An Engineer’s guide to Stock Options
blog.alexmaccaw.com
blog.alexmaccaw.com
1. The value of options is inextricably linked to tax and you need to understand the tax basics in evaluating the economic risks and benefits of holding and exercising any kind of option. With NQOs, you are taxed on the spread as ordinary income on the date of exercise (meaning, on the difference between what the stock is worth and what you pay to exercise). With ISOs, the value of the spread becomes subject to AMT and you can wind up paying large taxes that way in spite of the supposed tax benefits of ISOs. The way to avoid having a large spread subjecting you to such tax risks is to exercise as early as possible before the company value goes up much but you then need to take the economic risk associated with having to pay hard cash for stock whose long-term value is highly uncertain. Moreover, early exercise is not possible if your options haven't vested unless you specifically get an early exercise privilege as part of your grant. With an early exercise privilege, and particularly if the grant is made for a bargain price, you can early-exercise, file an 83(b), and (as long as you hold the stock for at least 2 years) get the equivalent of a restricted stock grant by which you pay no further tax until you eventually sell the stock at a liquidation event. In that case, you are also taxed at the lower long-term capital gains rates. Of course, in the early-exercise scenario, you do not get to bypass vesting and your shares remain subject to their original vesting requirements and can thus be forfeited in whole or in part if those requirements are not met. But early exercise does provide an elegant solution to most of the tax risks associated with options provided you are willing to assume the economic risks of paying for the stock up front.
2. Other than the early-exercise scenario, 83(b) elections are not required for option grants. Under 83(a) of the Internal Revenue Code, any service provider who gets property in exchange for services is taxed at ordinary income rates on the value of the property received. For example, if you do work for a startup and are paid in stock when you complete the deliverable, you are taxed on the value of the stock received. You are taxed on the value of that stock as it exists as of the date you receive it in payment for such services. So, if you do development work tied to a milestone, and you meet that milestone, and you get 100,000 shares for the work, you would be taxed on, say, the $1.00/sh that the stock is worth on the day six months or a year (or whatever) out when the milestone is met, and not on the $.01/sh that it was worth when the contract terms began. In contrast to this performance-based form of incentive, let us say that you get a time-based incentive by which you buy the stock up front for a nominal price but you must earn it out over time. With such a time-based performance incentive, which is what is called "restricted stock", you own the stock up front and you pay no tax at the time of purchase in the normal case where the amount you pay for it equals its fair value on the date of the grant. Because the stock must be earned out as part of a continuing service relationship, and is hence subject to a "substantial risk of forfeiture", there is a very important technical question under section 83(a) on what the date is on which you are deemed to have received the stock in exchange for your services. Well, the default rule under 83(a) is that you receive it on the date it is no longer subject to a substantial risk of forfeiture and that then becomes the relevant date on which the value of the stock is measured for purpose of computing the taxable service income on which you must pay tax. So, if you get your 100,000 share grant at $.01/sh, and you pay $.01 share, you pay no tax at inception. But, as that grant vests at, say, a monthly ratable rate over four years, the IRS treats you as having received 48 separate grants (one each month) over the four-year period. Thus, at each vesting point, you are treated as having received property in exchange for services under 83(a) and you pay tax on the difference between the value of the property received and what you paid for it. If you paid $.01 per share, and if the stock is worth $1.00 at a given vesting point, you realize $.99 worth of taxable income per share. In a venture whose value is rising quickly, in the absence of any saving mechanism, you might have as many as 48 separate tax hits (basically, having to pay tax on the difference between what you paid for your grant and the 409A valuation price placed on the common) just for the privilege of holding a piece of paper that may or may not ever have an ultimate cash value of any type. It is in this type of scenario, and only here, that 83(b) comes into play by providing that, in lieu of having to suffer under the default rule of 83(a), you can elect to pay all taxes up front on the grant and not be subjected to the often onerous workings of the default rule. This means that, for an 83(b) election even to be relevant, you must first own your stock (or other property) and that stock or property must be subject to a substantial risk of forfeiture. If you hold only an unexercised option, you do not yet own the stock and it is not subject to forfeiture (hence, 83(b) is not relevant). If you do an early exercise, though, and get stock under terms where it must still vest out and can be forfeited, then 83(b) does apply. But that is the only case normally where it becomes relevant at all to options.
3. Options really shine when they wind up on a level playing field with the preferred stock and they tend to dim commensurately to the extent they do not. Optimum case is IPO when all stock is (typically) forced to convert to common prior to the public offering and, thus, all shares participate equally in the benefits. This can happen too in big-scale M&A exits but a drop-off occurs on lesser ones in at least two ways: (a) where the total acquisition price is largely gobbled up by the liquidation preferences and/or management incentive plans; (b) where an acqui-hire occurs in which a few founders get a disproportionate share of the total value through employment arrangements made on the other side of the deal.
4. Given all of the above, and given that IPOs remain at far below the old bubble levels in frequency, it can be risky to lay out any excessive cash to exercise at any time before a liquidity event. Too many things can happen by which a seeming "sure thing" winds up evaporating before your very eyes, leaving you with no more than a pretty lousy capital loss that you get the privilege of deducting at the rate of no more than $3,000 per year unless you can find other capital gains to offset it against.
5. The 90-day tail for exercise upon termination of a service relationship applies only to ISOs and not to NQOs but, of course, ISOs have other advantages and they are what is typically offered in VC-backed ventures. In other types of ventures, where the company value is already somewhat high at the time of grant, I have seen executives bargain for and get NQOs with long exercise periods following termination just to have the flexibility to leave the venture if needed without being forced to forfeit the options.
6. In light of all of the above, having to pay an angel backer 25 or 30% of your gains to provide you with a risk-free exercise in an otherwise high-risk situation may be worth it even though the cost seems high on its face. It is a matter of preserving some decent part of your potential upside while giving up the rest to make the upside potential even a possibility for you given the tax risks involved. If IPOs come back strong some day, then you may be giving up too much at such a cost because they are the great leveler when it comes to weighing the value of options against other forms of equity holdings. Until that day comes, however, options remain a valuable but relatively high-risk way of deriving value from a startup if you need to part with any significant cash (either for the purchase or for the associate tax) for the privilege of hoping to profit from a startup. Again, for those who need to weigh their choices, this piece provides great insights and stands head and shoulders above the typical discussion of such issues. Great work by the author in making an otherwise dry and even formidable subject pretty accessible.
That being said, my own personal opinion is, if you're in early enough that options are on the table, you've basically taken a bet on the company anyway and you're probably already sacrificing salary for equity. I wouldn't go mortgaging the house to purchase your options, but it's unlikely that's necessary and if you're seeing strike prices of under a couple of dollars per share, then you're probably talking about very affordable options.
In Ireland, the main tax differential is income tax (effective rate of 52%) or CGT (@30%). I didn't pay enough attention to this, so word to the wise of anyone going through this. Go talk to someone now, not when your company is IPO'ing.
Some interesting tidbits here from an Irish perspective which probably applies to lots of other non-US countries on options in US companies:
* Pre-IPO, the fair market value of the share is calculated and reported to the revenue commissioner along with an FX (USD -> EUR) rate set by the ECB. Talk to your finance/accounts dept. who are obliged to report this periodically. This fair market value determines the amount of tax you pay.
* The difference between the fair market value of the share and the strike price is essentially counted as income (not BIK, not CGI) when you exercise. In a lot of cases (Facebook, Twitter, Google, LinkedIn, Workday) the fair market value of the share was substantially less pre-IPO (12 months, 24 months) than post-IPO. That means exercising early in most of these situations would have been to your advantage if you were at these companies. Be aware you're completely subject to market risk here.
* Once you exercise the options and own the stock, then increases are subject to capital gains. An example here might be if the strike price on your options is $1, the fair market value is $2 & your company IPOs at some point in the future at $10. If you purchased options at the earlier milestone with a fair market value of $2 and sold at IPO, you'd pay 52% tax on $1 ($2 - $1) and CGT (30%) on $8 ($10 - $2). If you purchased at IPO and sold immediately, you'd pay income tax on $9 ($10 - $1). However, you need to actually hand over cash to exercise options and pay the tax, so be very aware that this is essentially now an investment.
* FX (USD/EUR) fluctuations can be just as important as stock fluctuations. Make sure you take that in to account. Right now, for example, this isn't quite in your favour, with the USD to EUR rate at high 1.35's/1.37's lately. Look at the currency history. You have options to sell and hold your money in USD (banks in Europe will typically open you a USD account) in which case you can hold until you believe the FX rate comes in line with what you expect. Again, you are subject to market risk here (your investments may go up as well as down!). In Ireland, gains via FX like this are also subject to CGT.
I'm not a tax advisor, but what I hope I'm convincing most people here is that if you do think you just hopped on a rocket ship (a Twitter, Google, Facebook) and you're a non-US resident with a reasonably significant amount of options (1,000+), I'd go talk with a tax consultant immediately and consider at least purchasing some of your options up-front if you've got cash that you're willing to bet with.
We've had a number of high profile IPO's here in Dublin recently (LinkedIn, Facebook, Workday & Twitter) so hopefully this convinces someone who jumps on the next one to go talk to a tax advisor.
Happy to pass on details in Dublin for some folks I got advice from. I'll stick my email in my profile
- if you can afford, and think it's a good bet it buy the stock when it is granted to lock in the capital gains and avoid income tax
- otherwise go the exercise and sell route and pay tax at your marginal rate
anything in between IMHO is quite possibly a mistake .... don't forget all those people in the .com crash who'd been granted options at 10c, exercised at 2$ and found themselves at the end of the year without a job and a huge tax bill (and remember, without a job) on increases in value of shares that were now worthless - there are traps here
Why are not the CA senators and congressmen being told to sort that out ASAP by their constituents.
1 How can I owe tax on something that has no value.
2 I think we can all agree that Employee ownership is considered a good thing therefore any law which penalizes this is bad law if not actively immoral.
The law should only tax you when you have an actual +ve capital gain. (the need for sensible vesting and taper relive to avoid tax avoidance is of course a given).
On point 2 even the UK's SWP (Socialist Workers Party) allow members to take part in share option schemes.
The usual reason you are doing this is because you expect the stock to appreciate further say to $10 and you want to lock in the long term capital gains tax (25%) rather than your marginal rate (30somethingish %) when you sell it.
Now when the company goes under your stock goes to 0 you can claim back the loss ($20k) in a subsequent year's tax return, but only as an offset against some other investment income - something that might not be happening if you don;t have a job (though if you can't use this loss it might be a great time to tap your 401k/IRA and get that money out essentially tax free if you can)
By your argument all US pension funds should pay income tax on any capital gains.
And just saying well you cant pay your tax we will take your pension is just taking the piss (to be blunt).
Forget reforming the NSA/CIA its the IRS I would be worried about
US pension funds (at least personal funds like IRAs and 401Ks) are pre-tax - that is the money you put into them comes from your gross, before you pay tax on it - you still have to pay the tax when you withdraw money (including any increase) from them - the idea is that you put money in to avoid tax at your highest marginal rate, and remove it and pay tax at a much lower marginal rate when you are retired. However you do still have to pay income tax on money earned in pension plans.
As to the fact that you can't claim the tax loss if you're unemployed or bankrupt, that was part of the thing I was trying to point out, buying your options after their value has increased can put you into a dangerous situation (I wasn't trying to justify it, just explain to the unwary that it can, and has, happened)
What's even worse though is three years into employment deciding you hate your job and that you want to leave, realizing that staying and being alive are incompatible. And here we get real hypothetical ... you think the company has legs and that your stock might be worth something. But your strike price is $.05 per share and fair market value on Common Shares now is $1.50 per share. If you exercise your three years of options at this point hoping for the likely $10 per share IPO, you're stuck paying immediate regular income tax rates on your $1.45 per share immediate paper gain. And you may not have enough money to pay those taxes because they far outweigh your outlay for the stock exercise itself. And then you also risk the company going bust and you may end up with deducting max $3k/year in capital losses for the rest of your life.
That scenario is why I like buying up front in an early exercise.
In my last company I did the early exercise, though. And I stuck around for a long time. And that early stock was highly diluted and ended up being a small fraction of my overall stock option grant. I'm not sure it was worth it but we finally were acquired.
I like thinking about shares as a virtual currency.
Shareholders are speculating on that currency, and
the company is trying to increase its value. Companies
can inflate or deflate this currency depending on
their performance, perceived potential or by issuing
new shares.
This post didn't present any new 'facts' for me. I was already aware of all the details he explained (and most, but not all, of the implications of those details). My point was simply that by framing shares as currency presented them in a way that I had never considered before, and that comparison caused a number of other things to 'click.'
My apologies if my learning offended you...
I thought that shares as currency was an interesting analogy to draw too. Although I guess when you get down to it, anything that's reasonably fungible can be considered currency if you feel like it.
Wait, maybe if there was a higher context to share our approval of the article without distracting away from its content? Like some kind of high-level rating system that was enforced through a framework of some sort and presented as a low-friction indicator of the quality of the article? We could even improve it by presenting the highest quality articles above the fold.
Of course then content that appealed to the lowest common denominator would become the most approved, and people could congregate around shared understanding and beliefs, further cementing those ideas as the "right ideas".
Only if there were some social rules that would prevent this "circle jerking" behavior that causes forums to devolve into roaming bands of up-vote brigades. We could start by not "circle jerking" about the quality of the article, we could probably go a long way toward reducing congratulatory posts that celebrate elementary-level understanding of economic systems, and in turn, encourage feel good comments that are up-voted because people agree with them instead of them actually contributing anything.
I had assumed that excerpting a specific portion of TFA and highlighting why I found it particularly insightful would have been germane to the conversation thread.
If only there was a way you could have expressed your opinion that my comment didn't add anything to the conversation without resorting to sarcasm and obtuse rhetoric... (Unless you haven't crossed the 'able to down-vote threshold yet... in which case, no worries).
My favorite example is from the 1890s: Amalgamated Copper
Summary: http://www.jstor.org/stable/1884999
Book describing the process of getting banks to print money by ficticously reporting assets: http://www.gutenberg.org/ebooks/26330
Had the author written the book today, he would compare the practice to quantitative easing or injecting liquidity: http://en.wikipedia.org/wiki/Quantitative_easing
The big difference? Amalgamated Copper was a private entity whose owners used fraud and banks to print them millions of dollars.
In the "pre-exercise", I was able to exercise the stock before I'd vested in it, with the understanding, of course, that the company would buy back my unvested shares at the exercise price if I left the company before vesting all the options.
The disadvantage, of course, is that you pay for your stock up front, and will lose all or most of the money if the company doesn't pan out.
There are several advantages ...
Advantage: the price you exercise at is near the fair-market value of the Common Shares you purchase (and haven't yet vested in), so there's no immediate gain and so no immediate short-term gain tax consequences. You need to make sure to file an 83(b) form so you're telling the IRS you're paying your $0 tax up front, rather than monthly as your stock vests. (The disadvantage with the latter is that the difference between what you paid and what your stock is worth as it vests could be huge, and there's no way to liquidate your stock to pay that tax.) (There's also something about AMT in here, I'm kind of fuzzy, but I think consequences can be the same.)
Advantage: your long-term capital gains clock starts ticking the day you buy the stock, even though you bought before any of it vested. When, three years down the road, you can liquidate your stock in that acquisition or IPO or secondary-market sale, you already purchased your stock three years ago, and pay only long-term gains. Otherwise, you'd buy the stock and sell on the same day, with the gains considered as short-term-gains/income rather than long-term gains.
My personal outcome with pre-exercised stock: worked out OK twice, lost all my pre-exercise once, but overall I came out ahead on taxes even with the loss. YMMV.
What the article says is "pre-exercise" is just an "exercise" -- you vested the stock, you have every right to purchase it even though the company's stock isn't yet liquid. The problem, of course, is that you may have a huge gain and no way to pay for taxes on that gain.
(Edit: note about AMT, clarification.)
I don't see any reference to "pre-exercise" in the article.
More importantly, technical details aside, I think it's important for a prospective employee to make some strategic decisions about equity up front.
The author writes:
> If the company seems reluctant to answer these questions, keep pressing and don’t take ‘no’ for an answer. If you’re going to factor in your options into any compensation considerations, you deserve to know what percentage of the company you’re getting, and its value.
And in the next paragraph he writes:
> I’d be wary of compromising on salary for shares, unless you’re one of the first few employees or founders. It’s often a red flag if the founders are willing to give up a large percentage of their company when they could otherwise afford to pay you. Sometimes you can negotiate a tiered offer, and decide what ratio of salary to equity is right for you.
You can't have it both ways. If you focus on equity (by demanding that the company divulge detailed information about its share structure), you are sending the signal that equity is just as important or more important than salary, and thus opening the door to a negotiation that contemplates a trade of equity for salary. Precisely the thing that you want to avoid!
Unless equity is expected to be liquid in the near future (i.e. you're at a company expected to go public in the near future), an equity-focused negotiation is more likely to benefit the prospective employer than employee.
1. Calculating a true percentage associated with a grant can be difficult. You can identify the number of shares of stock outstanding across all classes, the number of currently authorized shares, and the size of the option pool. But you don't know how much of the option pool will actually be used, how many options will vest, etc.
2. Unless you're an executive hire or unicorn, most companies will not give you all of the data necessary to meaningfully evaluate the equity grant. You can ask for it, as so many suggest, but asking for something that a) you almost certainly won't receive and b) that you're not trying to focus on (for the reasons I originally gave) is not very strategic.
3. At an early-stage, venture-backed startup (my comments are not intended to address late-stage, liquidity-all-but-certain scenarios), the equity structure of the company is likely to change considerably and perhaps unpredictably, rendering your initial evaluation all but useless.
4. If an early-stage startup is capable of offering you a satisfactory salary (at market or, these days, above market), you are far better off trying to ascertain what the company's runway is. Your biggest risk at a startup is not that you're going to join the next Facebook as an early employee and walk away with next to nothing but rather that the company is going to run out of cash.
You're absolutely right that nothing your employer tells you at the time you're hired is going to be controlling once a new round of funding is taken. If the company is going gangbusters when it takes a new round, the new round probably won't hurt you at all. If it's a slog when you go for more money, it could totally ruin your returns.
If you're an employee that received options and the company is doing another round of funding, should you be worried or on the front foot about finding out what will happen to your options?
Founders and employees do not get to reinvest. Typically, when a VC-funded company is allowing employees to buy more equity is the last time to take that deal (it means the company is cash-poor and in bad shape). General rule: unless you're a founder, avoid taking the other side of any deal with VCs in it.
Founders generally have the same class of stock as employees (common stock), and so are in the same boat.
Investors have preferred shares. Preferred shares have a few special properties, but the most important is ‘liquidation preference’, meaning they’re first in line to get their money out if things go wrong. Sometimes investors have a right to a multiple on their money back: twice their money would be a 2x liquidation preference.
One thing to ask about in the case of a company that has raised money on convertible notes. Since they haven’t actually sold equity, but only debt which will later convert equity, it’s worth asking if a given stake is before or after those notes convert.
Generally, if things are going well, dilution isn’t worth worrying about. In any case, the founder will be just as diluted as any employees, so their interests are aligned.
Not quite - Another extremely important point is ensuring that there isn't a hidden type of equity/option ("Series FF" or alike) sitting above you as an employee. In this situation founders are less aligned with you as an employee as they get the option to cash out rather than being diluted in follow-on rounds. This is a mechanism designed to align founders with investors by causing founders to shoot for the moon even through appealing exit offers, but has the side effect of allowing them to stop caring and not exit until it's too late (they've got theirs, after all).
Just to clarify...
People who are just learning about this stuff (and many who aren't) learn about dilution and think it's total bullshit, get concerned about how much they're being diluted, feel like they're being stolen from if there's a dilution event, etc etc etc. The idea, however, is that if you're being diluted it's because someone wants to give the company money, and that's usually because the company is growing. Your piece of the pie will shrink but if your execs know what they're doing the pie will grow more than your piece will shrink and you will come out ahead in the end.
Bill [Gates :)] comes in and convinced Joe and Mary to sell him 50% of company for $1,000,000.
Joe and Mary issued 2 more shares (4 total shares now) and gave them to Bill in exchange for $1,000,000.
OMG, Joe and Mary just diluted themselves in half to 25% each!
But the difference is of course is that each share now cost $250,000.50, instead of previous $1.
If a company won't tell you enough to calculate the percentage, that's like you asking "What's your offer for salary?", "Dollars. Definitely dollars.", "Can you be more specific?", "No. We consider exact salary offers to be competitively sensitive."
~ $2,000,000 if they've only issued 500,000 shares ~ $100,000 if they've issued 13,000,000 shares ~ $2,000 if they've issued 40,000,000 shares.
And your returns would be negative for any greater number of shares.
The real problem is that you don't know the price per share from the current valuation.
Not that an at-the-money option has no value -- but I think for tax purposes, it's not treated as such.
On the other hand, any company that gives you no information on the number of outstanding shares makes their options worthless as compensation. You should let them know this on your way out the door.
Similarly, how liquid are markets like Second Market in terms of liquidating option value at a startup that's raised multiple rounds of funding but has yet to exit or IPO? Are there angels (or networks of angels) that buy small amounts of pre-exit equity?
The company doesn't really have any incentive to purchase your options from you, however they will likely have a clause that gives the company first right of refusal--that is, if you plan on selling any shares prior to a liquidity event, you have to first offer them to the company for FMV.
As to pre-IPO, post fund raise, your stock is typically Restricted stock units, which have clauses that prevent you from selling stock.
It's possible, with board approval to issue a special class of common stock, that can be sold to outside investors. This is usually done to allow long-term founders to get some liquidity outside a liquidity event. This typically doesn't happen for most employee's though.
In an IPO scenario, all outstanding shares convert to a single class of stock, which can be freely sold (after a lock-up period).
Liquidity highly depends on the company. SecondMarket, SharesPost and MicroVentures have online portals for buying+selling, but they also have a mailing list with people potentially interested in a secondary market transaction, so worthwhile exploring that option.
Can anyone clarify?
It is my understanding that you don't file an 83(b) for ISOs or any other type of options, only for actual restricted stock.
In those situations you acquire the 'right' to the stock over time (this is called vesting). And when you vest stock the IRS treats it like income and it gets added to your W2 as such.
The 83(b) election allows you to take the entire tax hit immediately even though you don't have the ownership rights on the stock yet. You need to come up with the tax payment but since you "own" the stock even when it vests you won't pay additional taxes, and your ownership starts the clock on long term gains (vs short term gains).
If the stock is going up an 83b can save you some money, if it is going down it makes it more complicated (you can write off up to $3,000 of "loss" per year of stock which is worth less than the 83b election price. I got to do that for just over 10 years on my dot com era 83b stock election.
Generally places like Facebook or Google will sell some of your RSUs as they vest to cover the tax hit so its pretty invisible to you.
Another great post on this subject (which may be a bit dated nowadays) was this one[3]. Hacker News startup lawyer had also some great comments on its corresponding HN thread[4]. Note that it embeds the Introduction to Stock Options[5] that also had an amazing discussion on HN a few years ago[6]
[1] http://www.paulgraham.com/airbnb.html
[2] http://www.avc.com/a_vc/2012/04/mba-mondays-live-employee-eq...
[3] http://gigaom.com/2011/06/05/5-mistakes-you-cant-afford-to-m...
[4] https://news.ycombinator.com/item?id=2623182
[5] http://www.scribd.com/doc/55945011/An-Introduction-to-Stock-...
Restricted stock, notably, is not the same as an RSU (Google's "GSU"); one of the reasons an RSU exists is to simplify taxes, and because you are not issued stock at the time of grant there is no 83(b) election for RSUs.
Think of restricted stock as a chunk of equity set aside for you that you gradually vest rights upon. RSUs, on the other hand, are a promise to give you equity on a similar vesting schedule but the equity is not set aside. The effect on the valuation of the security with regard to your taxes in both scenarios should be self-evident.
Not sure exactly what you mean by this, but I believe the same ISO rules apply if you exercise early: you don't owe taxes (under the normal income tax calculation; AMT is different for ISOs) until you actually sell the shares.
Edit: I should add that this only matters for AMT purposes. If you early-exercise ISOs then the 83(b) election doesn't change anything for regular income tax, but does effectively accelerate your AMT income.
Source: I've done this. I've early exercised ISOs and filed an 83(b).
View it like the company giving you a cash bonus - not many people would turn down the bonus, even if it meant there would be tax due on it.
If you think the shares have future value, then paying the tax on their current price would seem a good deal. If you don't think the shares are value, then share options would be even worse.
Admittedly you've still got to pay the tax up-front...
If you think the shares have a guaranteed future value, then the shares are better than the options.
If you think the shares have a guaranteed lack of future value, then the options are free, whereas the shares will cost you.
If you think there is substantial risk that the shares will have no value, then getting options rather than shares mitigates that risk. You only pay for that mitigation if you actually exercise the options, in which case the cost comes off of a big payoff, rather than an upfront payment out of pocket.
For restricted-stock, you cannot sell the stock, and thus have to pay taxes out of pocket.
If the company is public, you can sell some shares to cover this cost (typical for stock bonus awards), but as many tech companies aren't public, their stock is restricted such that you cannot sell it to other individuals.
For the company, there isn't much difference either way as far as I am aware.
Ok imagine a situation where stock X costs $100 today. Alice thinks that the price will go considerably up, bob thinks it'll go down. So they make a deal, one year from now, Alice will buy shares of stock X from Bob at $104 dollars[1]. Now if Alice's prediction is right, she'll make a profit by buying low ($104) and selling high (at the then market price). If bob's prediction is right, he'll profit by buying low (market price) and selling high($104). This is called a Forward Contract.
Problem with Forward Contracts are that they put you in an obligation to make that transaction, no matter how much loss. What if the price falls and Alice doesn't wanna buy from bob? So then instead of a Forward Contract, she'd get an option (a "Call" option to be specific). This will give her the option to either buy the shares at the agreed upon price (called "strike price") if it is favorable, else do nothing. Well what about Bob? He can get into a "put" option (with someone else) that gives him the option to sell stock X if it is favorable.
Pretty neat huh? but the difference here is, Forwards are free (except for tax etc) and options cost a "premium" to get into. But since options COST something, that means you can SELL them as well and make money off of that. And their prices vary just like the price of stock varies.
Hope this helps
It should be noted that Alex MacCaw and friends are offering a way out of this dilemma for 25-30% of the upside by supplying the cash required to exercise so that the employee can leave. This advertising is probably the whole reason Alex wrote the article.
This is technically different that what Alex is proposing, but the end result is fairly similar. He's offering to loan you money to exercise. You keep ownership of the shares, and the loan comes due if and when there is a liquid market for the shares. He's allowing you to move on from the company before any other investor is interested in the shares, but still provide upside to you if and when the shares are actually worth something. And he takes some cut because he's assuming the (very significant) risk that no other investor is ever willing to pay for the shares.
http://techcrunch.com/2011/12/17/facebook-shareholders-suck-...
"Then you have to figure out a spread. So the seller has to agree to $30, the buyer $31, and the dollar in the middle is split 15 ways. Its 30 million shares so that’s $30 million in the middle and everyone feels this is the transaction of a lifetime and they need to get a piece. And then, all of a sudden, the secretary of the mistress of the random king wants to get at least half of the spread in the middle or will block the whole thing. So everyone needs to get on the phone again. At 11 pm at night on a Saturday. And hagggle out fees."
- "We will give you a big share of our (of-course-soon-to-be-facebook-or-google) company (15%+ in stock options) if you'll agree to work for us for close-to-nothing".
- Senior officers starting leaving the company one by one.
- Senior officers giving small promises that have tendency not to materialize.
- Senior officers do not have any/good exit track record. Opposite would be a green flag.
It's just a sign that it's really risky, and the other founders obviously think the odds of it succeeding are low and are asking you to put in sweat equity, as it were.
What's interesting is that this chap Ivan Goddard is doing the Mill processor, and that has an interesting company structure; OotB has an agreement to incorporate, and they keep renegotiating it. He explains this in this talk: http://www.youtube.com/watch?v=Bxga49vukQ8
Learn from our mistaaaaakes!
http://www.amazon.com/Introduction-Stock-Options-David-Weekl...
I exercised NSO stock options of a private company after being vested for a year. Everything I read indicates I need to declare the spread of current FMV with the value of the option grant date. How do I determine the current FMV if their is no market though?
http://www.avc.com/a_vc/2010/11/employee-equity-the-option-s...
You probably shouldn't, as they are distinct terms. A futures contract obliges you to make the transaction on the specified transaction date, whereas an option gives you the option to do so.
We've found that it dampens the 'build-to-flip' mentality and lets us all enjoy the fruits of our labor while we're building the company, not afterwards =).
Who could be an interested buyer?
Maybe you could work as an employee one day a week and as a contractor for the remaining five and get the options as an employee? :-)
[1] http://www.hmrc.gov.uk/manuals/essum/essum40105.htm
[2] http://www.out-law.com/en/topics/tax/share-plans/hmrc-approv...
My main advice - if you think there potentially a chunk of money involved I would go and see an accountant or lawyer that knows the details of the current legislation and can give you detailed advice on what to do - I've done this in the past around options and the advice was worth every penny.
.
Current Salary On Open Market = X
Startup Salary = Y
Option Value Today = Z
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4(X) = 4(Y)+Z(2)
this is obviously the big IF, if people are saying think of it as windfall, maybe 1.5??
It entirely depends on the person and how risk-averse (or not) they are.
I own a few options in companies I was at. One went under and the other did a "tech deal" and then divested it's assets. Both cases my options are worth about $0 :)
The problem there is, the expected value is more or less the current market value of the options (if you believe in anything approaching an efficient market), which is more or less the strike price times the number of shares. So, often these are in the neighborhood of $10k over 4 years or $2500/yr.
In other words, don't try to talk yourself into it from an accounting perspective.
But just looking at expected value ignores risk. Most people are risk averse, especially at the amounts of money we're talking about here.
IMHO it takes risk into account in a very sobering way.
Speak for yourself.
IANAFinancialAnalyst.
So it's possible to start a job on Monday, have the company acquired on Tuesday and immediately vest for all 4 years going forward.
1. OP says: Once you’ve cliffed, you have the right to buy shares in the company.
"Cliffing", when used as a verb, refers to firing someone just before the cliff-- not an employee achieving it. It's something you'd rather avoid.
2. If the company isn't publicly traded, you should ask to see the cap table. If you're employee #30 and your share is 0.05%, that might be fair if it's a biotech that has already taken a $100M infusion from the venture capitalists (who'll typically take 90%, in that case). For a web startup, it's terrible. You need to know how much equity the investors, executives, and employees at various levels have, so you can evaluate your likelihood of getting an improvement if you perform well. Without the cap table, you don't know enough about the startup to decide whether to take a job there.
I've asked that at every non-public company where I've had "options" and they've never complied. Just have to treat the options as confetti from then on.
But your final sentence is the best advice: treat the options as a potential windfall, but don't otherwise factor them into your decision.
Agree. (1) Don't ever take a salary drop for options w/out cap table, and (2) don't make sacrifices that would hurt your career or home life because of them either.
Most people in the startup world have evolved enough to get (1) but (2) is where startup culture tends to go off the rails-- people start working 80-hour weeks on career-incoherent grunt work for their options, blissfully unaware of the 10-100x larger grants given to all of the nontechnical VPs who go home at 3:30.
Most engineers who join startups think that the 0.03% allocated when they join will be increased later on, and that the initial grant is just a "teaser". I mean, it has to improve, just because it's so ridiculously low, right? (Well, no. In fact, it usually won't.)
Perhaps 5 percent of the engineers who join VC-funded startups would still join if they knew that (a) their equity allotments wouldn't improve, and (b) the founders wouldn't take a personal interest in furnishing them with the connections/credibility to be founders in their next gig. That number becomes closer to 1-2 percent when you're talking about good engineers.
Having the cap table --- which you won't get anyways --- does not actually help you here. A feeling of entitlement isn't what gets you improved compensation. An understanding of your value on the market and a willingness to stand up for yourself is what does that.
Put differently: so what if the cap table suggests you're unlikely to get an improved allocation? If you're worth an improved allocation, you'll get one or the company will lose you.
The cap table is, to this whole conversation, a MacGuffin.
Also, does it really matter if I know? A later round could have wildly different liquidation preferences that wipe out my gains, right? Though I guess that's true of dilution as well...
Could you point me in the direction of some sources that back up the "90% [in the typical case]" claim? I'm genuinely interested in learning more.
"What was your most recent valuation?", "What is the size of my grant relative to the full dilution of the company as of today?", etc, get you more signal with less social awkwardness. I mean, at a minimum, it's more of an imposition than "Give me the salary details for everyone at this company", which is for better or worse radioactive almost everywhere, and in addition to similarly being against the corporate interest also tends to disclose privileged information about folks who wouldn't even be listed in salaries.csv.
P.S. In my n=2 experience as a very small angel investor I am struggling to remember ever seeing the full cap table. I'd have to check my docs to see if I'm allowed to ask for it, but my limited social radar for the Valley suggests that's the sort of thing that would be socially contentious. Founders I invested in were very circumspect about getting explicit permission to be able to quote the fact of the investment publicly, to say nothing of the amount.
P.P.S. Disregard the above if somebody who does this on a more regular basis suggests that you're more in touch with reality than I am. It's possible.
Cap table transparency would go a long way in making VC-istan honest because the equities in salary tend to be small while those in equity are massive. If engineers in a typical VC-istan startup found out that the non-tech VPs and "product people" working 10-to-4 were making $140k while they make $110k, nothing would happen. That's not enough of a difference to set most people off. If they found out that those people had 1% while they had 0.05%, it'd be epic. (That's why VC-istan hides cap tables. It doesn't want to have to admit that engineers are commodities to it.)
If you don't want to work at a company where a pencil-pushing meeting-dwelling financier is going to earn an outsized reward compared to your efforts as a software developer, don't work for VC-funded startups. On the other hand, VC-funded startups tend to work on fun speculative problems, because they're powered by other people's money.
What a "non-tech VP" makes has nothing to do with an engineer's outcome. Obsessing about what other people in the company make is unhealthy.
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