Startup ISOs are totally broken, and VCs and founders would rather write 30 page treatises on all their complexities (of course, glossing over the 99 ways to screw employees), than actually try to improve them.
A small percentage of people got rich off options a handful of times a long times ago, and since then countless people have been screwed.
Public RSUs for stock you can sell immediately on the open market are fantastic.
Common ISOs are toilet paper. At a _minimum_ you should get a 10 year exercise window, and if the CEO tries to say that would make it so early employees can hurt cap tables for future rounds, he's basically saying he doesn't consider your equity grant to be real equity as it deserves to be clawed back for the sin of not wanting to stick around for the 15 years it takes startups to IPO these days.
These exact same people will try to convince you that their ISOs are a valid subsitute to liquid RSUs, THEN say that they don't deserve to be "preferred" instead of "common" because the VCs put in actual money (hint: so did you if you turned down a public company to work at the startup. Biggest difference is only that you're way less diversified).
Am I ranting? Of course, but if VCs and founders are going to continually "educate" engineers on their equity offers, engineers need to stand up and inform each other of the pitfalls. I know countless people, myself included, who have been screwed by ISOs. You can actually lose money because the 30 day window forces you to pay strike price + taxes on gains, then you find out that the CEO sold the company at a bargain so liquidation preference kicked in and he just took a huge retention bonus instead.
The way out of this mess is not Github treatises on how to evaluate your equities. The way out is for engineers to continually tell founders/VCs that they will pick public companies instead of startups until ISOs get fixed. If ISOs screwed over VCs instead of engineers, they would have gone to DC and gotten this fixed 10 years ago. At an absolute minimum you shouldn't have to pay a dime in taxes until you've actually realized some money in your checkings account. VCs/founders don't care because they don't have to care because engineers are still too gullible and accept these bogus deals.
> don't deserve to be "preferred" instead of "common" because the VCs put in actual money
I agree with most of what you said, but a nit: one perspective I've heard on the motivation for preferred stock is this:
Suppose I give you $10M to start a company in exchange for 10% of it. You then easily sell the company for $9M, keeping 90% * $9M = $8.1M for yourself and returning $900k to me. Preferred (non-participating, 1x) shares prevent this problem by making sure you can't just run away with the money: you have to actually use it to build the business.
People investing in the company in non-liquid ways (e.g., the founders or engineers, via opportunity costs) aren't in the same boat, because their opportunity cost can't be immediately liquidated.
Except employees do invest money in the business by exercising their options. And that money, dollar for dollar, buys them an inferior product: lower priority in the liquidation stack; less liquidity because of abusive bylaws restricting secondary transactions; less tax benefits since your “gains” are taxed upfront.
The lower the pay, and the higher the relative cost of exercising, the worse it gets. So higher-paid executives are less penalized than entry-level employees who might spend their savings exercising options that will end up worthless.
This is one of the better explanations I've heard about preferred stock. I'd say the counter point for the engineers at least is that frequently the opportunity cost for them is vesting stock.
That lost revenue over the vesting period is IMHO the same as directly investing cash in the company that the company itself can liquidate. I would say that when shares are used for compensation with a vesting period they should be treated equivalently to investors that are directly putting cash in.
>Suppose I give you $10M to start a company in exchange for 10% of it.
The scenario you present is a great excuse for preferred stock but the same result could be achieved by other methods.
For example the minority shareholder in this case could be given a veto over the sale of the company for anything less than 1.x times the most recent valuation. Or they could be given the right of first refusal on the sale of any shares.
But yeah I think it's just generally pretty common in the gamut of human relationships for people to try and put themselves in positions where they can't get screwed by putting themselves in positions where they can do the screwing. It's also pretty common for predators and control-freaks to try to elevate themselves to advantageous positions by justifying it in terms of having the right to defend themselves.
I think a good partnership is one where all sides work together to not only align their interests, but also to structure things in a way where everyone feels safe. It's much easier for me to totally throw myself at a cause, especially one that may involve making sacrifices, if I don't have to worry about the potential for getting screwed for my efforts. Having shares that I know will be just as valuable as all the rest can go a long way towards achieving that.
Right, I think the way to think about this is that common shares are for sharing in the value created at the company over and above the money invested in building the company. If your company spends all that excess value on perks and generating usage, then your common is more likely to get wiped out.
So use tranches and don't invest in founders who are going to run away with your money? If you're afraid of losing $10M because you don't trust the founders to invest it in their business there are safer investments you can make.
Exactly this. As far as I'm concerned the purpose of ISOs at companies more than a year old is to trick junior engineers into accepting a lower salary than they would receive elsewhere. Unless you have at least half a percent of a company you really, truly believe in I'd just ignore this article and put the value somewhere between $0 and a roll of lottery tickets.
Worse, as OP states, they can cause you to lose money. They can be worth less than zero dollars. Pay piles of taxes on the exercised options and then watch the company get gutted and preferred investors take everything.
I'm not saying you're wrong at all -- most typical startup ISO offerings suck and are not good situations for employees.
That said, as a founder who custom designed our stock plan to be as employee-friendly as we could, there is a better way when actually done right and not just "following the standards".
Stock plan improvements like super long post-termination exercise, offering RSAs instead of just stock options, and most importantly in my opinion, adequately educating your employees on the risks and return possibilities of their equity!
It is irresponsible and manipulative. IMO, for a company to say, "we're giving you X shares worth Y dollars now and it might go up way more than that." While many employees' eyes will glaze over a bit if you start citing tax code, helping them get the basics and fully internalize the risk/reward tradeoff is both doable and necessary!
Equity can be a really valuable part of early employee equity and it's just as much of a peeve of mine to hear people say it's worth $0/lottery as to hear companies oversell the startup dream.
Classic tragedy of the commons scenario. ISOs were originally a great idea for how an early group of employees could take a big salary cut in exchange for a shot at getting wealthy. Founders and employees both had common stock and would sink or swim together.
Then over the decades information asymmetry started to chip away at this with investors realizing they really only needed to keep the founder happy, and they could steadily chip away at the outcomes for the rank and file given those young engineers would keep coming in based on the mythology of getting rich from the previous generation.
It took awhile, but now that trust has been fully eroded, and simultaneously FAANG have recognized the value of top engineering talent, paying salaries to ICs that would have been unthinkable in the 20th century.
It's going to be very difficult for investors to win back trust because now the information asymmetry works the other way, with young talent just assuming ISOs are worth nothing. Even if founders make an effort to do right by early employees, it's very difficult to demonstrate this to someone who is suspicious but not seasoned enough to know what questions to ask.
Yeah exactly. Early in my career, I loved working at startups, and aside from compensation would prefer to do so again, but the opportunity cost now is way too high. The one advantage I see at a startup is that if you pick one with a decent engineering culture, you can learn a lot more than most FAANG roles (although you'll probably learn more at the best FAANG roles than at good startup roles? Unclear.)
"VCs and startup founders are shooting themselves in the foot. It makes very little financial sense to work at a startup vs FAANG these days."
Consider that it makes no sense to do almost any job if you can work as a dev at a FAANG.
Not everyone can work at a FAANG, moreover, this is not just a VC/Founder vs staff problem, it's an existential startup problem vis-a-vis FAANG and the rest of the world. You see the issue in housing affordability etc..
Indeed. Real upside is the only thing that lets them at all compete for employees. Investors facilitating deals that screw early employees are poisoning the well for all their future investments.
Also these days a motivated eng will get exposed to many projects / processes at FAANG at usually a higher quality than at a random startup. You used to need to go the startup route for generalist experience but there's so much you can pick up at the big co's nowadays.
It seems that the fairest way to compensate employees at a startup is to pay them in cash, but also allow them to invest at each funding round with the same terms and conditions and liquidation preferences that the VC's are getting.
If the company also actually grows and is profitable, there is also little reason not to give out cash, because the equity is more valuable than cash. Usually equity is given so that employees would work more like owners, taking care of the long-term value of the company. However I don't see this working for many people because many people just don't see the value of owning companies - they don't invest in stocks etc.
Reminds me of employee stock purchase plans at big (non tech, older industries) companies where you can buy your employer's stock with your pre-tax income. There might be something to this idea.
But that causes employees to lose a powerful tool they have: ability to invest future earnings in the company and recall their future investment (by quitting) if things don't work out.
Some of the reasons VCs get a better class of shares than employees are structural and unlikely to go away no matter how ISOs are structured; for instance, VCs get liquidation preferences for reasons that are sort of intrinsic to the concept of equity investment.
The exercise window thing is a valid point and is a reason to devalue employee options.
Then perhaps the start up should just pay above market rate in salary and not offer any ISOs since those ISOs are so dang valuable but couldn't possibly be given the same liquidation preference?
83(b) election is one way to make ISOs more on par with RSUs. 83(b) isn’t cheap... But! These days a lot of companies (especially FAANG, but start-ups too) are offering $20k-$100k signing bonuses; those bonuses essentially give the appearance of competitive total comp while in actuality depress base salary growth. It might be productive for employees to push towards having signing bonuses turned into an 83(b) election bonus that covers strike and (some amount of) taxes. Then fewer employees get roped into dumb tax games that only entertain investors, and we’d be moving the notion of competitive compensation towards reducing stock risk for those who can least afford it. (If salaries grow more rapidly as a side-effect, that’d be nice too).
I've never taken a job in 20 years because of money and I don't advise anyone to do that. I choose a company for culture, the people I work with, the kinds of projects, and quality of life. Also a desire to ship things and not spend my days in meetings or dealing with bureaucracy, a desire not to work with jerks, and a desire not to work on lines of business that I find morally repugnant. The latter criteria have made most of my FAANG offers quite unappealing. But I love going to work at a startup with my buddies, building cool tools that help people, and spending plenty of time with my family.
They commenter isn't saying you should pick a job just because of money. But you should also avoid a job that is taking advantage of you, by giving you absolute crap compensation, by "selling" you ISO's as something valuable, when in most cases it isn't because of the constraints.
We all want to work on things that are cool, but we also have bills to pay, and retirement to prepare for.
If you’ve never done it, maybe you shouldn’t be giving advice on it?
I just took a job at a smaller public tech company that’s paying me almost what I’d make at a FAANG (more than double what startups were offering), and I’m experiencing none of what you’re talking about. Great work life balance, WFH whenever you need to, people are in the office 40 hours or less, people take 5 weeks vacation per year, we don’t have a crazy amount of meetings or bureaucracy, and our business is selling useful software tools to customers who pay us money for them.
Pretty nuts to do that while getting paid nearly half a million per year.
>... you find out that the CEO sold the company at a bargain so liquidation preference kicked in and he just took a huge retention bonus instead.
There's something potentially misaligned between the control of the founders and the final grant value on the other end. There are so many ways to distort this in the final exit deal and these are details that you probably won't learn about unless you happened to exercise stock before the exit happens. In general, the positive outcomes seem "capped" in that a founder is inclined to lock in their gains with an exit if the deal is reasonable for them.
Maybe the option shouldn't be as a share of the company but a share of everything the CEO/founder makes from there on out. :)
For really early stage, I generally assume that a founder is trying to at least 10x their net worth so any hand wavy exit estimate generally gets capped with that in mind.
I agree that the way a lot of companies structure their equity compensation is terrible. How would you structure equity compensation at a mid-stage startup where a share grant would come with a real, substantial tax hit, without any possibility of liquidity in the near future?
I'm asking because we're just starting to think about how to do this ourselves, and I agree that most equity plans are giving engineers a raw deal. The answer might just be large share grants, at least until the share value makes that unattractive. I'd love to hear other peoples' thoughts on this.
IIRC, much of the reason ISOs work the way they do is because of the way the IRS treats them, and companies that offer much longer exercise windows are having to work around these limitations to do so.
Having a 10 year exercise window on options helps quite a bit. In most cases there will either be a liquidity event within 10 years or (for companies that are successful but stay private longer than 10 years) the company will have multiple huge fundraising rounds and can allow early employees to cash out some shares in a secondary round.
To be fair the CEO should either eventually push for a liquidity event or should be open to allowing employees to sell shares on the secondary market.
Enough that's a nice bonus but still a minimal part of total compensation. IRS treatment of ISO/NSOs is part of the problem but the real issue is lack of liquidity. If you do make the equity significant at least give your employees the option to periodically liquidate to reduce the risk of them paying tax on money they'll never see.
Tax issues aside there are many startups whose equity is incredibly valuable on paper but the stock is trading for a third of the FMV on the secondary market, if there are any buyers at all.
The downside is that employees pay ordinary income on the full IPO value, but there are no upfront taxes and no exercise dilemma for people that leave after vesting.
"I think the biggest gap that this guide and every one I've seen like it that they undersell the positive value for employees of the Restricted Stock Award (RSA). RSAs can be significantly better than ISOs in many situations.
There is no actual reason why companies can only offer RSAs to founders and super early employees. The taxes get trickier once the strike price gets high enough, but employees should have the choice to maximize their equity value!
From the very beginning of founding my company and still 5 years later, we offer our employees the choice to take their stock as RSAs, options, or a combination of the two. We also teach a mandatory "Stock 101" course every quarter for new employees that is a 1.5hr version of this guide.
Too many employees' (engineers in particular in my experience), don't actually understand how their equity compensation works and I think it's the responsibility of the company to educate them -- both for their current role and possible future job offers."
This stuff is a huge personal passion of mine and we've put a lot of effort (and lawyer dollars) into this at my company. Feel free to reach out anytime.
Your post captures my feelings and experience perfectly. I will never trade cash compensation for ISOs again. It sucks because I'd rather be working for small companies, but I'll be God Damned if I'm going to get some asshole rich off of my hard work.
This! In addition to all of the above, it is very hard for the candidate to judge what "0.X % of the company" is worth. Like if one gave up, say 50,000 in salary, is the equity worth that much or some good multiple of it.
The "preferred shares" and various other gimmicks played by VCs mean they might let the "current value" appear inflated than it really is. I have seen startups "start" with a valuation of "50 million dollars" out of thin air. No sales, no product, but a combination of confusing paperwork makes it appear as if someone recently "invested at that valuation". It will be too late by the time you find that the investor was nothing other than the founder, who found a creative way to value his/her time or seed money.
Another major mistake made by new candidates is to miss the fact that there is a vesting period - the upfront large amount means nothing if you quit after a year. On top of it one may not even get any new ISOs in future years. Companies always show "current-year salary + total ISO issued" as "total compensation" - that is absurd. Even if you know what you are doing, you will fall for it after 10 repetitions.
The standards that have us thinking about this in terms of % ownership of the company is part of the problem IMO. Future rounds and other factors can quickly make this calculus impossible or with 1000% error margin.
IMO, the correct way to approach this is keep everything in terms of $$ values. There is available research online that can allow you to aggregate data for comparable companies on things like:
"if the preferred shares price was worth $X per share at the series A, what was the that same share worth at IPO/acquisition?" It's still not easy to answer as the data is sparse and widely varying, but thinking in these terms normalizes the conversation around dollars and gets rid of the "what dilution might happen" part of the equation.
For example, my company is in the open source data infra space. So while its hard to get very many data points, trying to get info about the preferred and common share prices at each round and all the up to IPO of companies like MongoDB, Hortonworks, Elastic, Cloudera, etc -- even though they all raised totally different number of rounds and IPOed at different valuations -- in aggregate you can start to build an insightful picture.
I've been in that scenario, and honestly I can't imagine why any sane person wouldn't have them convert to NQSOs rather than the true poison of needing to exercise within 90 days. An extremely common scenario:
1. You work your ass off at a startup for years, but even after all those years the company is still not public and the stock isn't liquid.
2. You quit, so you have 90 days to decide if you want to cough up the cash to pay for those options, with no real way to sell.
3. Oh, don't forget the huge AMT bill you'll likely get that year.
4. Pray to God that company is eventually sold for more than all the liquidation preferences of the investors.
Would you rather have that or take the 24-37% potential tax hit (when you can actually sell your shares) vs 15% capital gains.
Also note you can write it so that the decision is totally up to the employee: exercise within 90 days and they're ISOs, after that either lose them or convert to NQSOs.
> Public RSUs for stock you can sell immediately on the open market are fantastic.
I mostly agree with this statement, but they are not entirely without risk. With the almost universal 6 month lockup these days, through an IPO employees could be left with a large tax burden, including having to make quarterly estimated payments, on a bunch of income that might be worth less than it was taxed at, or even worthless, if the company folded.
Sure, it's unlikely, but look at some of the 2019 IPO flops. If you are taxed on a something like a million dollars of income, but only actually pocket half that, then at the end of the day you effectively have a quarter of what you started with.
But for an engineer they are comparable, because many are deciding between the two. So do you want the bucket of beautiful, fresh Honey Crisps, or 3 month old moldy juice oranges?
Fully agree with you. How would you solve it then - besides engineers being more explicit with founders? (not trying to be smart with you; honest question).
Sam Altman did a post with some simple things a couple years ago. Three easy things:
1. Extend the exercise period to 10 years as GP says. Many companies have done this. Literally, all engineers out there, just walk away if they insist on 90 days.
2. Make the option pool bigger. Altman has a very good point, that companies try to pretend that the size of the option pool is something set in stone. The board just made that number up, they can change it, and if the pool is too small to support decent equity compensation, again, walk away.
3. Founders will need to give up more equity. A founder does deserve to make a lot more as they took the initial risk on the idea, but it's bullshit that a founder deserves to make, say, 50x a very early critical engineering hire.
At the end of the day I do believe the market will force a shift. The FAANGs are paying so much, and while it's taken some time employees, especially junior ones, are starting to get better at evaluating their comp offers, specifically because of comment threads like this one.
Yes. Options given to you by your company as a non-cash compensation is an equity grant because it gives you the right to equity ( shares ) in a company. If you "exercise" the options, you get X amount of shares in the company.
I worked for a startup founder and personally watched him screw advisers out of stock agreements using different tactics, from technicalities in the agreements to outright not honoring the agreements when he knew it was disadvantageous for them to pursue him legally. He gloated about it and would speak very highly of all the ways he could manipulate situations.
In the end, I left and the startup went under, and I told him directly that I didn't trust him (to his surprise). The lesson that I learned was that I'd be a fool to take equity in a startup, given all the ways I could be screwed, and my lack of resources to pursue any legal recourse. Cash only, from now on.
I think the first thing someone should consider when looking at jobs is their risk tolerance.
If you don't have two parents who are alive and healthy and own their home mortgage-free, you probably have a low risk tolerance. Go work at a FAANG; ISOs have an effective value of $0 to you.
If your grandpa can afford to give you $10000 to start a startup, or if you can always move into your parents' basement when you become broke, then I would think about a startup. You can tolerate owing hundreds of thousands in taxes in the worst case, and the higher expected value (and higher personal growth, in the early years) is worthwhile.
“RSUs are often considered less preferable to grantees since they remove control over when you owe tax.”
Who the fuck cares when you pay tax? A small % of people will have enough value to worry about that. The vast majority of people tho have a bigger worry: the stock is worth less than what they pay to exercise, because when you leave your company you have to exercise em or lose em.
Dual trigger RSUs solve that. I don’t have to pay a freakin’ dime whether I stay or leave. I keep my vested RSUs and ride off into the sunset and if they someday become worth something, the company just withholds some shares to pay the tax. Again no up front cash when I leave the company and no large tax bill.
AND I get to keep the whole value of the share. For ISO you only get delta between exercise price and strike price. If my RSUs are $5 or $15 apiece who cares, it’s all risk-free gravy / upside. If I have ISOs I’m worrying about strike price and whether it’s worth it to exercise.
I don’t know who in their right mind would want ISOs over RSUs.
I have had a number of successful exits but the bottom line is that you're (probably) not getting nearly enough options to offset the risk.
Pasted from a comment I made in an earlier thread:
80% of startups fail and 20% succeed in some fashion. Which means if you normally make $50,000 and take a $5,000 paycut (no rsu) to work there you will lose $20,000 over the 4 year vesting period.
80% of the time when the startup goes bust you make 0 on equity and still lost money due to the paycut. For a total of 8x20 or $160,000 loss.
The two times you are successful you make 2xEquity.
This means your equity has to be at least worth $80,000 each time you succeed.... just to break even.
Factoring in the risk of your equity being 0 you should be getting a LOT more equity.
It's very similar to calculating expected value in poker.
Doing EV calculation with personal finances is also tricky, because you don't get repeated trials. In poker, assuming you have an appropriate bankroll, you should be able to make risky but positive-EV bets hundreds of times, such that you will realize that EV. For job choices, you're not going to get more than a few cracks at it. You really need to be more concerned with risk of ruin, especially when the ratios are greater.
The difference between FAANG and early-stage startups can easily be a 50% pay cut, with at least 5 years until liquidation. If you have a 50% chance of that bet paying off, then maybe it's okay - you can do this twice a decade, and you're reasonably likely to end up at least even over a career. If you have a 5% chance of the bet paying off, even if the rewards are large enough to make the EV even or positive, that's an insane amount of risk to take unless you're already financially independent, because over a career you're not likely to win even once.
This is one of the fundamental power imbalances between labor and capital: Capital can diversify. To go back to the poker analogy, VCs are playing cash games - they can take 100 bets of which they expect only 2 to pan out. Employees are in a short-stack tournament - even if you make the highest-EV play, if you're going to lose most of the time, you shouldn't be going all-in.
Working at 5 startups with 4 year vesting periods and a 20% success rate (which seems high) means ~12-16 years of taking a pay cut before you get your first win.
And don't forget the compound interest you'd be getting from investing that $20k/year (or $10-$15k after taxes) in a diversified investment like the stock market.
Basically, if you want to take stock, approach the decision like an investor or VC with that level of skepticism and thought. Otherwise you're just throwing darts.
So many of my friends have been screwed over by the technical nuances of equity compensation.
Started Compound (https://withcompound.com) to solve this problem (we generate personalized analyses to help you understand your equity – tax implications, potential value, etc).
If you have any questions/feedback, email me: jacob@withcompound.com.
ISO + early exercise + 83(b) election + QSBS treatment is a massive win as an employee. Very favorable tax treatment, but you have to early exercise, when the strike price is equal to the FMV. If it were me, and I believed in the company, I would value the equity highly, but make sure I negotiated a signing bonus or similar that allowed me to early exercise. The 90 day window doesn’t matter in that situation, although I will grant you that everyone’s financial situation is different, and that having to pay for the stock at all is a drawback. You also have to trust that the founders are going to have your back and not screw you. This is a judgment and personality call.
Context: sold my company a month ago, all employees with options that had early exercised got full acceleration, and even unexercised optionholders were paid out as if they had exercised and been fully accelerated (though did not get similarly preferable tax treatment, obviously). Treating the employees properly (and well) was a massive part of the negotiation.
I think the biggest gap that this guide and every one I've seen like it that they undersell the positive value for employees of the Restricted Stock Award (RSA). RSAs can be significantly better than ISOs in many situations.
There is no actual reason why companies can only offer RSAs to founders and super early employees. The taxes get trickier once the strike price gets high enough, but employees should have the choice to maximize their equity value!
From the very beginning of founding my company and still 5 years later, we offer our employees the choice to take their stock as RSAs, options, or a combination of the two. We also teach a mandatory "Stock 101" course every quarter for new employees that is a 1.5hr version of this guide. Too many employees' (engineers in particular in my experience), don't actually understand how their equity compensation works and I think it's the responsibility of the company to educate them -- both for their current role and possible future job offers.
Can you offer any details on the tax consequences of offering ISOs versus restricted stock? While there has been a ton of discussion of tax consequences for employees, the corporate incentives are less clear and yet understanding them is probably key for progress here.
The playbook for Equity compensation has changed dramatically in the last 20 years in drastic favor of the founders.
During the dotcom days, the number of shares that were given out was very generous. I know secretaries that made enough from IPOs in the late 90s that they could retire and buy a vineyard. Meanwhile I was a relatively early employee at a YC startup that had a successful exit. The founders made 8 figures and I made about 80k over 4 years. I would have made 10x more at a FANG with a regular comp package.
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A small percentage of people got rich off options a handful of times a long times ago, and since then countless people have been screwed.
Public RSUs for stock you can sell immediately on the open market are fantastic.
Common ISOs are toilet paper. At a _minimum_ you should get a 10 year exercise window, and if the CEO tries to say that would make it so early employees can hurt cap tables for future rounds, he's basically saying he doesn't consider your equity grant to be real equity as it deserves to be clawed back for the sin of not wanting to stick around for the 15 years it takes startups to IPO these days.
These exact same people will try to convince you that their ISOs are a valid subsitute to liquid RSUs, THEN say that they don't deserve to be "preferred" instead of "common" because the VCs put in actual money (hint: so did you if you turned down a public company to work at the startup. Biggest difference is only that you're way less diversified).
Am I ranting? Of course, but if VCs and founders are going to continually "educate" engineers on their equity offers, engineers need to stand up and inform each other of the pitfalls. I know countless people, myself included, who have been screwed by ISOs. You can actually lose money because the 30 day window forces you to pay strike price + taxes on gains, then you find out that the CEO sold the company at a bargain so liquidation preference kicked in and he just took a huge retention bonus instead.
The way out of this mess is not Github treatises on how to evaluate your equities. The way out is for engineers to continually tell founders/VCs that they will pick public companies instead of startups until ISOs get fixed. If ISOs screwed over VCs instead of engineers, they would have gone to DC and gotten this fixed 10 years ago. At an absolute minimum you shouldn't have to pay a dime in taxes until you've actually realized some money in your checkings account. VCs/founders don't care because they don't have to care because engineers are still too gullible and accept these bogus deals.
I agree with most of what you said, but a nit: one perspective I've heard on the motivation for preferred stock is this:
Suppose I give you $10M to start a company in exchange for 10% of it. You then easily sell the company for $9M, keeping 90% * $9M = $8.1M for yourself and returning $900k to me. Preferred (non-participating, 1x) shares prevent this problem by making sure you can't just run away with the money: you have to actually use it to build the business.
People investing in the company in non-liquid ways (e.g., the founders or engineers, via opportunity costs) aren't in the same boat, because their opportunity cost can't be immediately liquidated.
The lower the pay, and the higher the relative cost of exercising, the worse it gets. So higher-paid executives are less penalized than entry-level employees who might spend their savings exercising options that will end up worthless.
That lost revenue over the vesting period is IMHO the same as directly investing cash in the company that the company itself can liquidate. I would say that when shares are used for compensation with a vesting period they should be treated equivalently to investors that are directly putting cash in.
The scenario you present is a great excuse for preferred stock but the same result could be achieved by other methods.
For example the minority shareholder in this case could be given a veto over the sale of the company for anything less than 1.x times the most recent valuation. Or they could be given the right of first refusal on the sale of any shares.
But yeah I think it's just generally pretty common in the gamut of human relationships for people to try and put themselves in positions where they can't get screwed by putting themselves in positions where they can do the screwing. It's also pretty common for predators and control-freaks to try to elevate themselves to advantageous positions by justifying it in terms of having the right to defend themselves.
I think a good partnership is one where all sides work together to not only align their interests, but also to structure things in a way where everyone feels safe. It's much easier for me to totally throw myself at a cause, especially one that may involve making sacrifices, if I don't have to worry about the potential for getting screwed for my efforts. Having shares that I know will be just as valuable as all the rest can go a long way towards achieving that.
That said, as a founder who custom designed our stock plan to be as employee-friendly as we could, there is a better way when actually done right and not just "following the standards".
Stock plan improvements like super long post-termination exercise, offering RSAs instead of just stock options, and most importantly in my opinion, adequately educating your employees on the risks and return possibilities of their equity!
It is irresponsible and manipulative. IMO, for a company to say, "we're giving you X shares worth Y dollars now and it might go up way more than that." While many employees' eyes will glaze over a bit if you start citing tax code, helping them get the basics and fully internalize the risk/reward tradeoff is both doable and necessary!
Equity can be a really valuable part of early employee equity and it's just as much of a peeve of mine to hear people say it's worth $0/lottery as to hear companies oversell the startup dream.
Then over the decades information asymmetry started to chip away at this with investors realizing they really only needed to keep the founder happy, and they could steadily chip away at the outcomes for the rank and file given those young engineers would keep coming in based on the mythology of getting rich from the previous generation.
It took awhile, but now that trust has been fully eroded, and simultaneously FAANG have recognized the value of top engineering talent, paying salaries to ICs that would have been unthinkable in the 20th century.
It's going to be very difficult for investors to win back trust because now the information asymmetry works the other way, with young talent just assuming ISOs are worth nothing. Even if founders make an effort to do right by early employees, it's very difficult to demonstrate this to someone who is suspicious but not seasoned enough to know what questions to ask.
Consider that it makes no sense to do almost any job if you can work as a dev at a FAANG.
Not everyone can work at a FAANG, moreover, this is not just a VC/Founder vs staff problem, it's an existential startup problem vis-a-vis FAANG and the rest of the world. You see the issue in housing affordability etc..
The exercise window thing is a valid point and is a reason to devalue employee options.
The better startups will even loan employees "money" to exercise.
We all want to work on things that are cool, but we also have bills to pay, and retirement to prepare for.
I just took a job at a smaller public tech company that’s paying me almost what I’d make at a FAANG (more than double what startups were offering), and I’m experiencing none of what you’re talking about. Great work life balance, WFH whenever you need to, people are in the office 40 hours or less, people take 5 weeks vacation per year, we don’t have a crazy amount of meetings or bureaucracy, and our business is selling useful software tools to customers who pay us money for them.
Pretty nuts to do that while getting paid nearly half a million per year.
There's something potentially misaligned between the control of the founders and the final grant value on the other end. There are so many ways to distort this in the final exit deal and these are details that you probably won't learn about unless you happened to exercise stock before the exit happens. In general, the positive outcomes seem "capped" in that a founder is inclined to lock in their gains with an exit if the deal is reasonable for them.
Maybe the option shouldn't be as a share of the company but a share of everything the CEO/founder makes from there on out. :)
For really early stage, I generally assume that a founder is trying to at least 10x their net worth so any hand wavy exit estimate generally gets capped with that in mind.
I'm asking because we're just starting to think about how to do this ourselves, and I agree that most equity plans are giving engineers a raw deal. The answer might just be large share grants, at least until the share value makes that unattractive. I'd love to hear other peoples' thoughts on this.
IIRC, much of the reason ISOs work the way they do is because of the way the IRS treats them, and companies that offer much longer exercise windows are having to work around these limitations to do so.
To be fair the CEO should either eventually push for a liquidity event or should be open to allowing employees to sell shares on the secondary market.
Tax issues aside there are many startups whose equity is incredibly valuable on paper but the stock is trading for a third of the FMV on the secondary market, if there are any buyers at all.
The downside is that employees pay ordinary income on the full IPO value, but there are no upfront taxes and no exercise dilemma for people that leave after vesting.
From my other comment:
"I think the biggest gap that this guide and every one I've seen like it that they undersell the positive value for employees of the Restricted Stock Award (RSA). RSAs can be significantly better than ISOs in many situations.
There is no actual reason why companies can only offer RSAs to founders and super early employees. The taxes get trickier once the strike price gets high enough, but employees should have the choice to maximize their equity value!
From the very beginning of founding my company and still 5 years later, we offer our employees the choice to take their stock as RSAs, options, or a combination of the two. We also teach a mandatory "Stock 101" course every quarter for new employees that is a 1.5hr version of this guide.
Too many employees' (engineers in particular in my experience), don't actually understand how their equity compensation works and I think it's the responsibility of the company to educate them -- both for their current role and possible future job offers."
This stuff is a huge personal passion of mine and we've put a lot of effort (and lawyer dollars) into this at my company. Feel free to reach out anytime.
The "preferred shares" and various other gimmicks played by VCs mean they might let the "current value" appear inflated than it really is. I have seen startups "start" with a valuation of "50 million dollars" out of thin air. No sales, no product, but a combination of confusing paperwork makes it appear as if someone recently "invested at that valuation". It will be too late by the time you find that the investor was nothing other than the founder, who found a creative way to value his/her time or seed money.
Another major mistake made by new candidates is to miss the fact that there is a vesting period - the upfront large amount means nothing if you quit after a year. On top of it one may not even get any new ISOs in future years. Companies always show "current-year salary + total ISO issued" as "total compensation" - that is absurd. Even if you know what you are doing, you will fall for it after 10 repetitions.
IMO, the correct way to approach this is keep everything in terms of $$ values. There is available research online that can allow you to aggregate data for comparable companies on things like:
"if the preferred shares price was worth $X per share at the series A, what was the that same share worth at IPO/acquisition?" It's still not easy to answer as the data is sparse and widely varying, but thinking in these terms normalizes the conversation around dollars and gets rid of the "what dilution might happen" part of the equation.
For example, my company is in the open source data infra space. So while its hard to get very many data points, trying to get info about the preferred and common share prices at each round and all the up to IPO of companies like MongoDB, Hortonworks, Elastic, Cloudera, etc -- even though they all raised totally different number of rounds and IPOed at different valuations -- in aggregate you can start to build an insightful picture.
1. You work your ass off at a startup for years, but even after all those years the company is still not public and the stock isn't liquid.
2. You quit, so you have 90 days to decide if you want to cough up the cash to pay for those options, with no real way to sell.
3. Oh, don't forget the huge AMT bill you'll likely get that year.
4. Pray to God that company is eventually sold for more than all the liquidation preferences of the investors.
Would you rather have that or take the 24-37% potential tax hit (when you can actually sell your shares) vs 15% capital gains.
Also note you can write it so that the decision is totally up to the employee: exercise within 90 days and they're ISOs, after that either lose them or convert to NQSOs.
I mostly agree with this statement, but they are not entirely without risk. With the almost universal 6 month lockup these days, through an IPO employees could be left with a large tax burden, including having to make quarterly estimated payments, on a bunch of income that might be worth less than it was taxed at, or even worthless, if the company folded.
Sure, it's unlikely, but look at some of the 2019 IPO flops. If you are taxed on a something like a million dollars of income, but only actually pocket half that, then at the end of the day you effectively have a quarter of what you started with.
> Public RSUs for stock you can sell immediately on the open market are fantastic.
Both correct statements, but apples and oranges.
1. Extend the exercise period to 10 years as GP says. Many companies have done this. Literally, all engineers out there, just walk away if they insist on 90 days. 2. Make the option pool bigger. Altman has a very good point, that companies try to pretend that the size of the option pool is something set in stone. The board just made that number up, they can change it, and if the pool is too small to support decent equity compensation, again, walk away. 3. Founders will need to give up more equity. A founder does deserve to make a lot more as they took the initial risk on the idea, but it's bullshit that a founder deserves to make, say, 50x a very early critical engineering hire.
At the end of the day I do believe the market will force a shift. The FAANGs are paying so much, and while it's taken some time employees, especially junior ones, are starting to get better at evaluating their comp offers, specifically because of comment threads like this one.
In the end, I left and the startup went under, and I told him directly that I didn't trust him (to his surprise). The lesson that I learned was that I'd be a fool to take equity in a startup, given all the ways I could be screwed, and my lack of resources to pursue any legal recourse. Cash only, from now on.
Are there risks with ISOs? Yes.
Should you value them 1:1 with cash? Probably not.
Should you value them at $0? Probably not.
People should make decisions based on the company, what they're doing, and how much they trust the board/founders.
It'd be a mistake to categorically dismiss equity since that's the best way to leverage your human capital into wealth.
It's also a mistake to think that equity is valued exactly at what the company is advertising it as when trying to hire you.
There's some risk, but engineers should consider their options.
If you don't have two parents who are alive and healthy and own their home mortgage-free, you probably have a low risk tolerance. Go work at a FAANG; ISOs have an effective value of $0 to you.
If your grandpa can afford to give you $10000 to start a startup, or if you can always move into your parents' basement when you become broke, then I would think about a startup. You can tolerate owing hundreds of thousands in taxes in the worst case, and the higher expected value (and higher personal growth, in the early years) is worthwhile.
A classic example of an individual who would be 10x richer if they were 10 percent less greedy.
“RSUs are often considered less preferable to grantees since they remove control over when you owe tax.”
Who the fuck cares when you pay tax? A small % of people will have enough value to worry about that. The vast majority of people tho have a bigger worry: the stock is worth less than what they pay to exercise, because when you leave your company you have to exercise em or lose em.
Dual trigger RSUs solve that. I don’t have to pay a freakin’ dime whether I stay or leave. I keep my vested RSUs and ride off into the sunset and if they someday become worth something, the company just withholds some shares to pay the tax. Again no up front cash when I leave the company and no large tax bill.
AND I get to keep the whole value of the share. For ISO you only get delta between exercise price and strike price. If my RSUs are $5 or $15 apiece who cares, it’s all risk-free gravy / upside. If I have ISOs I’m worrying about strike price and whether it’s worth it to exercise.
I don’t know who in their right mind would want ISOs over RSUs.
Pasted from a comment I made in an earlier thread:
80% of startups fail and 20% succeed in some fashion. Which means if you normally make $50,000 and take a $5,000 paycut (no rsu) to work there you will lose $20,000 over the 4 year vesting period. 80% of the time when the startup goes bust you make 0 on equity and still lost money due to the paycut. For a total of 8x20 or $160,000 loss.
The two times you are successful you make 2xEquity.
This means your equity has to be at least worth $80,000 each time you succeed.... just to break even.
Factoring in the risk of your equity being 0 you should be getting a LOT more equity.
It's very similar to calculating expected value in poker.
The difference between FAANG and early-stage startups can easily be a 50% pay cut, with at least 5 years until liquidation. If you have a 50% chance of that bet paying off, then maybe it's okay - you can do this twice a decade, and you're reasonably likely to end up at least even over a career. If you have a 5% chance of the bet paying off, even if the rewards are large enough to make the EV even or positive, that's an insane amount of risk to take unless you're already financially independent, because over a career you're not likely to win even once.
This is one of the fundamental power imbalances between labor and capital: Capital can diversify. To go back to the poker analogy, VCs are playing cash games - they can take 100 bets of which they expect only 2 to pan out. Employees are in a short-stack tournament - even if you make the highest-EV play, if you're going to lose most of the time, you shouldn't be going all-in.
And don't forget the compound interest you'd be getting from investing that $20k/year (or $10-$15k after taxes) in a diversified investment like the stock market.
Basically, if you want to take stock, approach the decision like an investor or VC with that level of skepticism and thought. Otherwise you're just throwing darts.
Started Compound (https://withcompound.com) to solve this problem (we generate personalized analyses to help you understand your equity – tax implications, potential value, etc).
If you have any questions/feedback, email me: jacob@withcompound.com.
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Context: sold my company a month ago, all employees with options that had early exercised got full acceleration, and even unexercised optionholders were paid out as if they had exercised and been fully accelerated (though did not get similarly preferable tax treatment, obviously). Treating the employees properly (and well) was a massive part of the negotiation.
There is no actual reason why companies can only offer RSAs to founders and super early employees. The taxes get trickier once the strike price gets high enough, but employees should have the choice to maximize their equity value!
From the very beginning of founding my company and still 5 years later, we offer our employees the choice to take their stock as RSAs, options, or a combination of the two. We also teach a mandatory "Stock 101" course every quarter for new employees that is a 1.5hr version of this guide. Too many employees' (engineers in particular in my experience), don't actually understand how their equity compensation works and I think it's the responsibility of the company to educate them -- both for their current role and possible future job offers.
During the dotcom days, the number of shares that were given out was very generous. I know secretaries that made enough from IPOs in the late 90s that they could retire and buy a vineyard. Meanwhile I was a relatively early employee at a YC startup that had a successful exit. The founders made 8 figures and I made about 80k over 4 years. I would have made 10x more at a FANG with a regular comp package.