Attorney Mary Russell, Stock Option Counsel, counsels individual employees and founders to negotiate, maximize and monetize their stock options and other startup stock. You are invited to contact Stock Option Counsel for help in negotiating and evaluating your job offers and post-acquisition employment agreements, making stock option exercise and tax decisions and identifying your rights and opportunities to sell startup stock.
"Hey baby, what's your employee number?" A low employee number at a famous startup is a sign of great riches. But you can't start today and be Employee #1 at Square, Pinterest, or one of the other most valuable startups on Earth. Instead you'll have to join an early-stage startup and negotiate a great equity package. This post walks through the negotiation issues in joining a pre-Series A / seed-funded / very-early-stage startup.
Q: Isn't it a sure thing? They have funding!
No. Raising small amounts from seed stage investors or friends and family is not the same sign of success and value as a multi-million dollar Series A funding by venture capitalists. According to Josh Lerner, Harvard Business School’s VC expert, 90 percent of new businesses don’t make it from the seed stage to a true VC funding and end up shutting down because of it. So an equity investment in a seed-stage startup is an even riskier game than the very risky game of an equity investment in a VC-funded startup.
Q: How many shares should I get?
Don't think in terms of number of shares or the valuation of shares when you join an early-stage startup. Think of yourself as a late-stage founder and negotiate for a specific percentage ownership in the company. You should base this percentage on your anticipated contribution to the company's growth in value.
Early-stage companies expect to dramatically increase in value between founding and Series A. For example, a common pre-money valuation at a VC financing is $8 million. And no company can become an $8 million company without a great team. So think about your contribution in this way:
Q: How should early-stage startups calculate my percentage ownership?
You'll be negotiating your equity as a percentage of the company's "Fully Diluted Capital." Fully Diluted Capital = the number of shares issued to founders ("Founder Stock") + the number of shares reserved for employees ("Employee Pool") + the number of shares issued or promised to other investors ("Convertible Notes"). There may also be warrants outstanding, which should also be included. Your Number of Shares / Fully Diluted Capital = Your Percentage Ownership.
Be aware that many early-stage startups will ignore Convertible Notes when they give you the Fully Diluted Capital number to calculate your ownership percentage. Convertible Notes are issued to angel or seed investors before a full VC financing. The seed stage investors give the company money a year or so before the VC financing is expected, and the company "converts" the Convertible Notes into preferred stock during the VC financing at a discount from the price per share paid by VCs.
Since the Convertible Notes are a promise to issue stock, you'll want to ask the company to include some estimate for conversion of Convertible Notes in the Fully Diluted Capital to help you more accurately estimate your Percentage Ownership.
Q: Is 1% the standard equity offer?
1% may make sense for an employee joining after a Series A financing, but do not make the mistake of thinking that an early-stage employee is the same as a post-Series A employee.
First, your ownership percentage will be significantly diluted at the Series A financing. When the Series A VC buys approximately 20% of the company, you will own approximately 20% less of the company.
Second, there is a huge risk that the company will never raise a VC financing. According to CB Insights, about 39.4% of companies with legitimate seed funding go on to raise follow-on financing. And the number is far lower for seed deals in which legitimate VCs are not participating.
Don't be fooled by promises that the company is "raising money" or "about to close a financing." Founders are notoriously delusional about these matters. If they haven't closed the deal and put millions of dollars in the bank, the risk is high that the company will run out of money and no longer be able to pay you a salary. Since your risk is higher than a post-Series A employee, your equity percentage should be higher as well.
Q: Is there anything tricky I should look out for in my stock documents?
Yes. Look for repurchase rights for vested shares or termination of stock options for violations of non-compete or bad-leaver clauses. Have your attorney read your documents them as soon as you have access to them. If you don't have access to the documents before you accept your offer, ask the company this question:
Does the company maintain any repurchase rights over my vested shares or any other rights that prevent me from owning what I have vested?
If the company answers "yes" to this question, you may forfeit your equity when you leave the company or are fired. In other words, you have infinite vesting as you don't really own the shares even after they vest. This can be called "vested share repurchase rights," "clawbacks," "non-competition restrictions on equity," or even "evil" or "vampire capitalism."
Most employees who will be subject to this don't know about it until they are leaving the company (either willingly or after being fired) or waiting to get paid out in a merger that is never going to pay them out. That means they have been working to earn equity that does not have the value they think it does while they could have been working somewhere else for real equity.
Q: What is fair for vesting? For acceleration upon change of control?
The standard vesting is monthly vesting over four years with a one year cliff. This means that you earn 1/4 of the shares after one year and 1/48 of the shares every month thereafter. But vesting should make sense. If your role at the company is not expected to extend for four years, negotiate for an vesting schedule that matches that expectation.
When you negotiate for an equity package in anticipation of a valuable exit, you would hope that you would have the opportunity to earn the full value of the package. However, if you are terminated before the end of your vesting schedule, even after a valuable acquisition, you may not earn the full value of your shares. For example, if your entire grant is worth $1 million dollars at the time of an acquisition, and you have only vested half of your shares, you would only be entitled to half of that value. The remainder would be treated however the company agrees it will be treated in the acquisition negotiation. You may continue to earn that value over the next half of your vesting schedule, but not if you are terminated after the acquisition.
Some employees negotiate for “double trigger acceleration upon change of control.” This protects the right to earn the full block of shares, as the shares would immediately become vested if both of the following are met: (1st trigger) after an acquisition which occurs before the award is fully vested (2nd trigger) the employee is terminated (as defined in the stock option agreement).
Q: The company says they will decide the exercise price of my stock options. Can I negotiate that?
The company will set the exercise price at the fair market value ("FMV") on the date the board grants the options to you. This price is not negotiable, but to protect your interests you want to be sure that they grant you the options ASAP.
Let the company know that this is important to you and follow up on it after you start. If they delay granting you the options until after a financing or other important event, the FMV and the exercise price will go up. This would reduce the value of your stock options by the increase in value of the company.
Early-stage startups very commonly delay making grants. They shrug this off as due to "bandwidth" or other nonsense. But it is really just carelessness about giving their employees what they have been promised.
The timing and, therefore, price of grants does not matter much if the company is a failure. But if the company has great success within its first years, it is a huge problem for individual employees. I have seen individuals stuck with exercise prices in the hundreds of thousands of dollars when they were promised exercise prices in the hundreds of dollars.
Q: What salary can I negotiate as an early-stage employee?
When you join an early-stage startup, you may have to accept a below market salary. But a startup is not a non-profit. You should be up to market salary as soon as the company raises real money. And you should be rewarded for any loss of salary (and the risk that you will be earning $0 salary in a few months if the company does not raise money) in a significant equity award when you join the company.
When you join the company, you may want to come to agreement on your market rate and agree that you will receive a raise to that amount at the time of the financing. You can also ask when you join for the company to grant you a bonus at the time of the financing to make up for your work at below-market rates in the early stages. This is a gamble, of course, because only a small percent of seed-stage startups would ever make it to Series A and be able to pay that bonus.
Q: What form of equity should I receive? What are the tax consequences of the form?
[Please do not rely on these as tax advice to your particular situation, as they are based on many, many assumptions about an individual's tax situation and the company's compliance with the law. For example, if the company incorrectly designs the structure or the details of your grants, you can be faced with penalty taxes of up to 70%. Or if there are price fluctuations in the year of sale, your tax treatment may be different. Or if the company makes certain choices at acquisition, your tax treatment may be different. Or ... you get the idea that this is complicated.]
These are the most tax advantaged forms of equity compensation for an early-stage employee in order of best to worst.:
1. [Tie] Restricted Stock. You buy the shares for their fair market value at the date of grant and file an 83(b) election with the IRS within 30 days. Since you own the shares, your capital gains holding period begins immediately. You avoid being taxed when you receive the stock and avoid ordinary income tax rates at sale of stock. But you take the risk that the stock will become worthless or will be worth less than the price you paid to buy it.
1. [Tie] Non-Qualified Stock Options (Immediately Early Exercised). You early exercise the stock options immediately and file an 83(b) election with the IRS within 30 days. There is no spread between the fair market value of the stock and the exercise price of the options, so you avoid any taxes (even AMT) at exercise. You immediately own the shares (subject to vesting), so you avoid ordinary income tax rates at sale of stock and your capital gains holding period begins immediately. But you take the investment risk that the stock will become worthless or will be worth less than the price you paid to exercise it.
3. Incentive Stock Options ("ISOs"): You will not be taxed when the options are granted, and you will not have ordinary income when you exercise your options. However, you may have to pay Alternative Minimum Tax ("AMT") when you exercise your options on the spread between the fair market value ("FMV") on the date of exercise and the exercise price. You will also get capital gains treatment when you sell the stock so long as you sell your stock at least (1) one year after exercise AND (2) two years after the ISOs are granted.
4. Restricted Stock Units ("RSUs"). You are not taxed at grant. You do not have to pay an exercise price. But you pay ordinary income tax and FICA taxes on the value of the shares on the vesting date or at a later date (depending on the company's plan and when the RSUs are "settled"). You probably will not have a choice between RSUs and stock options (ISOs or NQSO) unless you are a very early employee or serious executive and you have the power to drive the company's capital structure. So if you are joining at an early stage and are willing to lay out some cash to buy common stock, ask for Restricted Stock instead.
5. Non-Qualified Stock Option (Not Early Exercised): You owe ordinary income tax and FICA taxes on the date of exercise on the spread between the exercise price and the FMV on the date of exercise. When you sell the stock, you have capital gain or loss on the spread between the FMV on the date of exercise and the sale price.
Q: Who will guide me if I have more questions?
Attorney Mary Russell is available to guide individual employees and founders in negotiating and monetizing startup stock. You are invited to contact Stock Option Counsel for help in negotiating and evaluating your job offers and post-acquisition employment agreements, making stock option exercise and tax decisions and identifying your rights and opportunities to sell startup stock.