Stock options are complicated
benkuhn.net
benkuhn.net
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.
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.
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.
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 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.
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.
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.
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.
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.
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?
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.
That's a biiiiiig if. In my experience, this is definitely not the case for the vast majority of startup employees I know.
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 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.
Whoever has the most leverage in the transaction tends to win.
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 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.
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.
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.
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.
Is this arrangement just a loophole?
If they didn't have a high degree of confidence in the company, the safe bet would always be to not exercise.
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.
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.
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.
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.
Hopefully more startups will offer extended exercise windows of several years. Some are. See: https://github.com/holman/extended-exercise-windows
> 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).
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.
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.
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.
Could you elaborate on (2) on what you mean by "given a similar deal to investors"?
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.
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.
http://www.theglobeandmail.com/globe-investor/personal-finan...
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.
> 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.
http://tk-tax-accounting.com/en/english-taxation-of-stock-op...
Might be because foreign options cannot be qualified. IANAL.
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!
Obviously rife with other consequences.
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.
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.
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.
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.
I think Quora was the first to do this: https://dangelo.quora.com/10-Year-Exercise-Periods-Make-Sens...
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.
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
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.
And keeps an ongoing list of companies that offer extended exercise windows: https://github.com/holman/extended-exercise-windows
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
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.
Keep in mind for someone reading this comment, this is about private companies.
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.
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!
https://www.congress.gov/bill/114th-congress/house-bill/5719
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.
>"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.
The fmv is recalculated every year, or on any fundraise events. It needs to be a defensible number or the irs will be upset
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.
So you get 1000 shares x $1/share = $1000 of income, and you pay taxes on 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.
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!
That is likely not actually usable because there may be no consideration [1].
[1] https://en.wikipedia.org/wiki/United_States_contract_law#Con...
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.
If there are no liquidation preferences, then you are correct.
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."
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.
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.
https://en.m.wikipedia.org/wiki/Option_style#Difference_in_v...
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?
That doesn't mean you can't sell your ISOs to someone else; there just isn't a marketplace for it.