In my experience most people at startups who leave end up not exercising their options due to the cost of exercising them coupled with the fact that they may be underpaid due to the assumption that their options may end up quite valuable. So basically they pay somebody 90k/year then give them ~20k/year in options. Then they quit after 2 years and have 90 days to buy like 50k worth of stock at the strike price they were promised.
So they end up paying 50k to buy some common shares (not preferred). An investor who paid 50k to invest in the company most likely got preferred shares, so the young guy who paid 50k who probably can barely afford that is now taking way more risk for a much smaller percentage of the company. If the company goes under the preferred shareholders have a chance to get their money back during a firesale of assets or IP or whatever, but the common shares are screwed.
So I tell virtually everybody unless there is a well established secondary market to sell your shares of your particular company, then don't take the options.
I honestly think the 90 day exercise is totally ludicrous in the startup world. I think that should be a major negotiation point with anybody who is joining a startup. They should just insist on it no matter what.
> I honestly think the 90 day exercise is totally ludicrous in the startup world. I think that should be a major negotiation point with anybody who is joining a startup. They should just insist on it no matter what.
Unfortunately, while the number of options, salary, holiday, etc are relatively easy for a company to change, I think changing the contracts around exercising for a single employee is a change large and complicated enough that companies are unlikely to do it.
Yea I'll have to find some term sheets laying around, but I can't remember seeing the 90 day exercise being explicitly written into most term sheets. I only have seen it written into people's offer letters. Does anybody know where that language would be written actually otherwise? Some sort of bylaws or something -- seems like that could be relatively easily changed to read something like "exercise period of employee stock options is 90 days after termination of employment unless otherwise stated in employee offer letter and should not be greater than 10 years."
Eh, worked at one where there was a departmental exodus while the company was expected to IPO within the year (and it did). Plenty of people left due to political reasons or after full vest, exercised their options, and made out well. Anecdotes.
> An investor who paid 50k to invest in the company most likely got preferred shares, so the young guy who paid 50k who probably can barely afford that is now taking way more risk for a much smaller percentage of the company.
The common shares cost less than preferred shares as they lack the preferences. So when the employee leaves, her 50K will buy a larger percentage of the company than your hypothetical investor. She may of course still be taking a larger risk as she probably has a smaller asset base than the investor and his customers (err, LPs).
> Then they quit after 2 years and have 90 days to buy like 50k worth of stock at the strike price they were promised.
This is missing the key point of the article which is that there are also taxes to pay, not just the strike price. What you're saying is valid -- even the strike price can be a lot for someone to afford on their way out without any liquidity. But it is very important to understand that it's much worse than that at "successful" startups that have increased in value substantially over those 2 years. You also have to pay AMT (28%) on much of that gain in value, which could end up costing even more than the strike price itself.
To add a counter-anecdote, I left a startup while still having a good amount of faith in the company. Left after finishing work on a couple of their products because I wanted a lifestyle change and had an opportunity to strike out on my own venture. The product was great, but engineering culture was a death march, partially due to the seasonal industry (hardware/toys) and partially due to management.
Oddly enough, a bunch of other engineers also left shortly after -- after all the hard work was done. Company is profitable now due to increased sales, but also cutting salary costs. Strike price was still low when I left, so I bought my options.
Just playing devil's advocate here: So they are leaving because they have low faith in the company, but still expect to be able to collect rewards on other peoples' work years later if the company happens to succeed?
If they didn't have a high degree of confidence in the company, the safe bet would always be to not exercise.
Curious about this, what "distinction" are you referring to here exactly? My understand is that the whole point of preferred vs. common shares is that there's a distinction: preferred shares get, well, preference in a liquidity event. This ensures investors recoup their losses if things go awry.
At this point, anybody offering those terms is well-aware it's not in the employee's best interest. And they don't give a shit. I agree, 90 days is totally ridiculous.
A 90-day window might be better for you if you want to stick around at a company for a while and there were other people that came before you, but left. "Dead equity" of startup employees who have left but not exercised means that they can let you do all of the work while they dilute the available equity pool (i.e., take money directly out of your pocket). This a16z article goes into this: http://a16z.com/2016/06/23/options-timing/ (Though I'm not saying I agree 100% with their naturally biased position)
An extended exercise window is not an end-all-be-all solution. Other solutions that don't have the dead equity problem include:
1. Actually pay startup employees reasonable salaries and don't pretend their equity is 100% certain to lead to great riches since it is a risk
2. IRS / Congress could fix tax treatment in this situation, since it is not serving the purpose it was intended to (avoid rich people dodging taxes)
3. Startups actually IPO / get liquid faster instead of contributing to our existing private equity bubble where liquidity events are delayed indefinitely, rendering equity useless. More liquid cash flying around is generally better for everyone as long as it's not a dotcom-era bubble.
Employees have just as much of a responsibility to learn this stuff as their employers do to act generally ethically. They're your employer, not your parents.
I can't help but feel the system is highly rigged in favour of investors.
Many countries have tax incentives for investors, but when it comes to people actually joining startups, investing their time and effort, then all you get is a tax bill - and mostly at a highly inconvenient time to pay it!
It very much feels like the system is designed to keep the rich rich, and to put the working (wo)man in their place.
Our perspective depends on the relative value/scarcity of capital.
If capital is scarce and valuable, it makes sense for a system to be designed to reward and protect capital risk.
But the "standard terms" haven't changed much since the 80's and capital is definitely more abundant today than it was before. Valuations for early companies are ~10x what they used to be decades ago. Founders give up a fraction of ownership compared to what they used to.
The question is where the right balance point is given current parameters.
Also, wages have never been higher for tech employees. I'm happy to have a 2x wage level conspared to 15 years ago rather than have the same wage but 2x equity (obviously a simplification), so something's at least working well here wrt labor gaining some ground on capital.
There are two different things going on here though - one is whether we offer incentives for investors.
The other is how the tax system works when people receive options / equity.
The problem with 'receiving' equity is that 1) Current laws treat equity as if it was cash - but it's not. 2) Whether employees should be compensated and recognised for their potential opportunity costs - essentially given a similar deal to investors.
Keep in mind that many startups will offer equity in lieu of the salary that they would otherwise command.
Also, if you're offered a significant portion of equity in a startup, then taxes currently make a large disincentive for people to accept and join the startup.
Some countries let you pay taxes on liquidation, others demand to be paid on receiving something, despite it being impossible to liquidate. The USA is the second kind of country with AMT, and that is the fundamental problem.
The US is probably the worst in this respect, and I heard Canada is quite bad, but most of European tax systems follow the "pay taxes only when money comes your way" principle, which puts all investors on equal footing.
On the other hand, if you are lucky enough to work somewhere in the UK that grants options, those options are likely void the moment you leave the company so this entire discussion wouldn't even take place.
I've been granted options twice, both times essentially designed to stop people leaving during a rough period. Given how few UK startups float it wasn't much of an incentive!
After working at 4 different startups over the past 10 years I can tell you with a very high certainty that the only people who will make much $$$ from options are founders and investors.
Early Employees generally are shafted. Don't think your 20-200 basis points will be worth anything at the end of it. Make a decent salary and avoid companies that work you to death. Take it as a learning experience and look at the options as pure monopoly money.
EVERYTHING is skewed towards founders and investors.
Do you have voice and power in future negotiations about the direction and equity breakdown of the company? If so, the promises are worth something. If not, they likely are only worth enough to convince you to not sue about it, because that's what the actual incentives are in future capital negotiations.
Stock options are not complicated. Most people who look into the details of them will find them very plain and actually quite simple. The issue is you don't often deal with this area of finance so it looks foreign until you spend some time looking into the terms.
Your options are a contract between you and the company for you to buy shares at a given price.
If the value of the shares is worth more then you pay, the difference is income. "Value" is a 409a valuation ask your CFO what it when you execute.
Enter the accountant who will tell you how much your liability is for that income ( it varies no more then a dozen other factors affecting your yearly taxes )
Your shares are illiquid, and likely worthless. VC's and other institutional investors have contracts with the company that means they will get paid well before and much better then you. This should really be the first point since you should have known this when accepting your compensation package.
> If the value of the shares is worth more then you pay, the difference is income.
This turns out to be true, but I think it overlooks hidden complexity.
1) You'll find a bunch of stuff online that says you don't have to pay tax on that difference if you're getting ISOs. Options newbies who believe that ISOs have no tax burden, newbies who don't know that AMT is a thing, are going to have a bad time.
2) Since AMT is a thing, it's difficult ("complex") to use options safely, if only in the sense that it requires making a prediction about the future. Exercise early and you could lose your investment if the company fails. Exercise late but pre-IPO and you can find yourself in huge trouble, on the hook for hundreds of thousands in taxes with no way to sell your stock to pay your taxes. If you exercise post-IPO and sell on day one and you'll more tax than you would if you hold for a year. Making the right choice here can be difficult.
Agreed. Takes maybe a few hours to understand the terms.
BUT, most technical folks are very uninformed about investing and finance in general. Many brilliant engineers at my previous employers were utterly confused about their options as well as their decision making after IPO.
So I think the difficulty also stems from a lack of development in financial acumen generally.
+1 for development of financial acumen. We can often point to people taking out 18% APY car loans, or going to Payday loan vendors and say how silly they are for not understanding finance, but we turn a blind eye when its the finance that effects us ( even though one could argue that compounding interest on a payday loan is probably more complex then your basic stock option grant )
Just a bit off topic: I'm from Brazil, working as a contractor for a company in the US. They offered me stock options and I'm totally lost about this. Not only because this isn't normal in Brazil, but, the majority of the articles in the wild only focus in the US scene. I want to know more about how this works when you're not in the same country as the company. Will I be double taxed (in US and Brazil)? On what rules I'll be able to exercise my options?
Regarding stock options expiring 3 months after leaving the company, it doesn't have to be this way and a lot of startups are moving in the direction of 10 year exercise periods.
As somebody who has personally experienced every aspect of the stock option lifecycle (which fortunately worked out for me), I would never take a job at a company [1] if they didn't have an extended exercise window. The 90 day expiration period creates a massive gap between the risk/reward of equity for founders and the risk/reward of equity for employees, when the whole point of giving equity is to align those.
1: Assuming it was the type of company that compensated people with stock options
I'm not sure about "a lot of startups", I'm personally only aware of a very few that are doing this. Word on the street that I hear is that maaaaybe your current employer might do this for employees they like, but not as a consistent policy. Many board members, founders, etc... feel they will take a retention hit if they were to implement something like this.
I personally think the status quo is insane, and I will never take another role with a options component of the package that does not have a policy like this.
> Regarding stock options expiring 3 months after leaving the company, it doesn't have to be this way and a lot of startups are moving in the direction of 10 year exercise periods.
This requires converting all options to NSOs, and the tax implications of NSOs are not pretty. (From a tax perspective, ISOs aren't great[0], but they're much better for employees, by design).
[0] You have to pay AMT on the spread between the option price and current value at the time you exercise, whether or not the equity is liquid, so you could end up paying a large tax bill only to find that the company goes bankrupt before you have the opportunity to ever sell your equity.
The kicker here is that the option life is 10 years, even if you have left the company. So you can avoid tax by not exercising until you plan to sell. It becomes a personal choice between 1) do i want the option still, even if i quit, and 2) do i plan to have ownership in the company for a period longer than a year before i sell. Typically most people would prefer 1 over 2.
Keep in mind for someone reading this comment, this is about private companies.
What are the tax implications of NSOs?
ISOs are a pretty huge gamble, basically a lotto ticket, if you leave before a liquidity event occurs or is known to be on the near horizon.
Have any startups with 10 year exercise periods had a liquidity event yet? I'm genuinely interested to see how true to the idea they were, or whether they (eg) issued a bunch of new stock to current employees that diluted vested ex-employees.
Some companies allow their employees to sell a portion of vested stocks whenever they're doing a new round. SpaceX is one of the top examples I know of. This is how they retain the top talent.
What is the general view on this? I don't have an economics background, but.. Well, the 'startup scene' isn't necessarily mature and/or tested enough for employees to be able to take a 10 year risk. In a sense, for a failing startup, stock options might as well be monopoly money.
It's not really a 10 year risk, as you keep the options that have vested whether or not you're still with the company. And if the startup fails, if you haven't exercised, you shouldn't be out any money.
AMT and the 90 day limit on exercising after leaving a company are the main things that make options painful. There has been some movement in the industry to get away from the 90 day limit (by converting from ISOs to NSOs), but has there been any recent attempts to get the AMT rules changed for ISOs? Does anyone think the current AMT rules for stock options are fair? I'm curious how this is viewed by people outside the industry.
Most people think AMT is a badly thought out disaster, but it brings in too much tax revenue and effects the upper middle class, so there isn't much sympathy / political capital for it. AMT also ignores state income tax deductions, which is pretty screwed up!
I think ironically to the bubble many of us live in the Silicon Valley, this was proposed by a Republican and passed in the House. Never made it in the Senate. A refreshing reminder good ideas still come from all slices of our political spectrum.
Everyone hates the AMT; very roughly Democrats think it's a broken tool for addressing a real problem, and Republicans see the problem it addresses as a good thing.
I'm curious how ISOs can be abused without the existence of AMT (which gets at the same question from a different angle). Maybe for executive compensation?
This is great write up. Kudos to the author for taking the time. I did have a question about the following sentence:
>"If an employer gives you straight-up shares, then the IRS will tax the shares (at ordinary income rates) when they vest."
What would be treated as income and taxes here, the strike price x the number of options vesting? Is that correct? For regular worker bees this not very much though right? For instance say an employee has 25 shares vest in a quarter and their stick price is $20. 20 x 25 would be $500 more being taxes as income. Or am I completely not understanding something?
If it is not the strike price being taxes as income what is it, since the the value of an option is often unknown to rank and file employees let alone the IRS.
Shares vested x fair market value at vest. So you get 1000 shares when you join, worth $1/share. 250 vest on your first year, and that's when tax is due. But say the company grows and shares are $5/share. 5x250 is 1250 taxed income on the anniversary. Normally at early stages you're talking many thousands of shares though, that can increase rapidly.
The fmv is recalculated every year, or on any fundraise events. It needs to be a defensible number or the irs will be upset
>"The fmv is recalculated every year, or on any fundraise events."
This is the piece I was missing. Thank you for the clear explanation.
That being said it would be interesting to buy exercise them just to see what the company is actually valuing those options at, since this is often opaque to the average worker. I wonder if it's possible to exercise a single option and use it as a barometer of sorts to quantify you actual compensation? My guess is no.
But you can frontload all the "income" and taxes upfront. That's what an 83(b) election is: "Hi IRS, I'd like to pay/recognize this taxable event all right now, even before it vests".
So you get 1000 shares x $1/share = $1000 of income, and you pay taxes on it.
Readit News
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.
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.
> 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).
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
Deleted Comment
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.
If they didn't have a high degree of confidence in the company, the safe bet would always be to not exercise.
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.
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.
Obviously rife with other consequences.
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!
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.
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.
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.
I think Quora was the first to do this: https://dangelo.quora.com/10-Year-Exercise-Periods-Make-Sens...
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
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.
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.
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.