Incentive stock options startup

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How Startup Options (and Ownership) Works.

One of the things that struck me most during our recent pieces on startup employee option plans is how things that impact the value of those options aren’t well understood, even if communicated or known at the onset. Many people reported feelings of a sort of “sticker shock” (or reverse!) on leaving their first startup. Meanwhile, founders genuinely want to do right by their employees and other stakeholders — but owning part of a company isn’t a static, fixed thing; it’s fluid, and there are a number of factors that could change the overall ownership equation over time.

Part of the problem is the sheer amount and complexity of information required to understand equity and ownership in the first place. Which is why many founders are working hard to build trust while navigating shifting ownership — their own, their employees’, their co-founders’, their investors — along the way, often dedicating resources to educating folks. There are also some great overviews, guides, templates, and tools out there now that cover how options and compensation works. So we thought we’d share more here about how the economics behind startup options and ownership works…

The capitalization or “ cap” table reflects the ownership of all the stockholders of a company — that includes the founder(s), any employees who hold options, and of course the investors. For most people to understand how much of a company they actually own, all they really need is the fully diluted share count, the broader breakout of ownership among different classes of shareholders, and a couple other details. The fully diluted share count (as opposed to the basic share count ) is the total of all existing shares + things that might eventually convert into shares: options, warrants, un-issued options, etc.

Let’s introduce a hypothetical example that we’ll use throughout this post. Here’s a new company that has no outside investors, and existing stock allocated as follows:

If someone were offered 100 options, those shares would come out of the 1,000-share option pool, and so they’d own 100/10,000 or 1.0% of the fully diluted capitalization of the company.

But that’s just the starting point of ownership, because any analysis of percent ownership in a company only holds true for a point in time. There are lots of things that can increase the fully diluted share count over time — more options issued, acquisitions, subsequent financing terms, and so on — which in turn could decrease the ownership percentage. Of course, people may also benefit from increases in options over time through refresher or performance grants, but changes in the numerator will always mean corresponding changes in the denominator.

Financing History.

For each financing round (of convertible preferred stock), there’s an original issue price and a conversion price:

The original issue price is just what it says: the price per share that the investor paid for its stock. This price tells us what various financial investors believe the value of the company was at various points in time. The conversion price is the price per share at which the preferred stock will convert into common stock. Remember, “preferred” stock is usually held by investors and has certain corporate governance rights and liquidation preferences attached to it that the rest of the “common” stock does not have.

In most cases, the conversion price will equal the original issue price, though we’ll share later below where the two can diverge.

The exercise price of employee options — the price per share needed to actually own the shares — is often less than the original issue price paid by the most recent investor, who holds preferred stock. How much of a difference in value depends upon the specific rights and the overall maturity of the company, and an outside valuation firm would perform what’s called a 409a Valuation (named for a specific section in the IRS tax code) to determine the precise amount.

Dilution is a loaded word and tricky concept. On one hand, if a company is raising more money, it’s increasing the fully diluted share count and thus “diluting” or reducing current owners’ (including option-holding employees’) ownership. On the other hand, raising more money helps the company execute on its potential, which could mean that everyone owns slightly less, but of a higher-valued asset. After all, owning 0.09% of a $1 billion company is better than owning 0.1% of a $500 million company.

If the company increases the size of the option pool to grant more options, that too causes some dilution to employees, though hopefully (1) it’s a sign of the company’s being in a positive growth mode, which increases overall value of the shares owned (2) it means that employees might benefit from those additional option grants.

Let’s return to the example we introduced above, only now our company has raised venture capital. In this Series A financing, the company got $10 million from investors at an original issue price of $1,000 per share:

The fully diluted share count increases by the amount of the new shares issued in the financings; it’s now 20,000 shares fully diluted. This means the employee’s 100 options now equate to an ownership in the company of 100/20,000, or 0.5% — no longer the 1% she owned when she first joined. But… the value of that ownership has increased significantly: Because the price of each share is now $1,000, her stake is equal to 100 shares * $1,000/share, or $100,000.

While not all dilution is equal, there are cases where dilution is dilution — and it involves the anti-dilution protections that many investors may have. The basic idea here is that if the company were to raise money in a future round at a price less than the current round in which that investor is participating, the investor may be protected against the lower future price by being issued more shares. (The amount of additional shares varies depending on a formula.)

Most anti-dilution protections — often called a weighted average adjustment — are less dilutive to employees because they’re more modest in their protection of investors. But there’s one protection that does impact the other shareholders: the full ratchet . This is where the price that an investor paid in the earlier round is adjusted 100% to equal the new (and lower) price being paid in the current round. So if the investor bought 10 million shares in the earlier round at a price of $2 per share and the price of the current round is $1 per share, they’re now going to get double the number of shares to make up for that, equaling a total of 20 million shares. It also means the fully diluted share count goes up by an additional 10 million shares; all non-protected shareholders (including employees) are now truly diluted.

By the way, this isn’t just theoretical: We saw the effects of such a full ratchet in the Square IPO, where the Series E investors were issued additional shares because the IPO price was half the price at which those investors had originally purchased their shares.

Ideally, anti-dilution protections wouldn’t come into play at all: That is, each subsequent round of financing is at a higher valuation than the prior ones because the company does well enough over time, or there aren’t dramatic changes to market conditions. But, if they do come into play, there’s a “double whammy” of dilution — from both the anti-dilution protection (having to sell more shares, thus increasing the denominator of fully diluted share count) as well as the lower valuation.

Liquidation Preferences.

Some investors may also have liquidation preferences that attach to their shares. Simply put, a liquidation preference says that an investor gets its invested dollars back first — before other stockholders (including most employees with options) — in the case of a liquidity event such as the sale of the company.

To illustrate how such a preference works, let’s go back to our example, only now assume the company was sold for $100 million. Our Series A investor — who invested $10 million in the company and owns 50% of the business — could choose to get back its $10 million in the sale (liquidation preference), or take 50% of the value of the business (50% * $100 million = $50 million). Obviously, the investor will take the $50 million. That would leave $50 million in equity value to then be shared by the common and option holders:

Given the high sale price for the company in this example, the liquidation preference never came into play. It would, however, come into play under the following scenarios:

Scenario 1. If the sale price of a company is not sufficient to “clear” the liquidation preference, so the investor chooses to take its liquidation preference instead of its percentage ownership in the business.

Let’s now assume a $15 million sale price (instead of the $100 million) in our example. As the table below illustrates, our Series A investor will elect to take the $10 million liquidation preference because its economic ownership (50% * $15 million = $7.5 million) is less than what it would get under the liquidation preference. That leaves $5 million (instead of the $50 million) for the common and option holders to share.

Scenario 2. When a company goes through several rounds of financing, each round includes a liquidation preference. At a minimum the liquidation preference equals the total capital raised over the company’s lifetime.

So, if the company raises $100 million in preferred stock and then sells for $100 million, there’s nothing left for anyone else.

Scenario 3. There are various flavors of liquidation preference that can come into play depending on the structure of the terms. So far, we’ve been illustrating a 1x non-participating preference — the investor has to make a choice to take only the greater of 1x their invested dollars or the amount they would otherwise get based on their percentage ownership of the company.

But some investors do more than 1x — for instance, a 2x multiple would mean that the investor now gets 2x of their invested dollars off the top. The non-participating can also become “participating” , which means that in addition to the return of invested dollars (or multiple thereof if higher than 1x), the investor also gets to earn whatever return their percentage ownership in the company implies. The impact of this on other stockholders can be significant.

To isolate the effects of these terms, let’s first look at what happens when our Series A investor gets a 2x liquidation preference. In the $100 million sale scenario, that investor will still take its 50% since $50 million is greater than the $20 million (2 x $10 million liquidation preference) it’s otherwise entitled to. The common and option holders are no worse off than they were when our investor had only a 1x liquidation preference:

But, if the sale price were the much lower $15 million, the investor is going to capture 100% of the proceeds. Its 2x liquidation preference still equals $20 million, but there’s only $15 million to be had, and all of that goes to the investor. There’s nothing left for common and option holders:

Finally, let’s take a look at what happens when we have participating preferred , colloquially referred to as “double dipping.”

In our $100 million sale scenario, the Series A investor not only gets its $10 million liquidation preference, but also gets to take its share based on its percentage ownership of the company. Thus, the investor gets a total of $10 million (its liquidation preference) plus 50% of the remaining $90 million of value, or $55 million in total. Common and option holders get to share in the remaining $45 million of value:

In the $15 million scenario, the common and option holders get even less. Because the Series A investor gets its $10 million in preference plus 50% of the remaining $5 million in proceeds, for a total of $12.5 million, only $2.5 million is left for the rest of the shareholders:

There are a bunch of non-economic factors — legal, tax, and corporate governance-related issues — that we aren’t addressing here: which stockholders are required to approve certain corporate actions like selling the company; raising more capital; and so on. They’re important considerations, but we’re focusing here only on economic factors in options and ownership.

However, there is one factor still worth paying attention to because it’s really an economic issue cloaked as a governance issue — the IPO auto convert . This is the language that determines who gets to approve an IPO. In most cases, the preferred stockholders, voting as a single class of stock, get to approve an IPO: Add up all the preferred stockholders together and the majority wins. This is a good check on the company as it ensures one person/one vote, though each preferred stockholder has a say proportional to their economic ownership of the company.

Sometimes, however, different investors can exercise control disproportionate to their actual economic ownership. This typically comes into play when a later-stage investor is concerned that the company might go public too soon for them to earn the type of financial return they need having entered late. In such cases, that investor may require that the company get its approval specifically for an IPO, or if the price of the IPO is less than some desired return multiple (like 2-3x) on its investment.

And that’s how a seemingly governance-only question quickly turns into an economic one: If an investor’s approval is required for an IPO, and that investor is not happy with its return on the IPO, this control can become a backdoor way for the investor to agitate for greater economic returns. How would they do this? By asking for more shares (or lowering the conversion price at which its existing preferred shares convert into common). This increases the denominator in the fully diluted share count.

To be clear, none of this is to suggest nefarious behavior on the part of later-stage investors. After all, they’re providing needed growth capital and other strategic value to the business, and are looking to earn a return on capital commensurate with the risk they’re taking. But it’s yet another factor to be aware of among all the other ones we’re outlining here.

ISOs vs non-quals (and exercise periods)

Besides the financing and governance factors that could impact option value, there are also specific types of options that could affect the economic outcomes.

In general, the most favorable type of options are incentive stock options (ISOs) . With an ISO, someone doesn’t have to pay tax at the time of exercise on the difference between the exercise price of the option and the fair market value (though there are cases where the alternative minimum tax can come into play). Basically, ISOs mean that startup employees can defer those taxes until they sell the underlying stock and, if they hold it for 1 year from the exercise date (and 2 years from the grant date), can qualify for capital gains tax treatment.

Non-qualified options (NQOs) are less favorable in that someone must pay taxes at the time of exercise, regardless of whether they choose to hold the stock longer term. Since the amount of those taxes is calculated on the exercise date, employees would still owe taxes based on the historic, higher price of the stock — even if the stock price were to later fall in value.

So then why don’t all companies only issue ISOs? Well, there are a few constraints on ISOs, including the legal limit of $100,000 of market value that can be issued to any employee within a single year (this means getting NQOs for any amount over $100,000). ISOs also have to be exercised within 90 days of the employee’s leaving the company. With more companies thinking about extending the option exercise period from 90 days to a longer period of time, companies can still issue ISOs — but if they’re not exercised within 90 days of exiting the company, they convert to NQOs regardless of the company’s exercise time, at least under current tax law.

One of the most frequently asked questions about options is what happens to them if a startup is acquired. Below are some possible scenarios, assuming four years to fully vest but the company decides to sell itself to another company at year two:

Scenario 1. Unvested options get assumed by the acquirer.

This means that, if someone is given the option to stay with the acquirer and choose to stay on, their options continue to vest on the same schedule (though now as part of the equity of the acquirer). Seems reasonable… Unless of course they decide this wasn’t what they signed up for, don’t want to work for the new employer, and quit — forfeiting those remaining two years of options.

Scenario 2. Unvested options get cancelled by the acquirer and employees get a new set of options with new terms (assuming they decide to stay with the acquirer).

The theory behind this is that the acquirer wants to re-incent the potential new employees or bring them in line with its overall compensation philosophy. Again, seems reasonable, though of course it’s a different plan than the one originally agreed to.

Scenario 3. Unvested options get accelerated — they automatically become vested as if the employee already satisfied her remaining two years of service.

There are two flavors of acceleration to be aware of here, single-trigger acceleration and double-trigger acceleration:

In single trigger , unvested options accelerate based upon the occurrence of a single “trigger” event, in this case, the acquisition of the company. So people would get the benefit of full vesting whether or not they choose to stay with the new employer. In double trigger , the occurrence of the acquisition alone is not sufficient to accelerate vesting. It must be coupled with either the employee not having a job offer at the new company, or having a role that doesn’t quite match the one they had at the old company.

Note, these are just general definitions. There are specific variations on the above triggers: whether everything accelerates or just a portion; whether people accelerate to some milestone, such as their one-year cliffs; and so on — but we won’t go through those here.

Not surprisingly, acquirers don’t like single triggers, so they’re rare. And double triggers give the acquirer a chance to hold on to strong talent. Still, it’s very unusual for most people to have either of the above forms of acceleration. These triggers are typically reserved for senior executives where it’s highly likely in an acquisition scenario that they won’t — or literally can’t (not possible to have two CFOs for a single company for example) be offered jobs at the acquirer — and thus wouldn’t have a chance to vest out their remaining shares.

The simple way to think about all this is that an acquirer typically has an “all-in price” — which includes up-front purchase price, assumption of existing options, new option retention plans for remaining employees, etc. — that it is willing to pay in the deal. But how the money ultimately gets divided across these various buckets can sometimes diverge from what the initial option plan documents dictate as acquisition discussions evolve.

As mentioned earlier, anything related to compensation and ownership boils down to building and navigating trust — whether it’s through education, communication, or transparency. There’s also an important S. E.C. rule that is in play here: Rule 701, the exemption for issuing employee stock options. This rule says that up to about $5 million in annual option issuances, a company must provide the recipient a copy of the options plan; and then once a company goes beyond the $5 million annual limit, it must also provide a summary of the material terms of the plan, risk factors, and two years worth of GAAP financial statements. Which is great.

But times have changed, and the 701 requirements that were put into effect April 1999 have failed to keep pace. Companies are now staying private longer and are therefore raising more capital, often from new entrants to venture investing with more complicated terms. So simply reviewing a company’s last two years of financial statements doesn’t say much about the ultimate potential value of options. Rule 701 should be updated to better reflect the information people need to understand options.

The good news is that if a company goes public, all of the above different rights that preferred stockholders have go away because everyone’s shares convert into common shares. There may still be different classes of common stock (such as dual classes with different voting rights to protect founder-driven long-term innovation) — but those don’t impact an individual’s economics.

Startup outcomes are, by definition, unpredictable. Every startup is unique, every situation has unknown variables, and new data will always change the economic outcomes. Working at a startup means getting in early for something that has yet to be proven, which means it could have great risks … and potentially, great rewards.

Mashable.

Entertainment.

Perhaps you’ve heard about the Google millionaires: 1,000 of the company’s early employees (including the company masseuse) who earned their wealth through company stock options. A terrific story, but unfortunately, not all stock options have as happy an ending. Pets and Webvan, for example, went bankrupt after high-profile Initial Public Offerings, leaving stock grants worthless.

Stock options can be a nice benefit, but the value behind the offer can vary significantly. There are simply no guarantees. So, whether you’re considering a job offer that includes a stock grant, or you hold stock as part of your current compensation, it’s crucial to understand the basics.

What types of stock plans are out there, and how do they work?

How do I know when to exercise, hold or sell?

What are the tax implications?

How should I think about stock or equity compensation relative to my total compensation and any other savings and investments I might have?

1. What are the most common types of employee stock offerings?

Two of the most common employee stock offerings are stock options and restricted stock.

Employee stock options are the most common among startup companies. The options give you the opportunity to purchase shares of your company’s stock at a specified price, typically referred to as the “strike” price. Your right to purchase – or “exercise” – stock options is subject to a vesting schedule, which defines when you can exercise the options.

Let’s take an example. Say you’re granted 300 options with a strike price of $10 each that vest equally over a three-year period. At the end of the first year, you would have the right to exercise 100 shares of stock for $10 per share. If, at that time, the company’s share price had risen to $15 per share, you have the opportunity to purchase the stock for $5 below the market price, which, if you exercise and sell concurrently, represents a $500 pre-tax profit.

At the end of the second year, 100 more shares will vest. Now, in our example, let’s say the company’s stock price has declined to $8 per share. In this scenario, you would not exercise your options, as you’d be paying $10 for something you could purchase for $8 in the open market. You may hear this referred to as options being “out of the money” or “under water.” The good news is that the loss is on paper, as you have not invested actual cash. You retain the right to exercise the shares and can keep an eye on the company’s stock price. Later, you may choose to take action if the market price goes higher than the strike price – or when it is back “in the money.”

At the end of the third year, the final 100 shares would vest, and you’d have the right to exercise those shares. Your decision to do so would depend on a number of factors, including, but not limited to, the stock’s market price. Once you’ve exercised vested options, you can either sell the shares right away or hold onto them as part of your stock portfolio.

Restricted stock grants (which may include either Awards or Units) provide employees with a right to receive shares at little or no cost. As with stock options, restricted stock grants are subject to a vesting schedule, typically tied to either passage of time or achievement of a specific goal. This means that you’ll either have to wait a certain period of time and/or meet certain goals before you earn the right to receive the shares. Keep in mind that the vesting of restricted stock grants is a taxable event. This means that taxes will have to be paid based on the value of the shares at the time they vest. Your employer decides which tax payment options are available to you – these may include paying cash, selling some of the vested shares, or having your employer withhold some of the shares.

2. What’s the difference between “incentive” and “non-qualified” stock options?

This is a fairly complex area related to the current tax code. Therefore, you should consult your tax advisor to better understand your personal situation. The difference primarily lies in how the two are taxed. Incentive stock options qualify for special tax treatment by the IRS, meaning taxes generally don’t have to be paid when these options are exercised. And resulting gain or loss may qualify as long-term capital gains or loss if held more than a year.

Non-qualified options, on the other hand, can result in ordinary taxable income when exercised. Tax is based on the difference between the exercise price and fair market value at the time of exercise. Subsequent sales may result in capital gain or loss – short or long term, depending on duration held.

3. What about taxes?

Tax treatment for each transaction will depend on the type of stock option you own and other variables related to your individual situation. Before you exercise your options and/or sell shares, you’ll want to carefully consider the consequences of the transaction. For specific advice, you should consult a tax advisor or accountant.

4. How do I know whether to hold or sell after I exercise?

When it comes to employee stock options and shares, the decision to hold or sell boils down to the basics of long term investing. Ask yourself: how much risk am I willing to take? Is my portfolio well-diversified based on my current needs and goals? How does this investment fit in with my overall financial strategy? Your decision to exercise, hold or sell some or all of your shares should consider these questions.

Many people choose what is referred to as a same-day sale or cashless exercise in which you exercise your vested options and simultaneously sell the shares. This provides immediate access to your actual proceeds (profit, less associated commissions, fees and taxes). Many firms make tools available that help plan a participant's model in advance and estimate proceeds from a particular transaction. In all cases, you should consult a tax advisor or financial planner for advice on your personal financial situation.

5. I believe in my company’s future. How much of its stock should I own?

It is great to have confidence in your employer, but you should consider your total portfolio and overall diversification strategy when thinking about any investment – including one in company stock. In general, it’s best not to have a portfolio that is overly dependent on any one investment.

6. I work for a privately-held startup. If this company never goes public or is purchased by another company before going public, what happens to the stock?

There is no single answer to this. The answer is often defined in the terms of the company’s stock plan and/or the transaction terms. If a company remains private, there may be limited opportunities to sell vested or unrestricted shares, but it will vary by the plan and the company.

For instance, a private company may allow employees to sell their vested option rights on secondary or other marketplaces. In the case of an acquisition, some buyers will accelerate the vesting schedule and pay all options holders the difference between the strike price and the acquisition share price, while other buyers might convert unvested stock to a stock plan in the acquiring company. Again, this will vary by plan and transaction.

7. I still have a lot of questions. How can I learn more?

Your manager or someone in your company’s HR department can likely provide more details about your company’s plan – and the benefits you qualify for under the plan. You should also consult your financial planner or tax advisor to ensure you understand how stock grants, vesting events, exercising and selling affect your personal tax situation.

Images courtesy of iStockphoto, DNY59, Flickr, Vicki's Pics.

Tony Wright.

A Newbie’s Guide to Startup Compensation (or “Stock Options will Make Me Rich!”)

My first experience with stock options was at the ripe age of 34 years old, when I was selling Jobby (retired) to Jobster (Gah, make the Web 2.0 names STOP!). Before that, I’d been running my own business for close to a decade– with good success, but there really wasn’t any sense in setting up an options plan.

So when selling our company and getting presented with a cash/stock options package, I was damn excited about the options. I dutifully did a bit of research to try to understand how they worked, asked some smart questions, and was a proud new owner of startup equity. 365 days later, I left Jobster– on good terms, but I chose not to exercise my options.

Now, as RescueTime is expanding its team, I’m on the other side of the equation– putting together stock option plans for new hires. So I figured it might be useful for folks we’re talking to for me to put together so thoughts and resources about startup compensation, particularly in the area of stock options. A big part of my motivation here is that I think most startups are QUITE content to let employees think that options are this magical ticket to wealth and prosperity… It feels dishonest.

3 Harsh Realities of Startup Options.

1. Employees with decent salaries and options will almost NEVER get rich in a liquidity event. The people who might get rich with startup equity are the founders and the investors (not coincidentally, the people who took significant risks). There are obviously exceptions here– I read that Google minted 900 new millionaires when they IPO’d. Good for them. But when you do the math on probably exits for most startups, it’s good– but it’s not quite so rosy. VentureHacks has a breakdown of what startup employees might expect in terms of equity. Assuming you don’t get diluted with further investment down the road, a lead dev or director might expect 1% ownership (vesting over 4 years). So in the event of a $50,000,000 exit, they’d walk away with a cool $500k, IF they’d been there for 4 years or longer.

2. Options vest over 4 years. Everyone loves the idea of the overnight success with a quick-flip to Google. It’s vanishingly rare, but it does happen. When it does, the founders generally do okay, but what happens to the late-comers with unvested options is a question mark. Those unvested shares COULD accelerate (meaning they could all vest when the buy happens). Or they could convert to options in the purchasing companies stock (par value). That’s all part of the negotiation and it all depends on the leverage you have with the buyer.

3. How the options are set up very much effect how attractive the company is to a buyer. We’d LOVE to offer 100% acceleration upon change of control to our hires– that’d mean that all options would immedietely vest and our whole team would be rich and happy– but not particularly incentivized to stay and work for the buyer.

So are Options a Crappy Deal?

The best way to look at options are as a high-risk investment– it’s important to look at the cost of the investment, the chance that the investment will “hit”, the likely magnitude of the return on investment, and the percentage you’ll likely have in your pocket at the time of a liquidity event. Here’s the best way to look at the math.

The COST of the investment is the difference between what you could be making (your market value) minus the salary that you are offered. So if you’re worth $85k/yr and the offer is $75k/yr, you’re investing $10k per year in this high-risk opportunity. If you’re getting paid market value, then… Well, there’s no risk– and you shouldn’t be expecting much reward. The CHANCE the investment will hit is a huge question mark. Think hard about the market for such a company. Who would buy it? Can you imagine Google and Microsoft fighting over the company? The MAGNITUDE of the return is another question mark. If it’s a web startup, there’s lots of data out there about sale prices. The question is: how big is the opportunity? What are companies in your space getting bought for? It’s easy to test a few scenarios. The PERCENTAGE of ownership is a bit of a moving target, but you can at least know where you start. Again, take a look at VentureHacks for a reality check.

So to boil it down in an example, let’s say we have an engineer who is getting .5% of the company vested over 4 years. He’s making $80k, but probably could make $90k at a company with limited equity opportunity. Let’s assume a target exit price of $50,000,000 (oh, happy day!).

Our engineer is spending $10k per year to have a shot at a $62,500 per year. If he spends the full four years there, he’s “invested” $40k for a shot at $250k (a 6x+ return– not bad). When you run the same scenario with a billion dollar exit, it’s starting to look a lot prettier. When you run it at a Flickr-sized exit ($20m), it’s not looking like that great of a bet. If you want to get into the finer points, you should probably consider the benefits as well as the cost of the options.

The only way to buy more reward is with more risk. Some founders will be willing to give up lots more equity if you’ll work for less, but it’s honestly fairly rare if they’ve reached the point where they have enough cash to hire people for them to be terribly eager to part with lots of equity. There’s obviously a small army of “idea guys” out there who would happily give you huge piles of equity if you’ll work for free. And, of course, the best way to get rich with equity is to start your own company.

If you don’t fancy rolling the financial dice by “investing” in a startup, most startups are probably happy to pay you market rate and dial down your options… But either way, there are lots of career perks that you’re buying by working in a startup. Which brings me to…

You’re Buying More than Just a High Risk Investment.

Needless to say, most options aren’t a very good investment. A chance at a 5x return is great, but most startups are facing longer odds than 5 to 1– so you should be damn sure that you believe in the company, the team, and (most importantly) your ability to influence the outcome.

I think it’s important to note that our engineer in the above example is buying a heckuva lot more with his $10k… Though they are things with a very subjective value.

He’s buying startup experience. If you plan on spinning up your own thing someday, there is no substitute for working in a startup to learn what works and what doesn’t. You don’t have to sign on with a experienced startup founder… It’s good enough to get paid to watch them make mistakes that you can avoid when it’s your turn. He’s buying a “clean slate”. If you get to a startup early enough, there is lots of blue sky. The early days of product development (for many people) are the most rewarding. He’s buying startup cred. When it comes time to spinning up his own thing or getting his next gig, it’s a big plus to have that background. It’s obviously a HUGE plus to be part of a winning team (if an exit happens). He’s buying relationships. One of our investors says that 99% of his deal flow comes from people he’s previously invested in or people on their teams. Working at an early stage startup is an opportunity to meet investors and other important startup folks– good leads for future endeavors. He’s buying a work environment that is comparatively bullshit-free. Little bureaucracy, few meetings, flexible work schedule/environment, etc. If you’ve ever had an environment like this, you know how addictive it is and how elusive it is in larger companies. He’s (hopefully) buying a chance to work on a product he likes/wants to use.

Obviously, all of these perks are really only perks for people who see themselves working on/in startups in the future… For people like this, the $10k price tag (when you roll in the high-risk investment op) is a great investment. For folks who are just chasing the idea that they are going to get rich taking decent-paying jobs with post-funding startups, they are in for a long series of disappointments.

(note: if other folks have insights on startup compensation/options, please chime in. Despite writing a Newbie’s guide, I am, admittedly, a bit of a newbie! )

RescueTime, Startups 1511 Words.

Thanks for this, Tony! As someone who's worked at many startups but never been around through an acquisition, it's great to hear from someone who's at least been through it. I also appreciate the links you mentioned.

I've been thinking a lot about options for options, and appreciate your perspective. Fortunately I've got more than a 1% stake in my present endeavors ;-).

Much luck on the $50M, er, $1B exit…

Excellent write up, especially the part about how it's not all about money.

One note: I may have missed it somewhere in there, but you might want to note that often there's an expiration on the options. Where I work, it's tied to when you leave. So, if I quit, I have 60 days to exercise my options, which means actually plunking down money to buy the stock. I'm betting a lot of people don't realize that you may have to spend some money in order to get your stock.

Or, I could be totally wrong about that part too.

Hi Tony, I found this post helpful and have already forwarded it to some of my friends. I am curious to hear your thoughts on the (diminishing?) value of receiving options as a company takes subsequent rounds of funding. I'm familiar with dilution (at least in principle), but haven't found many clear examples of how the math works.

Also, I've heard that companies often won't share your percentage of ownership with you. Is this what you've seen? How can this number be calculated?

Having been through two very successful IPO events a decade apart (MCAF in 1992 and PYPL in 2002), I can tell you that it's definitely doable to get a million dollar event (on paper, at least) for a non-founder employee. Of course you have to be smart about the money if you're going to keep it.

I've also been through two companies where I had/have options, but those options are, and are likely to continue to be, worthless, and two where I left before my initial shelf vested. Still, out of 6 startups, all of which were fun at the time, two major successes is better than most people get.

The real idea (to me) is that you can do work you are excited about doing, in an environment where _your_ decisions affect the success of the company, get paid for it, and have a non-zero chance of getting a particularly excellent pay-out if you make the right decisions and build something people really care about.

Sure, as an employee (instead of founder) there are factors out of your control, but in a startup you have much more control than an employee in an established company, along with more risk and commensurately more potential reward.

In my experience few people optimize their salary quite to the extent that they can reasonably say, 'Okay, I'm taking a $10K pay cut from what I could be making, in exchange for an extra 0.X% of the company'. Most folks in the successful startups I've been part of just looked at their base salary (and typical benefits), decided if they could live with that, and ignored the options as being merely a potential bonus.

Actually with the first company I went public with, employees didn't even have 'stock options' until we began the process of going public. Typically employee stock options weren't something that line employees got, back then.

People often call it the 'stock option lottery', but I can't think of any lotteries that pay you to participate, and you can improve your chances of winning by doing great work.

To throw in my voice, michah: that's a good point (there's actually almost always an exercise-by date even if you _don't_ leave the company), and it's also worth talking about the different tax consequences of early exercise, same-day exercise and sell, and exercise and hold for > 1yr.

Danielle, you can basically calculate your percentage of potential ownership based on the number of shares granted divided by the number of shares outstanding. It's hard to get that number out of most private companies before (and sometimes after) joining them.

Dilution by subsequent rounds of funding is often bad. I had a 200:1 reverse stock split happen on one company I'd worked for, which meant I got 1 share for every 200 I previously had, and then they added new shares and sold them to raise more money. There's also squirrely issues with preferred stock.

The basic answer (in my experience) has been that the more rounds of funding, the less likely a liquidity event is, so make sure you're comfortable with your salary _first_. Rare is the company who actually 'just needs a little bridge loan to get to profitability'.

Hey Morgan– I agree that a million dollar payday is a possibility, but liquidity nowadays seems to be limited to M&A– generally smaller dollar amounts. The IPOs you see don't have the run-up that they used to have. Interesting to look at:

That's a list of acquisitions in 2007.

Those are the top Tech IPOs in 2007 (a much shorter list of companies that had a long, hard, and expensive road).

I think the first boom minted quite a few more (paper?) millionaires than this one has (or will).

As Morgan said (hey Morgan!), you definitely need to know the outstanding shares to know percentage. If you don't, it's really meaningless. 1,000 shares is a lot if there are 2,000 shares outstanding. Not so much if there are 10,000,000.

Subsequent rounds will dilute your position, but ideally, the cash influx will make your shares more valuable. So if you owned 50% of a $1,000,000 company and then took another million in funding, you'd then own 25% of a 2,000,000 company. In theory (and on paper) than has the same value– the idea is that additional funding can be leveraged to make the company more valuable. In practice, that money is sometimes used to “stay alive” rather than move the ball, so it leaves you with less equity.

[edit: It important to note that all sorts of crazy stuff can happen on subsequent funding rounds-- they can functionally do stuff to dramatically change the position of people who've left the company-- to incentivize the folks who are still slogging away]

At Jobster, they were pretty open book with the # of outstanding shares (we are at RescueTime as well). I would insist on knowing the # of outstanding shares– if they wouldn't share that #, I'd focus entirely on the salary.

Danielle, some companies won't tell you the percentage of the company that your options represent but they should be willing to tell you how many shares are outstanding. This will allow you to calculate for yourself the percentage of the company you are being optioned. Presumably it's too easy for legal issues to arise when you tell an employee that they are getting a certain percentage of the company and that number doesn't turn out to be exactly right – a number of options is exact.

In reality you want to know the total number of fully diluted shares outstanding, with preferred converted to common. Of course it would be nice to understand all of the terms of the everyone's employment, investment agreements, liquidation preferences, participation, etc. to really understand how the picture would look in an exit. Most of these details are going to be closely held, but some will freely share them.

If the company you're considering working for doesn't even have the decency to give you a rough idea of what percentage of the company they are offering you, I would strongly urge looking elsewhere. This is a pretty strong indication that management has little respect for its employees and is not going to be forthright in the future. How are you even supposed to evaluate such an offer? A million-option grant looks pretty good until you find out there are a trillion outstanding.

Excellent post Tony – thank you!

You're right, in a lot of ways, that the current boomlet is going to be a little lower key, but one of the things I notice from those lists is that the companies who actually have a product/service they sell (as opposed to media outlets, where they only make money by advertising) are consistently going for more. 'Profitable' isn't a dirty word anymore.

As for the IPO's not having the run-up, I completely ignored the 'opened at $20, jumped to $200' type of IPO. Opening at $12, and jumping to $20 is _awesome_, and is what made me a paper millionaire back in 1992. (Being profitable for 2 years before going public, and an obscene profit margin helped.)

As for your article, you also should note the differences between Non-Qualified options and Incentive Stock Options, as they have very different tax implications.

This is a great article on how to look at startup compensation from both sides. I particularly like the section entitled “Your buying more than just a high risk investment”. It really helps entrepreneurs formulate an incentive argument that doesn't necessarily cost us much in terms of equity and cash.

Great job and keep it coming!

love the cost benefit analysis! at last a clear presentation!

very nice and interesting thankx!

Very useful rightup and specially thanks for the market figures link to venture hacks.

About your .5% example, the math really helped put the amounts in perspective. Does the following variation make sense.

One point, for the $50M exit, won't there be a different breakup for preferred and common, while the .5% is for common. So, in effect, it would be 0.25% or less. Then there are common variations like removing invested money before, different multiple for each category and so forth. So, now it is down to maybe 12%. That is $15k return with risk for $10k per year.

Very useful rightup and specially thanks for the market figures link to venture hacks.

About your .5% example, the math really helped put the amounts in perspective. Does the following variation make sense.

One point, for the $50M exit, won't there be a different breakup for preferred and common, while the .5% is for common. So, in effect, it would be 0.25% or less. Then there are common variations like removing invested money before, different multiple for each category and so forth. So, now it is down to maybe 12%. That is $15k return with risk for $10k per year.

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