especially if you are no longer involved with the company.
What are the tax implications of NSOs?
ISOs are a pretty huge gamble, basically a lotto ticket, if you leave before a liquidity event occurs or is known to be on the near horizon.
Have any startups with 10 year exercise periods had a liquidity event yet? I'm genuinely interested to see how true to the idea they were, or whether they (eg) issued a bunch of new stock to current employees that diluted vested ex-employees.
Some companies allow their employees to sell a portion of vested stocks whenever they're doing a new round. SpaceX is one of the top examples I know of. This is how they retain the top talent.
What is the general view on this? I don't have an economics background, but.. Well, the 'startup scene' isn't necessarily mature and/or tested enough for employees to be able to take a 10 year risk. In a sense, for a failing startup, stock options might as well be monopoly money.
It's not really a 10 year risk, as you keep the options that have vested whether or not you're still with the company. And if the startup fails, if you haven't exercised, you shouldn't be out any money.
AMT and the 90 day limit on exercising after leaving a company are the main things that make options painful. There has been some movement in the industry to get away from the 90 day limit (by converting from ISOs to NSOs), but has there been any recent attempts to get the AMT rules changed for ISOs? Does anyone think the current AMT rules for stock options are fair? I'm curious how this is viewed by people outside the industry.
Most people think AMT is a badly thought out disaster, but it brings in too much tax revenue and effects the upper middle class, so there isn't much sympathy / political capital for it. AMT also ignores state income tax deductions, which is pretty screwed up!
I think ironically to the bubble many of us live in the Silicon Valley, this was proposed by a Republican and passed in the House. Never made it in the Senate. A refreshing reminder good ideas still come from all slices of our political spectrum.
Everyone hates the AMT; very roughly Democrats think it's a broken tool for addressing a real problem, and Republicans see the problem it addresses as a good thing.
I'm curious how ISOs can be abused without the existence of AMT (which gets at the same question from a different angle). Maybe for executive compensation?
This is great write up. Kudos to the author for taking the time. I did have a question about the following sentence:
>"If an employer gives you straight-up shares, then the IRS will tax the shares (at ordinary income rates) when they vest."
What would be treated as income and taxes here, the strike price x the number of options vesting? Is that correct? For regular worker bees this not very much though right? For instance say an employee has 25 shares vest in a quarter and their stick price is $20. 20 x 25 would be $500 more being taxes as income. Or am I completely not understanding something?
If it is not the strike price being taxes as income what is it, since the the value of an option is often unknown to rank and file employees let alone the IRS.
Shares vested x fair market value at vest. So you get 1000 shares when you join, worth $1/share. 250 vest on your first year, and that's when tax is due. But say the company grows and shares are $5/share. 5x250 is 1250 taxed income on the anniversary. Normally at early stages you're talking many thousands of shares though, that can increase rapidly.
The fmv is recalculated every year, or on any fundraise events. It needs to be a defensible number or the irs will be upset
>"The fmv is recalculated every year, or on any fundraise events."
This is the piece I was missing. Thank you for the clear explanation.
That being said it would be interesting to buy exercise them just to see what the company is actually valuing those options at, since this is often opaque to the average worker. I wonder if it's possible to exercise a single option and use it as a barometer of sorts to quantify you actual compensation? My guess is no.
I've never had a company refuse to give me the 409a valuation if I asked point blank for it(just say you're considering exercising and it's important for tax planning). It's important to keep in mind though they tend to purposely depress that value. But investors get a premium because their stock has legitimately more value than yours(liquidation preferences, board seats, etc). And without a liquid market, if you do sell privately you end up taking a large discount. I think the opacity is largely that it's difficult to value things, not so much nefariousness
I see, I guess you just need to know to ask for it. I imagine many(most?) do not. I find these discussions and these types of articles really helpful. I would like to think we are all becoming more savvy about these a result. Thanks for the tip.
But you can frontload all the "income" and taxes upfront. That's what an 83(b) election is: "Hi IRS, I'd like to pay/recognize this taxable event all right now, even before it vests".
So you get 1000 shares x $1/share = $1000 of income, and you pay taxes on it.
If they are options, and your company allows you to exercise early, then you can buy them and pay $1000 to convert to restricted stock, file an 83(b), and it's $0 in taxes as theres no gain. If they are just restricted stock(not to be confused with RSU) then you can 83(b) like you said. But any way you do it, including holding options, has a bunch of risk so every situation is unique.
Stock options are definitely complicated, but so are your taxes. In fact, your taxes are much more complicated. However, there exist reasonably good software tools, eg TurboTax, to represent your taxes as a decision tree, and to walk you through it.
The problem isn't really that stock options are complex -- it's that there doesn't exist comparably good software for stock options.
I'm actually building software to solve this: http://www.optionvalue.io. Right now it covers value in exit scenarios, but am currently building out exercise / tax scenarios.
This doesn't mention transfer restrictions at all, and that's an altogether different reason that options are complicated. It's a bad idea to assume that you'll be able to sell private company shares, even if the company is popular and you've heard of other people selling. The existence of a market for the shares doesn't guarantee that you'll be allowed to get rid of them, because the company can enforce all manner of restrictions on sales.
The market for stock in a private company tends to be very small. Existing investors and prospective investors in the company can comprise most or all of it. Those folks care more about relationships with the company than getting their hands on a handful of employee shares. What this means practically is that if the company doesn't want you to sell for any reason, the buyers won't cooperate with you either.
If you're planning on selling, you should feel comfortable communicating this to the company. And they should agree to it. And that assent should be very recent and in writing.
You can find startups out there willing to buy derivatives on your exercised shares, which is functionally similar to selling shares. But this is a mixed bag, and you should read those terms carefully.
Read your option agreement. You'll note that among other things, it says that the agreement can be amended by the company at any time to say anything at all. Good luck!
> Read your option agreement. You'll note that among other things, it says that the agreement can be amended by the company at any time to say anything at all. Good luck!
That is likely not actually usable because there may be no consideration [1].
I (respectfully) disagree entirely with this conclusion.
If you want to do analysis like this, you need to weight these numbers against the possibility of it happening to get the expected value of each column. You have also simplified the smaller exit values to not include investor preferences (which means investors are first in line to get money, founders second, employees dead last).
Additionally, most contracts do not allow for early exercise so lots of these ideas are moot. If you do not have early exercise in your contract and you leave the company it's usually a leading indicator of failure. Either the company laid you off to reduce burn (do not under any circumstances buy stock if you have been laid off), or you left the company for a moral/business/whatever reason. In the latter case, it seems unwise to put your money where your heart isn't.
If you are optimizing your life for the best chance of striking it rich do not be a startup employee. Be a founder. Better yet, be an investor.
There are lots of reasons to be a startup employee, but being in it for the options is not one of them. Treat them as worth $0 and negotiate for more cash or things you care about like vacation or part time hours.
I meant to write founders and employees. Not founders and investors. Sorry. Not sure I screwed that up. The screwup made my statement completely wrong.
Investors, as you helpfully point out, generally have preferred stock with liquidation preferences and hence are "first in line."
In case you're holding stock options of a US company but need to pay your taxes in Germany I can highly recommend this article (in german): http://www.pinkernell.de/esop.htm
Serious question: why does the IRS insist on valuing private company stock on the basis of a 409a valuation without taking into account whether a market for it even exists? The 409a is paid for by the company which (as the article mentioned) has an interest in keeping it lower. And holders of common stock in private companies, in most cases, can't actually liquidate their holdings (leaving apart cases like pre-IPO Facebook which traded in secondary markets). So the stock is effectively worthless no matter what the 409a says. There shouldn't be tax due until there's a liquidation event that allows shares to be sold.
Stock options and private stock are taken in the hope that they'll be worth something someday, not because they're necessarily worth anything at present.
It's all well and good to say "X is the fair market value of this stock based on factors y, z and a"* . But when no market exists (or severely restricted ones where sellers have to take a loss) then that value is not relevant (or should be discounted appropriately).
* I tried looking up (briefly) whether the absence or presence of a market for the company's stock is taken into account for a 409a valuation but couldn't find anything.
The recommendation to immediately transform your options to shares and sell them is the exception rather than the rule. In this context, it is assumed that options are very illiquid.
But in general, if you want to recover as much as you can, you should sell your options directly. That is why the value of an American and a European option tends to be the same.
I'm getting into trading options but I don't work for an employer who grants them to me.
I'm curious, can you sell your options without exercising them or are the kinds of options you get from an employer not the kind of options you buy from an exchange?
The two types of options are similar in that they have the same general terms. However, you cannot sell your ISOs on the CBOE, because they differ in details, the most important one being that the exchanges only trade in options for publicly traded companies.
That doesn't mean you can't sell your ISOs to someone else; there just isn't a marketplace for it.
I still think start-ups should offer the equity, it helps motivation and retention. But also offering a well-defined bonus program would give a lot of the benefits to employees while not having to pay out as much in equity. Then employees are getting the benefits of the company doing well even if their stocks are still effectively worthless.
So they end up paying 50k to buy some common shares (not preferred). An investor who paid 50k to invest in the company most likely got preferred shares, so the young guy who paid 50k who probably can barely afford that is now taking way more risk for a much smaller percentage of the company. If the company goes under the preferred shareholders have a chance to get their money back during a firesale of assets or IP or whatever, but the common shares are screwed.
So I tell virtually everybody unless there is a well established secondary market to sell your shares of your particular company, then don't take the options.
I honestly think the 90 day exercise is totally ludicrous in the startup world. I think that should be a major negotiation point with anybody who is joining a startup. They should just insist on it no matter what.