Startup Employee Equity Compensation

Mar 5, 2015

Here's a collection of my notes and links on options, vesting, and equity incentives for startups.

Contents:

Equity Compensation

Anyone dealing with equity compensation should know the difference between “stock options” and “restricted stock” and the tax consequences of each. A stock option is the right to buy stock in the future at a pre-determined price. Restricted stock is almost the reverse: the employee receives the stock today, but the startup can buy it back from the employee in the future. Restricted stock tends to be the better tax arrangement for the employee, especially for early stage companies with low valuations (pre-seed or pre-Series A).

Number of Shares Outstanding (Fully Diluted)

Employers offer thousands of shares of company equity. “Thousands” is a big number, but by itself, the number of shares is meaningless. Imagine I told you I had a million dollars of gold divided up into equal-size slivers. Then I offered to give you 10,000 “slivers” of gold in exchange for 4 years of work. Obviously, you’d want to know the weight of each sliver.

Likewise, employees will want to know the percentage of the company that the equity represents. Specifically, they should ask for the number of shares outstanding on a “fully diluted” basis. The number of shares needs to include the common stock, preferred stock, options outstanding, unissued shares remaining in the options pool, warrants and convertible notes.

The one number you should know about your equity grant. By Chris Dixon, 2009. “The only thing that matters in terms of your equity when you join a startup is what percent of the company they are giving you. If management tells you the number of shares and not the total shares outstanding so you can’t compute the percent you own – don’t join the company!”

I have a job offer at a startup, am I getting a good deal?. By Babak Nivi, 2008. The AngelList founder lists 10 important questions to ask a potential employer, including “What are my options worth?” and “What percentage of the company do my options represent on a fully diluted basis?”

If you give 0.5% equity for an early employee, and if you make it to an exit, after several rounds of dilution, will the early employee have any significant % in the company?. Digital Ocean cofounder Moisey Uretsky provides a helpful answer in this Quora post.

What I Wish I’d Known About Equity Before Joining A Unicorn. Anonymous, 2017.

Stock Options - Startup’s Perspective

The Right Way to Grant Equity to Your Employees. By Andy Rachleff, 2014. A description of the equity incentive plan used at Wealthfront and other Benchmark Capital portfolio companies. It emphasizes increasing equity grants with each promotion, as well as evergreen grants that avoid any hard vesting “cliffs” that might encourage employee to think about leaving.

Renowned VC Fred Wilson has written a series of posts that attempt to explain employee equity, mainly from the startup’s perspective:

An alternative to employee options/equity grants. By Jason Fried, 2011. A short description of Basecamp’s simple contractual plan to pay bonuses to employees in the event of an IPO.

Stock Options - Employee’s Perspective

Basics. Stock options are a contract giving an employee the right to buy shares, in the future, at a pre-determined price. Ideally, the employee gets the right to buy shares at today’s price (say, $1), but at a future date when everyone else is paying a much higher price (say, $100).

Tax. Generally, the employee is not taxed on the grant date, but on the exercise date (the day the employee pays to buy the stock). The tax is based on the difference between the strike price (what the employee pays to buy the company) and the value of the options on the exercise date. This can result in an unfunded tax liability. That is, the newly purchased stock may be valuable on paper, but the employee may not be allowed to sell shares on the open market.

An Engineer’s guide to Stock Options. By Alex Maccaw, 2013. A thoughtful and detailed explanation. It’s a great place to start your research.

The 14 Crucial Questions About Stock Options. Andy Rachleff, Wealthfront, 2014. A nice overview of issues to consider before negotiating an equity incentive package.

Can the Startup Repurchase Vested Stock?

Some stock option grants will give the company the right to repurchase an employees fully vested stock at “fair market value.” Of course, the company will pick a “fair market value” that may not seem fair to the employee.

YCombinator’s Sam Altman called this arrangement “horrible” for employees. Angellist’s Babak Nivi suggests that employees should “run screaming from the right to purchase vested stock.”

Can the Company Take Back my Vested Shares? By Mary Russell, 2014. Provides an example of how a startup’s “fair market value” repurchase right could mean the difference between a $60k payday or a $1.6MM payout at an IPO.

Supersize Your Vesting with these Microhacks. By Babak Nivi, 2007.

Restricted Stock

In a restricted stock grant, the employee owns normal “common stock,” but the company has the right to buy the stock back in certain circumstances. Restricted stock can offer major tax advantages for founders and early employees. An employee can pay tax on restricted stock right away by filing an 83(b) tax election. If the company’s valuation is very low (e.g., pre-series A), the tax will be low.

For later employees, the company’s valuation will be higher, and employees will end up paying more substantial tax on upon receipt of their restricted stock. This may be a bad deal for the later employees because they are paying tax on stock that may one day be worthless. Because of this risk, stock options are likely to be a better deal for later employees.

409(a) valuations are not necessary for restricted stock grants.

Employee Equity: Restricted Stock and RSUs. By Fred Wilson, 2010.

Acquisitions: Assumption of Option Plan

Employees should know what will happen to their option plan if the company is acquired. Will the options vest immediately? Will the new company “assume” the option plan and give you the same deal? Some option plans do not require an acquiring company to assume the plan, which can hurt employees.

If you have startup stock options, check your option plan. Alex Devkar, 2015. “The acquirer—your new boss—comes to you and says that the remaining half of your options are gone. If you want to keep your job, you have to sign a new equity agreement which won’t make you nearly as much money and comes with a new 4 year vesting schedule that starts today. Can they do that?”

Tax Issues

Incentive Stock Options vs. Nonqualified Stock Options. By Joe Wallin, 2013. Incentive Stock Options (“ISO”) offer some tax advantage, but substantially increase complexity. Under many conditions, the Alternative Minimum Tax will eat away at the ISO’s benefits anyway. Nonqualified Stock Options (“NQO”) are less complicated, and often preferable to ISOs.

Tips on Negotiating Equity Incentives when Joining an Early Stage Startup. By Mary Russell, 2014. This post includes a good tax comparison of (a) restricted stock, (b) non-qualified stock options (early exercised), (c) incentive stock options, (d) restricted stock units, and (e) non-qualified stock options (not early exercised).

The 83(b) Tax Election

The 409(a) Valuation

The exercise price of stock options must be set at, or above, the fair market value of the underlying shares at the time of the grant. If it’s not, then the IRS (and California) will impose some extremely heavy tax penalties. This is a problem for the company as well as the employee, because the company must withhold these taxes and penalties.

To be safe, the fair market value should be determined by a “409(a)” valuation (a valuation method specifically approved by the IRS). Startups can hire a 409(a) valuation firm to perform the calculations.

Employee Equity: The Option Price. By Fred Wilson, 2010. “Companies are paying $5000 to $25,000 per year” to 409(a) valuation consultants. Fred also notes that employees who get hired after a big up-round of financing will tend to get less-valuable stock options (because the fair market value will be higher).

Other New Ideas in Employee Compensation

Introducing Progressive Equity. Detour 2015. Employee equity at a successful startup is distributed unevenly: “the founders make more money than they could spend in infinite lifetimes, a handful of early folks achieve financial independence, and everyone else gets a nice bonus, but nothing life changing.” A new idea called “Progressive Equity” attempts to fix that distribution by spreading some of the wealth down to later employees.