How Startup Options and Ownership Work
a16z.com
a16z.com
From the receiver's point of view, Stock Options are a bad deal 99 times out of 100, let's review the cases in which owners of options get screwed:
- Company gets acquired, new terms are put into place.
- Company gets acquired, company isn't good fit.
- Company gets massive amounts of funding (those Unicorns), and due to the increasing funding at each round, those with options are left with a hefty tax bill and only 90 days to exercise if they leave
- If you have stock options and are an employee of a early stage startup, chances are you don't have the liquidity to exercise it. You're also not being paid market value (since you have stock options) If you did have the capital, you could have just invested in the seed round for a much better discount and return.
- If a company goes out of business
- if A company stays private and doesn't offer an internal market
There are only a very few cases where employees with options are taken care of:
- Company sells and ensures there are triggers in the options - Company extends exercise period
- Company goes public and employees are able to exercise their options with the tax bill that goes along with that and still make money on their shares
We have a romanticized view of options because Google, Microsoft, Apple, Twitter, Facebook, and a handful of other companies have hit the bigtime; but that's the huge exception, not the rule, and yet we allow companies to treat options as equal to salary, and they're not.
I know companies face reporting requirements if they have more than 50 shareholders; but the earliest employees should be compensated in a way that respects their sacrifice and risk; and options don't do that. At best, options are a placebo.
The alternative is disastrous for a fast growing company. Each month, each year, you are vesting new shares at an exponentially increasing valuation, and now have to pay income tax on that completely illiquid gain with cash you literally don't have.
No RSU grant "requires" an 83(b) election.
Your second point is why RSU grants with normal vesting and delayed release is desirable.
Please note, Restricted Stock !== RSU, and RSUs are not eligible for 83(b) because they are just a promise of future shares, no stock is actually issued until the conditions are met. (see above)
Or do you "sell" a portion of the shares back to the company to pay taxes for the employee, then the employee gets 45-50% the number of shares that are vested. This is what Microsoft did when I was there, but they were publicly traded and had a public market to "sell" into (though it went straight to company stock buyback plan). Private companies don't have that luxury and would have to pay real money to the IRS to foot employees' tax bills at various vesting dates.
This all works best in the early days when the 409a valuation is zero. Once you have a high valuation, getting real amounts of equity into employee hands that has a good chance of actually being valuable in the future is extremely difficult, because with each share you give to an employee you are giving essentially 40-50% of that to Fed + State, plus another 30% of any future gain. Since this is all based on fantasy valuations of an illiquid asset, it is playing with fire in the worst way.
The only other option is options with high exercise prices based on highly speculative earnings forecasts, for shares which are 2nd or 3rd in line behind all the preferred stockholders. This might work out for late hires at Google and Facebook, but almost never anywhere else.
I mean think about it -- "Here are some common shares of my company; I just raised $50m at a $500m valuation, we are burning $5 - $10m in cash every quarter. We are are going to be absolutely massively huge and a billion dollar unicorn in no time. There are currently $100m of preferences ahead of you, and we will certainly need to raise huge amounts of more cash in the years ahead to achieve our vision. You will have no input into how the company is run, no effective voting power, and no seat at the table during an acquisition. Our 409a valuation is just $100m!" As an employee, getting an option to pay for that is supposed to be an incentive?!
The solution I would like to see? Illiquid shares in a private startup less than 5 years old and with assets less than $100mm should be valued at a discount to liquidation value, or ideally transferable with no taxable event whatsoever. If those shares are encumbered or sold, then the holder pays short or long-term capital gain rates on the full amount of the sale. No 409a, no exercise price, no 83(b). There's absolutely no reason to try to pre-tax a portion of the value of the shares up-front when they are illiquid and impossible to value. This proposal is basically tax-neutral. If you want, you could extend the short-term capital gains rate to 2 or even 3 years instead of 1 for this type of transaction, to avoid someone taking highly valuable shares of a later-stage company, and getting the full amount taxed as capital gains just 12 months later.
To put this in perspective, with QSBS / Section 1202 (qualified small business stock) the first 10x or $10m of gains on original issue shares is 100% Federal capital gains free after a 5-year holding period. This was made permanent in 2015. Some states also eliminate or reduce the state capital gains as well -- although not California for a few years now :-( So politicians are making startup investing very attractive for anyone who can get Founder/Restricted or Preferred shares, but they have left the employees' options completely in the dark ages. It's time to fight for some reforms here...
I'm curious/confused about how/why RSUs don't satisfy what you want to see here? Is it just because they aren't actually transferrable or sellable given that the company is private?
Which is why "liquidity event" is one of the conditions for vesting.
So you work for a startup for 10 years since inception, it's private all the time, you get annual grants for more and more options, building up options for 5% of the fully diluted shares, but then get disabled and have to stop working. Now you lose all your options because none of them have vested because the company didn't sell yet?
https://www.sec.gov/Archives/edgar/data/1439404/000119312511...
I don't think it would be hard to prevail on the facts arguing that a requirement for an IPO (or similar liquidity event) is wholly out of the employee's control and that a substantial risk of that not happening occurs up until the moment that it actually happens. IPOs fall apart/are withdrawn and mergers fail frequently enough that a substantial risk argument could probably be sustained.
Then there are RSUs - restricted stock units. This is more like an IOU in that the company promises now to grant you a block of restricted stock at some point in the future. It's to manage taxation, and again, that's less my area. A good explanation is here:
http://avc.com/2010/11/employee-equity-restricted-stock-and-...
Instead of pointing out how stock options are primarily a reaction to accounting and taxation changes over the years , or the conflicts of interest in giving a more objective answer
There are plenty of financial products possible that will tread the line of compensating employees for their risk and the lack of money and liquidity startups have
if a startup has VC's and lawyers sitting around dreaming up and codifying a complicated and rather arbitrary set of rules to protect their investment from the little people, there's enough cash floating around to pay the employees a fair salary, they just don't want to.
options are fool's gold, plain and simple. you are either a founder, or a venture capitalist, or lawyer, or you should expect a zero or negative value from this silly charade.
if you can't tell which person sitting at the poker table is the sucker...
>> Do you have any examples of these products?
> yeah, cash money.
Sorry, I don't follow. The standard term sheets available today can reduce the cost of issuing options or RSUs to a few thousand dollars. It's actually a very straightforward and simple process to get stared, and has to be done anyway to at least get shares into the Founder's hands on Day 1. So, yes, there are startup legal expenses, but you are paying it no matter what, adding an option pool up front does not really cost any extra.
But basically it is granted at no cost to the employee, offers coupon payments, and matures at a point in time for the full cash value.
In the US, this would be OTC product limiting its utility much like every other kind of financial product that the government is 'protecting us' from. But it wouldn't be impossible to offer to employees.
For startups, the coupon payments would be relatively small, and refresher grants can still be done. If the startup goes bust, it goes bust. Provisions to make it callable can be implemented so in a bigger liquidity event valuing the company higher, employees can still get a lot of liquidity early, and it would likely be senior to common stock.
Anyway, I'll try to get the name of it. It was a lot more counterintuitive than hybrid bond.
edit: genussscheine , or participation certificate. Exempt from securities regulation in germany, but would be OTC in US.
Participation certificates are derivatives of an underlying, either a separate share class, or even worse, options on a separate share class. Startup equity is hard enough to value outright. Derivatives on customized terms in a market which is by definition highly illiquid? No thanks.
(It doesn't help when the terms of both shareholder agreement and participation certificate agreement are slanted in favour of the early employees/founders by so much that the participation certificates are worthless on close inspection, but that's a different rant.)
Can't have it both ways.
(This is more of a response to the link, not your comment in particular)
> Can't have it both ways.
1) Generally by 200 employees your stock is starting to be expensive, so exercising is no longer a trivial amount of money. This is especially important if an employee wants to 83(b) exercise (which is pre-buying their shares as soon as they're granted, to move the long term capital gains clock up to a year ahead of where it would otherwise kick in).
2) Getting to 500 employees generally implies some attrition, and of course your investors are also on your cap table, so it's fairly easy to be approaching 2000 shareholders with a smaller number of employees depending on how fast you've grown and how many party rounds you've done.
3) RSUs are trivial for the company to control. Shares that you own can, without special restrictions which are only starting to become standard in the last few years, can be traded on secondary markets even if you can't trade them on a public exchange. RSUs are simply a promise, and while you could write a contract that dictates what you'll do at the time of RSU conversion, that doesn't affect the company because by definition they're already public by then.
Selling your vested options to another party is much harder on the company, since as shareholders this third party has an explicit relationship with the company and, depending on where they are incorporated, rights to examine the company's finances.
Oh, and rereading I just realized I didn't connect the dots from the 12(g) threshold forcing people to use RSUs. RSUs are not considered stock. For tax purposes they are ordinary compensation awarded at the time of conversion, and only then do you count as a shareholder in the company. A company like Uber (could easily have been over 2000 shareholders by now I'm sure) has been using RSUs for probably multiple years now.
I have successfully negotiated for founder stock instead of options in the past, so it's something you can definitely do.
But more importantly, in both cases you end up exactly and equally screwed in terms of you are holding the same class of stock (common) with the same vesting terms (no, single, or double trigger acceleration), all the exact same issues around dilution, liquidity, preferred shares, and unfair buyout terms funneling cash to key executives, etc.
Equity is a massive gamble all around, and there's no magic bullet that I've seen which can defray many of the inherent risks of owning common shares of a private company which has perhaps a 1 in 100 odds of ever seeing a public market or liquidity event that surpasses the total liquidation preferences.
Can you do this, though? 83b election with ISOs makes sense because the tax event is employee writing a check to pre-exercise his shares, so a transaction occurs. For RSUs the transaction seems to occur at the time of the actual grant - there's no money changing hands, no transaction on record, and hence no tax event.
Not a tax lawyer, just trying to understand the complexity that I thought I had under control.
Section 83(b) Election
Shareholders of restricted stock are allowed to report the fair market value
of their shares as ordinary income on the date that they are granted, instead
of when they become vested, if they so desire. This election can greatly reduce
the amount of taxes that are paid upon the plan, because the stock price at the
time of grant is often much lower than at the time of vesting. Therefore, capital
gains treatment begins at the time of grant and not at vesting. This type of election
can be especially useful when longer periods of time exist between when shares are
granted and when they vest (five years or more).
Taxation of RSUs
The taxation of RSUs is a bit simpler than for standard restricted stock plans.
Because there is no actual stock issued at grant, no Section 83(b) election is
permitted. This means that there is only one date in the life of the plan on which
the value of the stock can be declared. The amount reported will equal the fair market
value of the stock on the date of vesting, which is also the date of delivery in this
case. Therefore, the value of the stock is reported as ordinary income in the year the
stock becomes vested.
However, I still much prefer RSUs over options in the case where you're joining a large/later stage company. Say you go to a Slack or Uber today. They won't (I believe they legally can't?) issue you options below their FMV (fair market value). They will give you some arbitrary/negotiable number of RSUs and options however. Then consider the following scenarios:
(1) The company then IPOs or is acquired several years from now, at double the current valuation. In this scenario, assuming you 83(b)'d and early exercised, you get the favorable tax treatment on the gains for the ISOs. But you're still out the exercise price outlay. The RSUs meanwhile are worth what they're worth, and you are taxed on them at the higher rate and that's that.
(2) The IPO or change of control happens too soon (less than 2 years from date of grant or 1 year from date of 83(b)/exercise). Your fancy options spread is still just ordinary income with no advantage over the RSUs.
(2) The company IPOs or is acquired next year, for the same FMV. Your options are worthless, your RSUs are still worth a goodly amount hopefully.
(3) The company IPOs at half the FMV of when you joined. Your options are worthless, your RSUs are worth something.
(4) The company fails/does a down round/whatever. You are probably wiped out regardless.
The only scenario in which the options are more interesting is as noted, very early stage companies where the exercise price is really small, or insane rocketships with an active secondary market providing real liquidity. Or, I guess when the company itself is holding liquidity events regularly (and even then it's only interesting if the FMV continues to grow up rapidly).
In practice, there are huge differences between them. Generally stock is much friendlier to employees and signals a company/founder which actually values employee ownership.
I'm surprised by the number of companies which try to pull shady stuff like not sharing the exercise price for options that are part of an offer. Lots of people apparently think that employees should value options at a substantially higher value than investors do. I've seen cases where the gap between the 409a price and the last investment is only a few thousand dollars, while the company insists this somehow makes up for a substantially subpar salary.
Equity is a risk, yes, but the status quo is that the risk falls much more on the people least able to bear it. Investors get all sorts of protections, while employees only benefit in a very narrow set of outcomes.
So the vast majority of startup employees don't have the fancy tax-avoiding scheme that founders and investors have.
Investors never have vesting on their shares so 83(b) has nothing to do with the preferred stock investors receive. Founders of course do often have vesting and can benefit from filing an 83(b).
At that point I realized it didn't matter how many options I had, I was going to get screwed should there be an exit, and made my own.
Note: I am poor.
The correct answers are: "We don't give you options, we give you RSUs and they start vesting after 90 days. Here's the cap table"
Anything else is screwing you. Unless, course the RSUs are for preferred shares, that's real what it should be, but common seems a reasonable compromise given that investors think a dollar from them is worth more than a dollar from an employee and should be preferred.
I am not going to lock up a huge portion of my expendable compensation in an "investment" that's designed to benefit people besides me on the hopes that the company is one of the few successes to come to market. There are too many horror stories going on right now that the VCs are trying to keep quiet for me to trust most startups.
BTW, my CEO just gave me a significant bump in my options a few weeks ago. He acted like it was a huge deal. But, with the 'right of repurchase' and all the other BS clauses in my options contract, they're essentially worthless.
There's usually something missing from their combination of empathy and understanding which would allow them to care about the negative ramifications they're having. Look at Bill Gates, I don't think he's a bad person but he hurt a lot of people in industry and consumers to build Microsoft to what it is by destroying the competitive landscape. Steve Jobs is a better example, he proactively colluded to suppress wages and paid money for an organ that would only prolong his life but could have saved someone else's (seriously, I consider that an evil move).
One suggestion for you, it sounds like you're very angry about your current work environment. Maybe it's time to find a new place?
The chances of getting wealthy by joining a small startup are very small. It happens, but it's probably not going to happen for you.
If you really want to do well, you have to pull together the resources to start a successful company.
On a different note, I used to work for an almost billionaire, they were incredibly cheap. I often reminded myself that you don't make a billion dollars by wasting money!
I should go back to welding.
Companies can easily ameliorate this, especially for early employees, by permitting early exercise. The 409a valuation rarely changes between financing events so if you get 5000 $.50 options you can pay $2500, file 83(b), and not have to pay any tax until (unless you sell). If you leave before your vesting period is up the company pays you back what you paid for the unvested amount -- again, not taxable. I always make sure this is in the stock plan.
There's some minor subtleties (you want to put a voting agreement into place etc) but they require no heavy lifting at all, and they treat employees as what they should be: valued members of the team.
Yes, in later rounds when the share price climbs, this is less useful so but be it. It's annoying that 409a common valuations end up at about 20% of preferred these days; I think it was more fair back when the board could just determine that 10% was reasonable.
In reality they are probably handing out options with a strike price valuating the common shares at billions of dollars and those options are likely worse than worthless.
But for the early folks (B round or before), why not give them the maximum opportunity?
The keys are: a) being there early enough that the strike price is feasible for the cash you have and b) that the company becomes something more valuable later.
If you can do both of those, bravo. But don't count on it.
When the details of their stock options become material, employees are often surprised -- and usually not in a pleasant way. Many engineers become disillusioned with stock options, and eventually the whole startup scene.
It seems to me there would be a lower risk under the 10-year exercise window scenario. Under the 90-day window, the ex-employee would be forced to exercise or lose all of their equity and thus liable for a large AMT bill. To mitigate this, that ex-employee, with recent inside knowledge of the company's operations, would look to the secondary market to unload some of those shares and ease the tax burden unless their are strict transfer restrictions in place, increasing the divide between cash-rich and cash-poor employees.
Under a 10-year exercise plan, the ex-employee would be less likely to exercise (better to wait until the company's outcome is more certain) and wouldn't need the cash to buy the shares and cover those AMT taxes.
> ISOs have better tax treatment for employees because the employee does not have to pay taxes at the time of exercise on the difference between the exercise price of the option and the fair market value of the stock
This doesn't seem to count AMT taxes which is the big elephant in the room. In California and most high tax states, employees will have to pay AMT taxes on the difference.
Before may be a bad deal for startups, especially the ones that are keeping everything all the equity details under wraps.
After is a bad deal for the employee who makes the move, and could be a major bait and switch
A company which won't provide enough information to value an option grant contemporaneous with the written offer is being either abusive or stupid. There exist employment opportunities at companies which are neither abusive nor stupid. Take one of those instead.
Just because a company isn't forthcoming about all the stock option information doesn't mean that startup is unilaterally bad, in some cases the founders are just naive and don't really understand the complexities of your stock options vs their founder stock. However, if you ask the employer for the necessary information to fill out the website and they won't give it to you, then you essentially have no way to value the stock options and the only rational thing to do is value them at $0.
Many people just value stock options at $0 anyways and I don't agree with that. Stock options can be valuable (for example I've made much more money from startup stock options than from salary). However, if you don't have the full information about the stock options you are receiving you can't understand the risk you are taking and the potential rewards you might get.
Anything and everything in the contract can be taken away from you when you don't have a controlling stake in the company. The contract language is important, but the trustworthiness of the founding team is even more important. At the end of the day, if they are intent on screwing you over, your contract will be just a piece of paper anyways. By asking for the information up front, you get additional information on the trustworthiness and openness of the management team.
This article primarily describes carveouts for management retention in a public company, but they can be used in private companies and are not restricted to management.
This is the only mechanism I have any familiarity with, I'm also very interested in hearing about others.
You can start a company and raise money by selling common stock instead of preferred, but in return investors are going to want a much greater share of the company than they otherwise would. That's generally a bad deal for employees.
You can say that it's unfair that deals generally work out they way they do, but that's not really any different from saying that it's unfair that your salary is 100k (or whatever) instead of 200k. Welcome to a market economy. Prices are negotiated based on supply and demand.
When you fail that doesn't mean you got fucked. It just means you've failed. As I said, that's life.
Look at the structure and retention deals of acquihires.
Writing another blog post on a VC blog isn't going to solve the fundamental problem of information awareness and discovery.
It's very much like basic personal finance. The hardest part is becoming aware of the need to educate yourself in the first place. The second hardest part is figuring out what you need to learn. Much of this awareness comes from upbringing and is an element of social capital that we often take for granted.
Establishing a neutral, nonpartisan online resource under a transparent domain name would be a plausible first step.
[0] https://www.amazon.com/Consider-Your-Options-Equity-Compensa...
Reading the liquidation preferences section, particularly about double dipping, was a little irritating. How common are these situations?
What about the non-techinical employee? I generally feel marketing, sales, etc are screwed in startups. How can a someone making < 75k actually use their options?
If you're aware of an inaccuracy in the article, or an important fact (as opposed to swipe) that is left out, you could add value to the thread by mentioning it.