5 things you need to know about stock options
Equity compensation—getting a piece of the company—is one of the defining aspects of working at a startup. It is attractive not only for its perceived monetary value, but for the sense of ownership it gives employees.
However, potential employees should inform themselves before engaging in any equity plans as there are risks involved. For example, some employees of Good Technology actually lost money on their stock options when the company sold to BlackBerry for less than half of its private valuation.
Once you’ve settled on going to work for a startup, it’s important to learn how equity works and what it will mean for you as an employee. If you’re new to this, it can be an intimidating topic. Here’s what you need to know.
1. There are different types of equity
Equity, at its basic level, is an ownership share in a company. Shares are issued in a series and are typically either labeled as common or preferred.
Employees are typically granted common stock, which is different from preferred stock in that it carries no preferences, which are add-on perks that accompany the shares. I’ll go more into it later, but this basically means preferred shareholders get paid first.
Equity is distributed to employees from an “option pool,” a set amount of equity that can be distributed among employees. There is no hard and fast rule for how large or small an option pool may be, but there are some common numbers.
For example, LaunchTN CEO Charlie Brock said that he typically advises founders to provide minimum of 10% equity to the pool, as it gives enough allocation to attract quality people. However, he said, 15% option pools give the flexibility needed to make strong key hires because it gives founders more equity to offer potential employees.
Preferred stock usually goes to investors, as it has certain rights that come with it, said Jeff Richards of GGV Capital. For example, those rights or “preferences” may give a board seat to the shareholder, voting rights for major company decisions, or liquidation preference.
A liquidation preference is a guarantee of return on investment to a specific multiple of the amount invested. Most often, Richards said, you’ll see a 1X liquidation preference — which means that in the event of liquidation, like if the company is sold, those shareholders are paid back at least the same amount they invested.
This can spell problems for employees if the company doesn’t ever reach its expected potential value, because the founders are still obligated to pay back the liquidation preference to preferred shareholders.
In the event of an IPO, the playing field is leveled, to a certain degree.
“If a company goes public, all the shares convert into common,” Richards said.
2. How equity works
Although there are a variety of ways to get equity as a startup employee, the most common way is through stock options. A stock option is the guarantee of an employee to be able to purchase a set amount of stock at a set price regardless of future increases in value. The price at which the shares are offered is referred to as the “strike price,” and when you purchase the shares at that price, you are “exercising” your options.
Exercising stock options is a fairly common transaction, but Y Combinator partner Aaron Harris said there are some additional rules among startups that could present problems.
“There’s a rule that if you leave a company your options expire in 30 or 60 days if you can’t buy them right then and there,” Harris said.
While there are arguments in favor of that rule, Harris said it penalizes younger employees who don’t have the capital to exercise options and deal with the tax hit at the time.
Outside of stock options, Richards said that a growing trend is the issuing of restricted stock units (RSU). These stock units are generally awarded directly to the employee with no purchase required. But, they carry different tax implications, which I will address later on.
Shares in a startup are different from shares in a public company because they are not fully “vested.”
“Vesting of equity means that your equity is not immediately owned outright by you, but it instead ‘vests’ or becomes owned 100% by you over time, and the company’s right to repurchase it lapses over time,” said Mark Graffagnini, president of Graffagnini Law.
You’ll see this often referred to sometimes as a vesting schedule. For example, if you are granted 1,000 shares at four-year vesting, you would receive 250 shares at the end of each of the four years until it was fully vested. Richards said that a four-year vesting period is pretty standard.
In addition to a vesting schedule, you’ll also be dealing with a cliff, or the probationary time before the vesting will begin. A traditional cliff is six months to one year. You will not vest any shares before you hit the cliff, but all of the shares for that time will vest when you do hit the cliff.
For example, if you have a six month cliff, you will not vest any equity in the first six months of your employment, but at the six month mark, you will have vested six months worth of your vesting schedule. After that, your shares will continue to vest per month.
The implementation of a vesting schedule and a cliff are both done to keep talent from leaving the company too soon.
3. Equity and taxes
When you’re granted equity by a startup, it may be taxable. The type of equity you receive, and whether or not you paid for it play into the question, Graffagnini said.
“For example, a stock option granted to an employee with a strike price equal to fair market value is not taxable to the employee,” Graffagnini said. “However, a grant of actual stock is taxable the employee if the employee does not purchase it from the company. “
Standard stock options are known as incentive stock options (ISOs) by the IRS. Brock said that ISO do not create a taxable event until they are sold. So, when you exercise an ISO no income is reported. But, when you sell it after exercising, it is taxed as long-term capital gains. So, keep that in mind if you’re thinking of selling.
In the rare event that you have non-qualified stock options (NSOs or NQSOs), Brock said, those are taxed both at the time of exercise and at the time you sell them.
4. What your equity is worth
Determining the true dollar value of your equity is very difficult. Usually there is a range and it is dependent on the exit opportunities the company is pursuing.
The concept of value is further complicated by the potential legal and HR issues that arise around the conversation of equity value that founders could have with their employees. Richards said that most counsel will advise a founder to be very careful about having that conversation.
“They don’t want them to imply that there is any intrinsic value to those stock options when there is not,” Richards said. “You’re getting an option in a privately held company — you can’t sell that stock.”
Still, most founders will try be as transparent as possible about what you’re getting yourself into. Just understand that they might not be able to disclose all the details.
At the end of the day, it is an investment decision and a cash salary doesn’t always line up equally against equity, so it’s up to you to determine what risk you’re willing to take. Just remember, if the startup isn’t acquired or doesn’t go public, your shares may be worth nothing.
“In the end, they might have been much better off choosing higher pay over equity in that case,” Graffagnini said. “On the other hand, your startup just might be the one that hits it big, and it might be the best investment of your life.”
5. Look out for red flags
Because equity compensation packages are different for each company at each individual stage, it can be challenging to vet the deal. But, there are some red flags you can look out for.
“A basic red flag would be is there anything that’s not standard,” Richards said. For example, does the company have six year vesting with a two year cliff? That could be an issue.
Another red flag could be how much equity you are being offered. If you’re a very early employee and the opening offer is five basis points (0.05%), Harris said that could be indicative of a bad situation. Or, if the exercisability of grants differs wildly from employee to employee.
The ultimate red flag, Harris said, is “if the person making you the offer is unwilling to sit down and explain to you what it means.”
Keep in mind that the founder, especially if it is his or her first startup, might not have all the answers, so be willing to work through it with them. Also, Harris said, know that you have the right to negotiate even if it’s your first job out of school.
Do your research. Talk to your friends at similar stage companies and compare the offer they have with what you have on the table.
“Make sure, no matter what it is, you feel as if it’s fair, [and] that you are being fairly compensated,” Harris said.
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