Fixing the Inequity of Startup Equity
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For 30(?) years since the invention of stock options there has also been a de facto added protection against high turnover in infancy-stage startups, where having to rehire and retrain employees is extremely costly. Pre-IPO you basically had to pick a team and take it to that level of maturity before you could leave. You couldn't hop around seed-level startups without giving up your options, usually.
What's changed now is startups are staying private longer, leading to unfair scenarios. E.g. you're at a >$1B company with >100 employees for 6 years and you still lose your options. Traditionally a company would have gone public by that time, but now it's not, so we need a fix.
But if you overcorrect and now eliminate that added protections for younger startups, you risk creating an incentive to leave companies just for the sake of options portfolio diversification. Why bet on one team when you can bet on three, since even 1/3rd of a unicorn that makes it is worth more than 100% of the one that doesn't. And that individual decision leads to higher turnover which can kill infant startups.
Bottom line this fix should be more carefully targeted at what has changed to exacerbate unfair situations, namely startups that have reached "should be public" levels of maturity, yet are still staying private.
Options usually have cliffs in the first year and vest monthly. So no-one would get more than they deserve.
Why should any of us care about that? High turnover is a very good signal that the company is a bad one. If the company dies because of it, it was probably for a good reason.
You just want to leverage golden handcuffs to retain employees... I think honesty all around is the best method. Unfortunately, that further devalues the (already low imo / in my advice) value of options and suggests people are much better off going to established companies.
However if you change it so that early stage employees can take their options with them, then it becomes a question of "do I triple down on this one company or do I spread myself out over three." And most investment advisors will tell you to diversify your portfolio. So there is a real risk that this will lead to high turnover, even among happy employees.
Because it's early stage, even just one year's vesting is enough to get you rich if the company makes it. So do you stay and triple down on one stock or spread it out? Especially when equity is such a large component of your compensation at that stage of company? Investment diversification is a rational economic decision that a lot of smart people will make.
The current system forces teams to stick together until IPO/acquisition, maximizing the chances of the options ever being worth something. It should be made more explicit, but it's not necessarily a bad thing (for employee options holders who want them to be worth something).
I can't do something like that due to immigration, but I envy the flexibility.
And quite frankly, you're basically saying that the company should not have to compete for employees. Which is such an absolute shit of an opinion that I can't even begin to tell you why.
(Your latter comment makes no sense.)
Would you feel okay with an employment contract like this: "Your salary is $150k, but if you leave in less than ten years there will be a fee of $50k/yr."
That'll lock them to the company, too, and prevent turnover.
However I agree founders should be up front about the financial/investor makeup of the company.
I assume that the options are intended for people that are bad at math.
It does appear to be a way to get employees for cheaper than market rates by taking advantage of an arbitrage in employee lack of understand of the financial and legal issues concerning stocks.
Basically build in a big "you stayed until the end" equity bonus.
Right now I think the problem is that people think of their vesting schedule as when their stock becomes theirs and that's not really true. And most startups encourage (or at least do not dissuade) this illusion. That's a problem worth fixing.
Sam was in the room and added that he is "revising" his recommendation because "there needs to be more incentive to stay." (@26:00)
I personally haven't seen Sam post about his revised position. Would be great if he did.
[1] http://www.bhorowitz.com/one_management_concept_from_how_to_...
I think structural changes are necessary.
Ben's strongest point is in asking "Why now?" Options have been this way since the 80s. What's changed? Nobody is examining that as closely as they should. Maybe most of us are young and hubristic and tend to discount the past. But as engineers we should all possess a certain conservatism, a healthy skepticism to changing systems that have been stable for a long time. We must look closely to ensure there are no unintended consequences.
I think it is very notable that Sam Altman said he has revised his position to require stronger incentives to stay. Early stage startups need incentives to stick together as a team. If you don't have any extra protections at the earliest stage, then you're going to have smart, happy employees face the powerful economic logic of leaving to diversify their options portfolio. And that's not good for the value of anyone's options.
As I tend to do when encountering smart folks. :)
Agreed on all counts btw.
The same argument could be applied to the way VCs used to do business with founders (with respect to tactics, terms sheets, etc). Arguably, that was stable for a long time too (but seems to have changed in recent years). It's just a reformulation of "We've always done it this way".
No, and there shouldn't be. Any company that has high turnover usually deserves it.
For example, I was a jr. engineer at a stage A $5 million startup with ~%0.4 of the company in stock options. When it reached its $1 billion valuation 4 years later, my options with dilution were worth x25. But $500k/4 years is $125k/yr, which is pretty close to the stock compensation working at google. But these options were not cash equivalent like google's stock, and I had to drop it all on the floor because of the 90 day window. I lost $500k in compensation because I decided to work at the startup vs. google.
Imagine if your employees had a good amount of savings and could easily afford the $10-20k it costs to pre-exercise their options in your infant stage startup. Then these rules are pretty moot. It takes advantage of people who don't have the money to pre-exercise options, who tend to be younger people.
Also it's unfair, investors can diversify their income sources, while employees cannot.
You should be able to:
1) Get a loan from somebody who wants in on the startup to exercise the option.
2) Exercise option.
3) If company decides to buy back option via first right of refusal you return the loan plus a nominal increase and you pocket the difference in valuation between rounds minus the loan fee. If the company lets you sell it to the person than they get the equity in return for their early payment.
Do most stock grants disallow this transaction? Or is there not much of a market for these sort of third party buyers?
You also have to get a lot of paperwork together, that you usually don't have and it can take months as the company drags it's feet in giving it to you. There wasn't paperwork preventing this at the company I was at.
If anyone is thinking about a startup offer, I would suggest getting equityzen's documentation checklist upfront. It can take longer than you think, and a few months later, people who were interested in buying might not be anymore.
I was trying this a little less than a year ago, so it isn't as correlated to the current issues today.
Also I would try to get the stock paperwork agreement that they will have you sign for your options. Very surprisingly, for even some big superstars today it is very hard to get this from them until you start working for them. There can be hidden gotchas like after exercise stock buyback options at the current FMV. Or restrictions that even stop you from doing things like ESO fund.
I have to say that's a heck of a lot of dilution, too. 200x growth in valuation vs. only 25x in your stake? What's that, over 85% dilution?? Sounds like that juicy unicorn valuation was only achieved by a lot of fundraising rounds under presumably not awesome terms. Not that that makes you feel any better.
I'm thinking there should be some kind of extra incentive for early stage teams to stick together, but with a more explicit maturity point. It used to be IPO/acquisition. Now that IPO is often farther off there should probably be some other metrics. What are they? Valuation? Number of employees? Length of employment? Revenues? Some combination?
US startup stock options push the tax externality to their employees. In somewhere like canada, your tax bill is due at liquidation, not at the purchase of options. It makes a lot more of this problem go away. For most early stage employees that do well in a tax scheme like canada's then paying $20k for stock in a large valuation company isn't nearly as painful as paying $20k + $100k in AMT tax.
I think that would probably be reasonable for most angel investment and stage A teams. It isn't a stretch for the company to pay an extra $10-30k for a stock transaction where %60 of it cycles back to them anyway for a total of $4k-12k of a tax bill.
Also another way to value the stock to give to early employees is to treat them as investors investing the $500k+ or whatever equivalent they are giving up for 4 years and giving them that as their stock where you foot the tax bill. Also giving them the same visibility and protections that those equivalent angel investors would get.
The percentage points you start giving up for that although starts becoming too large for most founder's tastes, and thus we get the current situation we have today. Many engineers tell themselves, why should I join an early stage startup when I can do so much better as a founder with a similar risk profile?
edit:
I realized you want a way to keep the golden handcuffs that are unique with the US tax law and current equity structure to incentivize poor-ish early employees to stick around without creating an incentive to fire them with back loaded options.
You could create a second stock option reward for the early employees with a company performance + time condition vesting condition and pay the tax bills by giving them the stock right away.
Pinterest's long term stock option expiry date is contingent on being with the company 2-3 years, otherwise it goes back to the same 90 expiry window I think.
You could try many structures, and the market will respond to it compared to their other offers. A good way to start is to explicitly state what you actually want, and then engineers could state what their price is for that ask in comparison with what they can get.
But then it's hard to set a definite timeframe. What you want is to incentivize sticking together as an effective team to reach a point of maturity, to maximize the chances of getting there and thus the options being worth anything. It's probably more about size and valuation. That's what was nice about effectively tying it to IPOs (when IPOs happened earlier). Going public was a decision that the board made when they company was "ready".
The engineer market in SF right now is very highly heated, and this kind of incentive makes an offer from pinterest far more appealing. That and people are starting to compare notes and make articles on medium and others really spelling it out is probably hurting recruiting and this is coming out as a response.
Although, one trope about startups is that they usually pay crappy, so the likelihood of any given employee having significant savings is low.
It is already the case that employee option agreements don't start dispersing options until at least one year. Two for some.
This isn't about changing who deserves to get options, it's about making sure those who get them are likely to get actual the value from them.
The fact that founders sometimes are able to participate seems to imply that it's a possibility for regular employees too if the appropriate legal docs were standardized.
I am not your indentured servant, no matter how much you wish me to be.
Since both the 90 day exercise window form of the options and this 10 year exercise window form of the options will both have the 1 year cliff until first vest, the ability to hop around is roughly equal for both.
That's a bad assumption. Valuation increases can be substantial 1 year post seed funding at companies with traction.
This puts a stop to giving something then taking it back because of legal fine print you didn't read when you signed up all starry-eyed. If it's happened to you, the first time it stings a little when you want to take advantage and can't, and leaves the impression that you got tricked, then after that, you get just a little bit jaded. By agreeing to stick by your word that stock is part of the compensation package, you build trust.
Anyway, vesting schedules are already the main contractual level protection a startup has against turnover. Betting on three teams takes, at a minimum, three years. And then you're just trading options at one company for another. Might be a good bet, might not, but this doesn't change that equation at all, right? If you want to move around to collect different stocks, go for it.
Pre-IPO startups have had an added protection against this turnover pressure, which is actually stronger than vesting. It forces teams to stick together until IPO/acquisition. This change would now be taking away. Worth thinking through the consequences, because if startup turnover shoots up then nobody benefits, most of all stock option holders.
I'm not sure I understand- you're saying the 90 day exercise window is a stronger anti-turnaround measure than the vesting cliff? How so? The vesting cliff says you don't get anything unless you stick around, usually for a year, and you don't get it all until four years. Or 3 or 5, whatever. That's a pretty strong anti-turnaround measure. The exercise window doesn't automatically prevent anything, as long as you can afford it, you can walk away and still buy your stock. Some people buy their stocks and some don't, so if you're a pre-IPO startup, the vesting schedule adds a deterrent to leaving 100% of the time, and the 90 day exercise window adds a deterrent to leaving less than 100% of the time. Don't forget you can buy as much stock as you can afford, when you have the option, but if you don't have the option in the first place, you get nada.
I do appreciate your stopping to examine any possible unintended consequences, btw, I just don't forsee this causing any problems with turnaround. And it seems like it does solve a real problem with claiming options are part of compensation and then making it harder to realize any benefit. I do honestly believe this could help lower turnaround overall.
Because practically nobody could utilize that exercise window pre-IPO so it functioned essentially as an "IPO/acquisition cliff" on top of the regular vesting schedule.
Do you see what I mean? If you leave before IPO/acquisition you lose your options. Not after 1 or 2 years, but however many years it takes to get to that point of maturity. You have to stick together as a team to make it there.
That's bad when companies get to, say, Pinterest or Uber levels and push off their IPO, and that's what needs fixing. But we should be extremely careful about overcorrecting in a manner that hurts vulnerable early stage startups, where the financial logic of leaving to diversify options is strong. Why triple down on one high-risk stock when you can move after a year and diversify your holdings? That kind of logic applied on a large scale could kill small startups which can't handle that kind of rotation. You have to have added incentive at the baby stage to stay and grow the company to maturity.
We'd like to see more companies making this change, we'll be keeping the public list of YC companies who have either implemented or pledged to implement an extended window, updated here: https://triplebyte.com/ycombinator-startups/extended-options
As an employee, why would I want a dangling guillotine over my options/compensation?
If this is a legal limit, can anyone explain the rationale behind the limit?
This is incredible.
You might be the first recruiting startup to really advocate for the engineer.
> As Sam Altman wrote, this is an unfair situation and needs to be fixed.
And Ben Horowitz criticized his stance and Sam said he would be rethinking the way he communicated his position. Was that ever taken into consideration?
Most of the time I've been at a startup as a founder/early employee, the strike price was low enough that I'd be willing to take a roll of the dice and just exercise, if I was going to leave. It's usually 10's of thousands of dollars.
By the time I started vesting a fair amount, the TAX on that was non-trivial - 100's of thousands if not more. Something I personally can't really do.
The main problem is that startups are offering options instead of restricted commmon stock. That means the new hire is paying for stock as an investment. That's not a benefit at all.
I have talked at length elsewhere on HN [1] about the system we use to give employees actual common shares, at current strike price, and delay any taxes until exercise so they have zero out of pocket expenses until they have to pay taxes (usually only capital gains).
For an early startup, this would mean when there is a liquidity event, almost all of the gain would be capital gains.
In Canada, it would be even better: people can defer taxes on stock and option grants until disposition (sale/bankruptcy). And the stock could be placed in a registered (i.e. tax-sheltered) account.
After the 409a valuation of the startup gets too high, this option becomes much harder for employees, which is why you don't generally see it outside of the earliest stages.
(Disclaimer: I am not a lawyer, not your lawyer, this is not legal/tax advice, etc.)
As I understand it, it's not just the valuation, but also the tax implications. If the options (as granted) are worth more than a certain threshold (~$100K), you can't early-exercise them without losing ISO tax treatment on the value in excess of the $100K threshold. This threshold is on an annual basis, so not exercising them early means that you quadruple[0] the amount that will be eligible AMT (which is preferable to ordinary income tax).
[0] Assuming the standard vesting schedule, in which 1/4 of the shares are made available each year
Can you elaborate?
In effect, yes. When the employee purchases the stock, they sign a contract to sell their stock back to the company (with the number of shares to be sold left blank). Their vesting schedule establishes how the number of shares that the company is allowed to repurchase decreases with time, normally with a 'cliff', which removes the need for a probation period.
I see no reason not to do this for every employee in the first year or pre-Series A at a startup; the tax consequences of a grant of common stock are minimal when the common stock is worth little. We did this at a startup where I worked in 2007. I'd do it in the future. (the one "downside" is that people who have vested become real shareholders, which can trigger some information/reporting rights, but you'd have a very small number of people pre-A, and I'm pro information transparency.)
The other thing which would be interesting to me: startups offering shares via their own 401k.
It's certainly more challenging when you're bigger, but IMO everyone pre-A should be getting actual stock.
I've personally had to deal with these decisions and know many friends who struggled with figuring out how they could possibly pay for exercising their vested shares, in some cases after they were laid off and had no choice in the timing.
If I were getting a job, I'd only consider offers with extended exercise windows. If they combined it with a more back-loaded vesting schedule [1], I wouldn't mind and would evaluate that. But dealing with the 90 day exercise window is black and white: it isn't worth all the potential trouble and risk you can be forced to take on.
1: 20%/20%/30%/30% instead of 25%/25%/25%/25%, or 6 years instead of 4 years
If the stock has appreciated in value, your exercise price may be low but your AMT bill may be high even if you have no liquidity at all. In my case I paid more in AMT than I did to exercise all my shares, though both individually were large and incredibly risky investments.
I could afford the risk and it did eventually work out for me, but some people can't afford the risk or frankly don't want to deal with the incredible complication of doing it. Just trying to figure out what your AMT bill might be involves doing your entire tax return based on projections, which depending on what time of year you are leaving could introduce quite a bit of inaccuracy and guesswork.
If you have an extended exercise window you just don't have to worry about it. If you want to take the risk of early exercise to get better tax treatment, do it. But if you don't (which I suspect will be the majority of people), all of the complication goes away completely... just sit on your options and exercise-and-sell when/if you get a chance at liquidity.
The only good option (pardon the pun) here is to allow your employees to early exercise.
With a 10-year option, hopefully the company gets (or can offer) some liquidity to help you pay the IRS when you exercise later.
Stock compensation benefits anyone who holds stock in a company that grows unexpectedly. The meme that it's worthless is because many startups don't actually grow. However, if the company isn't growing, why are you even working there?
We need to get past this line of thinking. Why do companies not say the same thing for the salaries they've paid former employees? "Boy, I wish we could get back the $30,000 we paid Bob between July 2011 and October 2011."
We don't say that because the employee earned that and once they've earned it, it's out of your account and into theirs. Stock, though a different mechanism, needs to be thought of the same way. If someone has worked there long enough to vest that stock, they should have the option available to own that stock. Just because they made the company successful enough to not be able to afford to exercise their options in time doesn't mean we should take that possibility away from them.
Whether or not it was intended years ago when it became a norm, the 90 day exercise window, at this point, is a surrogate mechanism for companies to steal compensation from employees after the fact. That's horrible.
We've made huge progress in that direction over the last 5 years as ZIRP made money cheap (and since the main leverage investors have against companies is the scarcity of funding, their leverage has decreased dramatically since the 80's). But as the funding mania crescendo of 2015 has passed, ZIRP is being wound down, and as private and public market valuations of small young tech companies plummet, I am not sure if that trend will continue into the future.
If there is one cohort that can band together to change the status quo, right now, that would be the YC companies. I am hopeful that enough momentum can be built over the next small handful of years by these companies so that "what is normal" can change permanently.
Is this kind of plan unpopular with VCs; shark and Gordon Gekko ilk?
But back on topic, harj et al. what's your opinion of Restricted Stock for early employees? I believe the issue is just that granting Restricted Stock once the company / share valuation is high enough is a definite tax impact. But it seems like nearly every pre-Series-A company could give the early employees 100% Restricked Stock. Is there some reason I'm missing that this never seems to happen?
Edit: s/RSUs/Restricted Stock/ since that's what I actually mean (the weirdness of RSUs remains funny).
Honestly I suspect this is why it isn't more standard. It's kind of a pain in the ass to get right. Options are just easier.
Imo our industry needs this. Atm there is very little incentive for experienced people to join early stage start-ups as non-founders vs starting their own thing. Tikhon summarized this quite well: https://medium.com/@tikhon/founders-it-s-not-1990-stop-treat...
Making options more employee friendly by default in our industry is an important & good first step!
An example: I join a $5,000,000 Series A startup with a 1% equity grant that vests evenly over four years. At the end of each year, I get a $5000 bonus for the purpose of paying taxes on exercised options. It's a bit more than the tax cost for the first year, and likely a bit less in the later years, but after 4 years I've been given $20,000 which should be enough to cover most of the tax burden. If I leave at the end, I still have a 90 day window to exercise them and the money in the bank to do so. I could just keep the cash, exercise them at the end, or exercise them for a cheaper cost each year.
That doesn't seem too unreasonable for post Series-A startups cost wise. An extra 5k a year is nothing compared to the cost of a developer overall.
* It extends the retention effect of equity since it starts kicking in at year 3 and extends smoothly forward.
* It has no cash impact on the company since its buying the shares from itself.
* In the early years the tax impact should be minimal. In later years there should be secondary buyers who can give employees enough cash to cover the tax liability at the cost of offering a discount.
* It discourages the pure lottery players since it requires the employee to either cover the tax burden or engage a secondary firm and deal w the discount they require.
* The downside for the company (aside from increased dilution vs the status quo) is that it establishes a clear market price for common equity which can be disadvantageous.
Good investors shouldn't mind this clause that much (I'd think) as it takes away one major point of worry for engineers and lets them concentrate on their job from day 0.
Sounds like an excellent opportunity for a business. Providing short term loans, taking x% or the exercised options. Although I am not familiar with US laws that cover this area.
However the problem is most startups in this case are not liquid so you cannot sell your shares (with some exceptions). Google and other public companies give you direct shares via RSUs since they can sell part of your shares to cover the taxes.