startups, Stock Options, Restricted stock units, How to negotiate equity in a startup, How much equity should I ask for? Mary Russell startups, Stock Options, Restricted stock units, How to negotiate equity in a startup, How much equity should I ask for? Mary Russell

Startup Compensation Data Sources

Here’s some links to helpful market data for startup equity offers. Individuals negotiating a startup offer often struggle to find good resources for startup compensation data since the key data sources are only available on the company side.

Negotiating startup salary and stock options or RSUs? These are links to market data that readers have found helpful.

Negotiating startup salary and stock options or RSUs? These are links to market data that readers have found helpful. Photo by ThisIsEngineering.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Published February 2023. Updated regularly.

Market Data Sources

Individuals often struggle to find good resources for startup compensation data since subscriptions to the primary startup compensation data sources are only available on the company side. Companies are using Radford, Mercer, Carta (but see below re Friends of Carta!) and Pave (including the classic Advanced-HR Venture Capital Executive Compensation Survey, now owned by Pave). The imbalance is challenging to say the least.

Here’s some links that readers have found helpful:

Good luck! Please send along anything you’d like me to include on this list.

How to Use Market Data

And here’s some good links on how to use market data. They are written for companies, but helpful to any individual’s thoughtful approach to this topic.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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Startup Double Trigger Acceleration Clause Fine Print Details

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Working for a Startup? | Protect Your Equity Stake | Double Trigger Acceleration Clause

Working for a startup? Startup founders, executives and key hires often negotiate for Double Trigger Acceleration. This is the smart move to protect unvested shares from forfeiture at Change of Control. Not all Double Trigger Acceleration Clauses are created equal, though. The devil is in the details. Photo by Felix Mittermeier.

Double Trigger Acceleration Clauses

Startup founders, executives and key hires often negotiate for Double Trigger Acceleration to protect their unvested shares in the event of a change of control or acquisition. This is the smart move, as otherwise the value of the unvested shares can be lost in the event of a successful acquisition. For example, an executive with a 1% equity interest could end up with $0 if the company is acquired within the first year of service and the grant did not include a Double Trigger Acceleration clause.

Not all Double Trigger Acceleration Clauses are created equal, though. That same executive with a half-hearted Double Trigger Acceleration Clause could end up with $0 as well. The devil is in the details.

Ideal Double Trigger Acceleration Clause

The ideal Double Trigger Acceleration Clause would include the following:

  1. Full acceleration so that a qualifying termination at any time after change of control accelerates 100% of unvested shares;

  2. Application to a qualifying termination in anticipation of, or for a certain protective period of time prior to, change of control;

  3. Application to terminated by the company for Cause (narrowly defined, not to include arguable performance terms);

  4. Application to a resignation by the individual for Good Reason (defined broadly to include a change in cash compensation, a reduction in duties or reporting structure, a geographic change, and anything else that would amount to constructive termination for the individual);

  5. A broad definition of change of control including both (i) a transfer of voting control and (ii) a sale or lease of substantially all the company’s assets; and

  6. Immediate vesting at closing of the change of control if unvested shares would otherwise be cancelled without payment under a Cancellation Plan term.

Weirdness in Double Trigger Acceleration Clauses

Recently, I’ve seen three weird patterns in the fine print of Double Trigger Acceleration Clauses in offer letters for startup hires.

Absurdly Narrow Definition of Change of Control

First, I’ve seen definitions of Change of Control that are so narrow that they would very rarely apply. For example, “an acquisition of 100% of the company or a complete dissolution of the company.”

This would not include some of the common deal structures that are used in startup M&A deals and that would be included in the standard “change in control” definitions used as part of Double Trigger Acceleration Clauses such as the definition Treas. Reg. section 1.409A-3(i)(5):

(5) Change in the ownership or effective control of a corporation, or a change in the ownership of a substantial portion of the assets of a corporation—(i) In general. Pursuant to section 409A(a)(2)(A)(v), a plan may permit a payment upon the occurrence of a change in the ownership of the corporation (as defined in paragraph (i)(5)(v) of this section), a change in effective control of the corporation (as defined in paragraph (i)(5)(vi) of this section), or a change in the ownership of a substantial portion of the assets of the corporation (as defined in paragraph (i)(5)(vii) of this section) (collectively referred to as a change in control event). …

If the first trigger of the double trigger acceleration clause is so narrowly drafted as to be impractical to achieve, the clause itself would not effectively protect unvested shares. In that case, in evaluating such a startup equity offer, a hire can expect the potential upside only on the shares that will vest prior to an acquisition. That changes the cost/benefit analysis of a startup equity offer.

This can be addressed by revising the definition of Change of Control that applies to the Double Trigger Acceleration Clause. This would be negotiated in the startup hire’s offer letter and then flow through to the final grant documents / Carta vesting schedule.

Cancellation of Unvested Shares at Closing

Second, I’ve seen Double Trigger Acceleration Clauses that leave room for the company to cancel unvested shares - without payment or substitution - at a closing of a Change of Control. If there are no shares left after closing, and before the second trigger would be met through a termination of employment, there are no shares left to accelerate at such second trigger.

More on this here from Cooley:

Often overlooked, however, is that in order for double-trigger acceleration to be meaningful, the option grant or equity award must actually be assumed or continued by the acquiror in the transaction. This will not always be the case in a transaction – aquirors often have their own plans and ideas for incentivizing their employees. If an unvested option or equity award terminates in connection with a transaction, then technically, there will be no unvested options or awards to accelerate if the second trigger (i.e., the qualifying termination) occurs after the transaction.

This can be addressed by either:

  1. Including in the double trigger acceleration clause immediate acceleration of unvested shares at closing if those shares would otherwise be cancelled without payment or substitution (best solution); or

  2. Including in the definition of Good Reason (if applicable) such a cancellation of unvested shares at closing (not as good, but okay).

This would be negotiated in the startup hire’s Offer Letter and then flow through to the final grant documents / Carta vesting schedule.

Carta Does Not Match Offer Letter

Finally, I’ve recently seen a few Carta grants that do not include the Double Trigger Acceleration Clause language negotiated in the Offer Letter. Since the Carta grants include an integration clause invalidating any previously-negotiated terms not included therein, the absence of the Offer Letter’s double trigger language in the Carta vesting schedule could be read as forfeiting those rights.

Negotiating a Double Trigger Acceleration Clause

Like all startup equity offer negotiation points, evaluating and negotiating a robust and useful Double Trigger Acceleration Clause starts with the startup hire learning and understanding the fundamentals of startup stock. If you’ve read and grasped this post, you’re well on your way!

The time to include these terms is at hire, as the decision-makers at the time of an acquisition are not incentivized to (and could be prohibited by their fiduciary duties from) solving these problems for executives once the deal is on the table.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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Joining an Early Stage Startup? Negotiate Your Startup Equity and Salary with Stock Option Counsel Tips

Startup equity negotiation tips for early stage founders, executives, employees, consultants and advisors.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Startup Equity @ Early Stage Startups

"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 OpenAI, Discord, or one of the other most valuable startups on Earth. Instead you'll have to join an early-stage startup, negotiate a great equity package and hope for the company’s success. This post walks through the negotiation issues in joining a pre-Series A / seed-funded / very-early-stage startup. 

Q: Isn't startup equity 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. 

Carta’s data team published an update in December of 2023 showing the “graduation rates” from Series Seed to Series A within 2 years. They affirm that it’s not a sure thing to graduate from Series Seed to Series A and, therefore, even have the chance to make it all the way to a successful acquisition or IPO. In hot years of 2021-2022, the graduation rate hovered around 30% across all industries. In 2023, it ranged from:

  • 23% for FinTech

  • 20% for HealthTech

  • 19% for Consumer

  • 17% for SaaS

  • 16% for Biotech

Here's an illustration from Dustin Moskovitz's presentation, Why to Start a Startup from Y Combinator's Startup School on the chances so "making it" for a startup that has already raised seed funding. These 2nd Round “graduation” numbers are higher than Carta’s numbers, as this data was from 2017 (a hot hot time for startup funding).

What are the chances of a seed-funded startup becoming a "unicorn" (here, defined as having 6 rounds of funding rather than the classic “unicorn” definition of a $1 billion valuation)? Not great.

What are the chances of a seed-funded startup becoming a "unicorn" (here, defined as having 6 rounds of funding rather than the classic “unicorn” definition of a $1 billion valuation).

 

Q: How do you negotiate equity for a startup? How many shares of startup equity 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.

Imagine, for instance, that the company tries to sell you on the offer by insisting that they will someday be worth $1B and, therefore, your equity worth, say, $1M. The obvious question would be: Does it feel fair to you to make a significant contribution to the creation of $1B in value in exchange for $1M? For most people, the answer would be “no.”

Or, consider that the company is insisting that an offer of 1% is “worth” $1M because the company expects to raise a Series A - based in part on your efforts - at a $100M pre-money valuation. Leaving aside the wisdom (or lack thereof) of evaluating the offer based on its future value, you would want to ask yourself: Does it feel fair to you to make a significant contribution to the creation of $100M in value in exchange for $1M in equity (which would presumably be only partially vested as of the Series A)?

That would depend, of course, on how significant your contribution would be. And it would depend on the salary component of the offer. If the cash compensation is already close to market level, that might seem more than fair. If the cash offer is a fraction of your opportunity cost, you would be investing that opportunity cost to earn the equity. The potential upside would need to be great enough to balance the risk of that investment.

Q: Is 1% equity in a startup good?

The classic 1% for the first employee may make sense for a key 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 or survive past the seed stage.  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 big name 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: What is typical equity for startup? How should I think about market data for startup equity?

Data sets on employee and executive offer percentages for early stage startups can be misleading and encourage companies to make unrealistically low offers to early hires. There’s two reasons for this. First, these data sets are for employees who are earning something like market level salaries along with equity. Second, these data sets exclude anyone classified as a “founder” from the data set for employees. They keep different data sets for founders! So the gray area between the two classifications makes the use of data tricky. Who is a founder for purposes of the data set? Depends on the data set. Carta, for instance, excludes anyone with 5% or more from the employee/executive data set and classifies them as founders! Even if they are earning market-level cash from their start date.

Here’s the bottom line:

  1. If you are joining before you are being paid startup-phase-market-level cash salary, you are a late stage founder. You should evaluate your equity percentage relative to the other founders within the company or within the market data set.

  2. If you are joining for a combination of cash and equity at an early stage startup, the offer should make sense to you. Simply pointing to market data for the right % ownership is not enough. You’ll want to consider the market data for % ownership in conjunction with the dollar value of the equity based on how investors have most recently valued the company.

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 to other investors (“preferred shares”). There may also be warrants outstanding, which should also be included. Your Number of Shares / Fully Diluted Capital = Your Percentage Ownership.

Careful, though, because most startups do not issue preferred stock when they take their seed investment funds from their seed investors. Instead, they issue convertible notes or SAFEs. These convert into shares of preferred stock in the next round of funding. So if you negotiate for 1% of a seed stage startup funded with notes or SAFEs, the fully diluted capital number used as the denominator of that calculation does not include the shares to be issued for those seed funds.

How can you address this? First, make sure you know what’s included. You can ask:

How many shares are outstanding on a fully diluted basis? Does this include the full option pool? Are there any shares yet to be issued for investments in the company, such as on SAFEs or convertible notes? How many shares do you expect to issue upon their conversion?

If you are comparing your offer to other seed stage offers or to market data for seed stage offers, you would want to take that into consideration. The number the company provides is only an estimate, of course, but it’s a way to address this in your evaluation.

Earning equity in an early stage company? Negotiate your equity and salary with Stock Option Counsel's tips. Instead you'll have to join an early-stage startup, negotiate a

“Fully Diluted Capital” includes only issued shares and reserved shares. For an early stage startup, that would include founders shares, the option pool, and any preferred shares issued to investors in a priced round. It will not include shares to be issued upon conversion of SAFEs and convertible notes. Therefore, you will want to include some estimate for the conversion of those investments when you are understanding the percentage ownership in an early stage startup offer.

Q: Is there anything tricky I should look out for in my startup equity documents?

Yes. Look for repurchase rights for vested shares.

If so, you may forfeit your vested shares if you leave the company for any reason prior to an acquisition or IPO. 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” or "non-competition restrictions on equity.”

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.

According to equity expert Bruce Brumberg, "You must read your whole grant agreement and understand all of its terms, even if you have little ability to negotiate changes.  In addition, do not ignore new grant agreements on the assumption that these are always going to be the same." When you are exchanging some form of cash compensation or making some other investment such as time for the equity, it makes sense to have an attorney review the documents before committing to the investment. 

Q: What is fair for vesting of startup equity?

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, consider negotiating for a vesting schedule that matches that expectation.

Q: Should I agree to milestone or performance metrics for my vesting schedule for startup equity?

No. This is a double risk. Not only is there a high risk that the company will not be successful (and the equity worthless), there is a high risk that the milestones will not be met. This is very often outside the control of the employee or even the founders. More on this issue here. The standard is four-year vesting with a one-year cliff. Anything else is off-market and is a sign that the founders are trying to be too creative and reinvent the wheel.

Q: Should I have protection for my unvested shares of startup equity in the event of an acquisition?

Yes. 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 number of shares in the offer so long as you are willing to stay through the vesting schedule.

If you do not have protection for your unvested shares in the stock documents, unvested shares may be cancelled at the time of an acquisition. I call this a “Cancellation Plan.”

Executives and key hires 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) an acquisition occurs before the award is fully vested; and (2nd trigger) the employee is terminated after closing before they are fully vested.

There’s plenty of variation in the fine print of double trigger clauses, though. Learn more here.

Q: The company says they will decide the exercise price of my stock options. Can I negotiate that? 

A well-advised 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.

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.

I sometimes see people ask at hire to receive a bonus at the time of the financing to make up for working 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. Therefore, it makes far more sense to negotiate for a substantial equity offer instead.

Q: What form of startup 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.

Q: Who will guide me if I have more questions on startup equity?

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

 

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Am I an Employee or Founder???

"The difference between a founder and an early employee is gray, not black and white."
 

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Originally published April 23, 2013. Updated August 3, 2023 and November 1, 2023.

Quora Question:

Why do startups have an exponential drop-off in equity for employees? I've never heard a reasonable explanation of why there should be exponential drop-off in equity compensation based on joining time in a startup (vs. linear, for example). Obviously you need some time function to push prospective employees to make the jump when they are earning below-market salary, but is there a good reason why the drop-off is often exponential?

November 2023 Update: Great info on this point for technical co-founders / early employees from YC in this video called How Not to Get Screwed Over as a Software Engineer.

Stock Option Counsel Answer:

The Gray Area -- Revealed!

This is a great question because it reveals a truth: The difference between a founder and an early employee is gray, not black and white. There is not a true difference that would allow an exponential difference to be appropriate.

A Thinking Trick

It is very useful for an employee to reverse the exponential drop logic the company may use -- how much more than zero should this "employee" receive -- to acknowledge the gray area by thinking along the lines of "How much less than a founder should I receive?" While it is unlikely for an employee to come in at close to founder level, that should be ideal starting point to work from in your mental calculation of what is appropriate and will inspire you to perform at a founder level.

Founder Delusions

And remember that founders are notoriously delusional about how soon they will be funded, so don't drink the Kool-Aid. I see companies try to grant employee-level equity before a funding on the promise that they are "just about to be funded." They promise salaries that will be "deferred" until funding and try to bring on "first employees." If you're not getting paid a startup-phase-market-level salary today, you are not at an employee's level of risk. Be sure you are granted founder-level equity if you have founder-level risk.

Data Sets

Data sets on employee and executive offer percentages for early stage startups can be misleading and encourage companies to make unrealistically low offers to early hires. There’s two reasons for this. First, these data sets are for employees who are earning something like market level salaries along with equity. Second, these data sets exclude anyone classified as a “founder” from the data set for employees. They keep different data sets for founders! So the gray area between the two classifications makes the use of data tricky. Who is a founder for purposes of the data set? Depends on the data set. Carta, for instance, excludes anyone with 5% or more from the employee/executive data set and classifies them as founders! Even if they are earning market-level cash from their start date.

How to Think About This

Here’s the bottom line:

  1. If you are joining before you are being paid startup-phase-market-level cash salary, you are a late stage founder. You should evaluate your equity percentage relative to the other founders within the company or within the market data set.

  2. If you are joining for a combination of cash and equity at an early stage startup, the offer should make sense to you. Simply pointing to market data for the right % ownership is not enough. You’ll want to consider the market data for % ownership in conjunction with the dollar value of the equity based on how investors have most recently valued the company.

More here.

Link to Quora Q&A: https://www.quora.com/Startups/Why-do-startups-have-an-exponential-drop-off-in-equity-for-employees .

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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The One Percent: How 1% of Ruckus Wireless at Series A Became $1.7 million at IPO

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Originally published February 27, 2013. Updated August 30, 2023.

The biggest question I get about dilution is this:

What can I add to the fine print of my documents to protect me from dilution, or ensure I will get more shares later as I am diluted.

The answer is easy (but hard for people to accept):

  • Negotiate for enough shares up-front to ensure that you will have a sufficient stake by the time of an exit event to meet your goals.

  • Employees do not get anti-dilution protection, and if a company were to offer such protection that in itself would be a red flag.

  • 90% of the equity people get in a startup is in their original offer, so future grants should not be the expectation no matter what a company promises during the offer negotiation stage.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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Risk/Reward of Startup Employee Stock

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Startup employee equity should reward the risk you take in joining the company. Here's some ways to understand equity value so you can decide if your equity meets this standard.

For more information on joining an early stage startup before there is a VC valuation, see Joining An Early Stage Startup? Negotiate Your Salary and Equity with Stock Option Counsel Tips.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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Startup Negotiations: How Preferred Stock Makes Employee Stock Less Valuable

Originally published February 13, 2014. Updated August 30, 2023.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Common Stock v. Preferred Stock

Startup employees and executives get Common Stock (as options, RSUs or restricted stock). When venture capitalists invest in startups, they receive Preferred Stock.

Preferred Stock comes with the right to preferential treatment in merger payouts, voting rights, and dividends. If the company / founders have caved and given venture capitalists a lot of preferred rights - like a 3X Liquidation Preference or Participating Preferred Stock , those rights will dramatically reduce the payouts to Common Stock in an acquisition. An individual who holds 1% in common stock would be curious, therefore, about the preferred stock’s rights to know if their 1% would really be 1% in an acquisition.

Is Preferred Stock Negotiable for Employees and Executives?

No. Preferred Stock is not negotiable for employees and executives (other than perhaps founders preferred stock which relates not to acquisition payout amounts but to liquidity rights and voting rights). The key is to understand if the investors’ Preferred Stock has unusual, off-market liquidation preferences. If so, that would weigh in favor of negotiating for more shares, more cash compensation or - less often but occasionally - management retention plan terms to make up for uninspiring Common Stock rights.

Liquidation Preference & How It Affects Common Stock Payouts

One Preferred Stock right is a "Liquidation Preference." Without a Liquidation Preference, each stockholder – preferred or common – would receive a percentage of the acquisition price equal to the stockholder's percentage ownership in the company. If the company were acquired for $15 million, and an employee owned 1% of the company, the employee would be paid out $150,000.

With a Liquidation Preference, preferred stockholders are guaranteed to be paid a set dollar amount of the acquisition price, even if that guaranteed payout is greater than their percentage ownership in the company.

Here’s an example of the difference. An investor buys 5 million shares of Preferred Stock for $1 per share for a total of $5 million. After the financing, there are 20 million shares of common stock and 5 million shares of Preferred Stock outstanding. The company is then acquired for $15 million.                                                                                                                           

Without a Liquidation Preference, each stockholder (common or preferred) would receive $0.60 per share. That’s $15 million / 25 million shares. A hypothetical employee who held 1% of the company or 250000 shares) would receive $150,000 (that’s 1% of $15 million).

If the preferred stockholders had a 1X Liquidation Preference and Non-Participating Preferred Stock, they would receive 1X their investment ($5 million) before any Common Stock is paid in an acquisition. They would receive the first $5 million of the acquisition price, and the remaining $10 million would be divided among the 20 million shares of common stock outstanding ($10 million / 20 million shares of common stock). Each common stockholder would be paid $0.50 per share, and hypothetical employee who held 1% of the company would receive $125,000.

In an up-round acquisition, though, this 1X non-participating preference would not affect common stock payouts. In an acquisition at $100 million valuation, the investors would choose the higher of:

  • Their $5M liquidation preference and

  • Their percentage of the company valuation. If they had 20% of the company’s shares, they would of course here choose $20M in payouts. And all common stockholders would also receive their percentage payout.

Ugly, Non-Standard Rights That Diminish Employee Stock Value

The standard Liquidation Preference is 1X. This makes sense, as the investors expect to receive their investment dollars back before employees and founders are rewarded for creating value. But some company founders give preferred stockholders multiple Liquidation Preferences or Participation Rights that cut more dramatically into employee stock payouts in an acquisition.

If preferred stockholders had a 3X Liquidation Preference, they would be paid 3X their original investment before common stock was paid out. In this example, preferred would be paid 3X their $5 million investment for a total of $15 million, and the common stockholders would receive $0. ($15 million acquisition price – $15 million Liquidation Preference = $0 paid to common stockholders)

Preferred stock may also have "Participation Rights," which would change our first example above to give preferred stockholders an even larger portion of the acquisition price.

Without Participation Rights, Preferred Stockholders must choose to either receive their Liquidation Preference or participate in the division of the full acquisition price among the all stockholders. In the first example above, the preferred stockholders held 20% of the company and had a $5 million Liquidation Preference. When the company was acquired for $15 million, the preferred stockholders had the choice to receive their $5 million liquidation preference or to participate in an equal distribution of the proceeds to all stockholders. The equal distribution would have given them $3 million (20% of $15 million acquisition price), so they chose to take their $5 million liquidation preference, and the remaining $10 million was divided among 20 million shares of common stock.

If the Preferred Stock also had Participation Rights, (which is called Participating Preferred Stock), they would receive their Liquidation Preference and participate in the distribution of the remaining proceeds.

In our example with a 1X Liquidation Preference but adding a Participation Right, the Participating Preferred Stock would receive their $5 million Liquidation Preference AND a portion of the remaining $10 million of the acquisition price equal to their % ownership in the company.

$5 million Liquidation Preference + ((5 million shares / 25 million shares outstanding) * $10 million) = $7 million

Common stockholders would receive (20 million shares common stock / 25 million shares outstanding) * $10 million = $8 million.

Our hypothetical employee who held 1% of the company would receive $100,000 (.01 * $10 million) or 0.67% of the acquisition price.

Employee Focus – Quick and Dirty Analysis

These calculations are complicated, so most candidates who are evaluating a startup job offer keep it simple in considering the effects of preferred stock. The quick and dirty way to know if preferred stock is an issue in evaluating an equity offer is to find out:

Do preferred stock investors have any liquidation preferences beyond the standard 1X non-participating preference?

If not, it’s not an issue in any up-round acquisition (and so most startup hires would not be concerned about the preferences at hire).

Founder Focus – Negotiating Your Acquisition Payout

If you are a founder and are negotiating with an acquiror, consider renegotiating your investors’ Liquidation Preference payout. Everything is negotiable in an acquisition, including the division of the acquisition price among founders, investors and employees. Do not get pushed around by your investors here, as their rights in the documents do not have to determine their payout.

If your investors are pushing to receive the full Liquidation Preference and leaving you and/or your employees with a small cut of the payout, address this with your investment bankers. They may be able to help you play your acquiror against the investors so that you are not cut out of the wealth of the deal, as most acquirors want the founders and employees to receive enough of the acquisition price to inspire them to stay with the company after acquisition.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Thanks to investment banker Michael Barker for his comments on founder merger negotiations. Michael is a Managing Director at Shea & Company, LLC,  a technology-focused investment bank and leading strategic advisor to the software industry.

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RSUs - Restricted Stock Units - Evaluating an RSU Offer at a Startup

Working for a startup? Here’s how to think about Restricted Stock Units or RSUs.

Originally published February 10, 2014. Updated March 27, 2017 and July 5, 2023.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Working for a startup? Here’s how to think about RSUs.

What are RSUs?

Restricted Stock Units ("RSUs") are not stock. They are not restricted stock. They are not stock options. RSUs are a company's promise to give you shares of the company's stock (or the cash value of the company's stock) at some time in the future.

How Many Shares Do I Have?

One RSU is equivalent to one share of stock. The number of RSUs in your grant determines how many shares of stock (or the number of shares of stock used to determine your cash payment) you will receive when they are "settled" on the Settlement Date.

You’ll receive one share of stock (or the cash value of one share of stock) for every vested RSU on the Settlement Date. For startup (private company) RSUs, the Settlement Date is usually a company Liquidity Event. A company Liquidity Event might include (i) a Change of Control (aka Merger or Acquisition); (ii) after an IPO, when post-IPO lockup on employee sales expires or (iii) a company choice to have an early settlement in shares.

When are Startup RSUs Taxed?

Most startup RSUs are structured elegantly to defer taxes until after the shares can be sold to cover the taxes. That’s achieved with a two-tier vesting schedule. Before the RSUs fully vest (so they can be “settled” in shares or cash on the Settlement Date), two triggers must be met:

  1. Time-Based Vesting AND

  2. Liquidity-Event-Based Vesting

Time-based vesting is the classic vesting concept. You will meet the time-based vesting requirement over a set period of time of service (called the "Vesting Period"). The most common time- vesting period is quarterly vesting over four years with a 1-year cliff.

The liquidity-event vesting requirement is the tax-deferral concept. The shares will not be settled / fully vested for tax purposes until the company has a Liquidity Event. A company Liquidity Event might include (i) a Change of Control (aka Merger or Acquisition); (ii) after an IPO, when post-IPO lockup on employee sales expires or (iii) a company choice to have an early settlement in shares.

Without this liquidity-event vesting requirement, RSUs could become vested for tax purposes before there is a market to sell the shares (or even before shares are officially received in exchange for the RSUs at settlement). That would be very unappealing for startup employees and executives, as they would need to pay taxes out of their own funds based on the FMV on the vesting date.

[Careful! This two-tier vesting structure (sometimes called double trigger vesting) is a tax deferral mechanism. It is not the same thing as double trigger acceleration upon change of control! Those are often confused so be careful there.]

Do Startup RSUs Expire?

Yes! There’s two issues to watch out for w/r/t expiration / forfeiture of startup RSUs.

All startup RSUs include a deadline, so that if the Liquidity Event is not achieved by a certain date, all RSUs will be forfeited without payment. That is usually 5 or 7 years from the date of grant. Therefore, most RSUs are designed to be forfeited if the company does not go public or get acquired within 5 or 7 years of the employee or executive’s start date even if the RSUs have already time-vested by that date. Unfortunately, this term is not negotiable as it is a tax-driven deadline. The RSUs must be designed with a substantial risk of forfeiture in order to defer taxation.

In addition to this tax-driven deadline, some RSUs include a forfeiture clause. This is similar to the dreaded clawback for vested shares, even though it is technically part of the vesting schedule. Here’s how it works. If an employee or executive leaves the company, they forfeit any time-vested RSUs that have not yet been settled / vested at a Liquidity Event. In other words, the employee or executive has to survive all the way through a Liquidity Event to get anything for their time-vested RSUs. This type of forfeiture term greatly reduces the value of an RSU grant because it is not really "earned" even after the time-based vesting period.

Will I Receive Annual Refresh Grants of Startup RSUs?

Probably not! Most private companies do not make substantial refresh grants either annually or at the time of future financings. In my experience, approximately 90% of the equity individuals receive at startups is in their original, at-hire grant. This likely would be refreshed only after it is close to meeting its full time-vesting requirements.

This is usually a surprise to employees and executives coming from public companies, where regular refreshes are the norm. The reason for the difference is that startups are hoping for huge increases in valuation. If that happens, the original grant would be sufficiently valuable to retain employees and executives. If you are evaluating a job offer, there is a big difference in the value of your offer between a company that grants RSUs only at hire (and after they have vested) and a company that plans to make additional refresh grants regularly.

How Do I Value Startup RSUs?

There is no precise "value" for startup RSUs since they are not liquid (aka easily sold). But employees and executives who are evaluating startup RSUs offers do think about value when their considering how much equity makes sense for their role.

When evaluating the number of RSUs in an RSU grant, employees and executives use one or both of these approaches:

  1. Current Valuation Method (Fact-Based): For startup stock, most hires use the price per share paid by venture capitalists for one share of preferred stock in the most recent financing as a proxy for the value of their RSUs. This is the closest number you can find for today's value. It tells you that X Venture Capitalist paid $Y for one share of the company's stock on Z date. The usefulness of this approach is somewhat limited for stale valuations, especially in the 2022-2023 market. For more on this approach, see Venture Hacks' post on startup job offers.

  2. Percentage Ownership: Executive hires also consider their percentage ownership compared to market for their role at this stage of company. Individuals often struggle to find good resources for startup compensation data since subscriptions to the primary startup compensation data sources are only available on the company side. Here’s a blog post with publicly-available startup compensation data links that readers have found helpful.

  3. Future Valuation Method (Guesstimate Based): To look forward and define a future payout for your RSUs, you have to do some guesswork. If you could guess the startup's value at exit and dilution prior to exit, you would know how much the stock will be worth when you receive it at settlement/post-IPO. Be careful, though, not to use price/share in isolation as stock splits would affect that in unpredictable ways.

Employees and executives often consider these facts to build those approaches of analysis:

  • Recent VC price per share of preferred stock

  • Current number of fully diluted shares in the company or the offered percentage ownership in the company

  • Possibilities around expected dilution, exit scenarios, exit timing and future valuation?

Need More Info?

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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startups, Stock Options, Restricted stock units, negotiation, How much equity should I ask for?, How to negotiate equity in a startup Mary Russell startups, Stock Options, Restricted stock units, negotiation, How much equity should I ask for?, How to negotiate equity in a startup Mary Russell

VIDEO Startup Stock Options: Startup Valuation

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Startup valuation basics

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Read More
Stock Options, startups, How much equity should I ask for?, How to negotiate equity in a startup, Restricted stock units Mary Russell Stock Options, startups, How much equity should I ask for?, How to negotiate equity in a startup, Restricted stock units Mary Russell

Startup Stock Options | Post Termination Exercise Period | Examples of Good Startup Equity Design by Company Stage

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Originally published August 11, 2017. Updated March 17, 2023.

It’s helpful for startup employees to understand early expiration of stock options and the  possible solution of a full 10 year post-termination exercise period. But the full 10 year term stock option is not the right design for every startup equity grant! In some cases it would be the wrong ask, and pushing for it can can lead to embarrassment or a disadvantageous design.

Examples of Good Startup Equity Design by Company Stage

I work with individual clients to balance their priorities for investment timing, tax timing, tax rates and value structure. These are some examples of how the trade-offs are made at each stage. You can also read more about option exercise strategies here in the Menu of Stock Option Exercise Strategies.

1. Earliest Stage - Startup Restricted Stock Purchase

While a startup is in its early stages and its Fair Market Value (FMV) is quite low, consider purchase of Restricted Stock for founders and early employees.  This is the model used for Founders’ Stock at startups, and it is also ideal for executives and employees who are willing to pay the FMV of the common stock up-front for their shares. With the use of an 83(b) election with the IRS, Restricted Stock purchase provides for tax deferral until sale of stock, favorable capital gains tax rates at sale of stock, and fewer tax penalties than stock options in the event the IRS determines the FMV was underpriced for the shares.

2. Early to Mid-Stage - Early Exercise of Startup Stock Options

For those who are willing to take early investment risks for tax deferral and lower tax rates, consider early exercise of stock options. This is an obvious choice for early-stage startup hires who can afford the stock purchase price at hire. For example, at a very early stage startup an employee’s total exercise price might be less than $1,000. Early exercise may also be a good choice for some individuals at mid-stage startups with somewhat higher exercise prices or even later stage startups with high growth potential, as an early investment may be worth it for future tax savings and/or tax deferral.

Early exercise stock options can be exercised before vesting. If they are exercised before the FMV rises above the exercise price, tax payments are deferred until sale of stock by use of a Section 83(b) election at the time of purchase.

However, the investment risk is real, as the purchase price is delivered up-front and shares are held as an investment. If the shares were to become worthless, the investment amount would be lost for both vested and unvested shares.

Early exercise stock options are preferable to restricted stock if the employee is not sure about making the investment up-front. Unlike the purchase of restricted stock, the choice to exercise stock options (even with early exercise rights) can be deferred for some time. However, if the exercise or early exercise is made after the FMV has gone up, the exercise will lead to taxable income.

The early exercise structure can be combined with an extended exercise period (see below under #3 or more here on the blog), so that the employee has the choice between early exercising to minimize tax rates or deferring exercise until any time within the full 10 year term.

Note that the right to early exercise can be a disadvantage for stock option grants with an exercise price greater than $100,000 if they are not early exercised. Any amounts over $100,000 would be ineligible for ISO status due to the ISO rules’ $100,000 limitation.

3.  Early to Mid-Stage - Stock Options with Full 10-Year Exercise Period

While there is still potential for high growth in value, stock options are an advantage for employees. However, a high exercise price or a high tax bill at exercise can make it impossible for employees to take advantage of the value of stock options. This is because stock options have traditionally been granted with a disadvantageous early expiration term requiring exercise within three months of an optionee’s termination date. Therefore, stock options are most advantageous where they are granted with a full 10 year term to exercise regardless of the date of termination. This allows the optionee to defer the investment decision and the associated tax bill for exercise.

Additional consideration: Optionees who take advantage of an extended exercise period (exercise their options after 90 days from last employment) lose their Incentive Stock Option (ISO) tax treatment.  Shares exercised after 90 days from last employment will be treated as Non-Qualified Stock Options (NQSOs) and generally come with a higher tax rate.  However, with this extended exercise design, optionees can choose to exercise within 90 days and keep their ISO classification, or wait to exercise and accept the NQSO classification. This flexibility is key in rewarding optionees of all types and financial circumstance.   

4. Later Stage - Restricted Stock Units

Employees may prefer RSUs to stock options at later stage companies for both tax deferral and offer value purposes. Well-designed RSUs defer taxes until liquidity so long as it is within a certain time frame (such as 7 years from the date of grant). RSUs are less advantageous for tax rates, though, as the value of the shares is taxed as ordinary income at settlement. RSUs are advantageous from an investment perspective because there is no investment risk as there would be in a stock option exercise prior to liquidity.  RSUs also give the employee the full value of the shares at liquidity as there is no purchase price to pay for the stock as there would be with a stock option exercise price. For this reason, a grant of RSUs generally consists of fewer shares than a grant of stock options at a company of the same stage.

Wrapping Up

This is Part 3 of a 3-part series on the startup scene’s debate about early expiration stock options. See Early Expiration of Startup Stock Options - Part 1 - The $1 Million Problem for more information on the issue and Early Expiration of Startup Stock Options - Part 2 - The Full 10-Year Term Solution for more information on the full 10-year term solution.

Thank you to attorney Augie Rakow, a partner at Orrick who advises startups and investors, for sharing his creative solution to this problem in Early Expiration of Startup Stock Options - Part 2 - The Full 10-Year Term Solution.

Thank you to JD McCullough for edits to this post. JD is a health tech entrepreneur, interested in connecting and improving businesses, products, and people.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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Startup Stock Options | Post Termination Exercise Period | The Full 10-Year Term Solution

Working for startup stock options? An option exercise extension can save you from a $1M problem.

Startup stock options often come with a standard 3 month-post termination exercise period. An option exercise extension can save you from a $1M problem. Photo by olia danilevich.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Originally published March 28, 2017. Updated March 17, 2023.

Startup Stock Options and the $1M Problem

The startup scene is debating this question: Should employees have a full 10 years from the date of grant to exercise vested startup stock options or should their rights to exercise expire early if they leave the company before an IPO or acquisition?

This is Part 2 of a 3-part series. See Early Expiration of Startup Stock Options - Part 1 - The $1 Million Problem for more information on the issue and Early Expiration of Startup Stock Options - Part 3 - Examples of Good Startup Equity Design by Company Stage. 

Full 10-Year Term Solution

Some companies are saving their optionees from the $1 million problem of early expiration startup stock options by granting stock options that have a full 10 year term and do not expire early at termination. The law does not require an early expiration period for stock options. Ten years from date of grant is usually the maximum exercise period, as the legal landscape for stock options makes anything beyond a 10 year exercise period impractical in most cases. The 10 year exercise window (without an early exercise period) enables employees to wait for a liquidity event (IPO or acquisition) to pay their exercise price and the associated taxes. This extended structure is designed to compensate employees in a way that makes sense for them. 

Startups who choose a full 10-year term in place of early expiration may do so because their recruits or founders have faced the problem of early expiration at prior companies and become disillusioned with stock options as a benefit. Or their recruits may have read about the issue and asked for it as part of their negotiation. Or their founders may have designed their equity plan to be as favorable to employees as possible as a matter of principle or as a recruiting tool.

Other companies are extending their early expiration period for existing stock options.  One example of this is Pinterest, which extended the term in some cases to 7 years from the date of grant.  This move was in response to their valuation and extreme transfer restrictions that made the early expiration period burdensome for option holders.

An exercise more than 90 days after the last date of employment changes tax treatment for options originally granted as Incentive Stock Options (ISOs).  Such an exercise will be treated as the exercise of a Non-Qualified Stock Option (NQSO) instead. Most employees would prefer to have the choice that an extended exercise period allows, the choice between exercising within 90 days of termination of employment for ISO treatment or waiting to exercise and being subject to NQSO treatment.

You can see a list of companies that have adopted an extended option exercise period or changed from the short early expiration period to longer periods.

Current State of the Market as of 2023

Carta’s State of Private Markets for Q4 2022 shared their data on the number of options expiring in that quarter with an extended post-termination exercise period. They report that:

  • Employees owning 17% of all terminated options in Q4 2022 were given longer than 90 days; and

  • Employees exercised just 32% of their vested options before expiration during Q4

This is an increase - in my view - from the date of the market on this point in 2017 when I first wrote on this topic. However, it still leaves many startup option holders without an extended post-termination exercise period and makes exercise planning and thoughtful offer negotiation on option rights essential for startup employees and executives.

Creative Modifications to the Full 10-Year Term Solution

Companies may prefer early expiration of stock options because terminated stock options reduce dilution for other stockholders. Or they may prefer that their employees are bound to the company by the “golden handcuffs” of early expiration stock options as a retention tool.

For companies that are concerned about excessive dilution, it might make sense to eliminate early expiration only if the company’s value has increased since grant. In other words, employees have a full 10-year term only if the FMV of the common stock on the date of their departure is greater than the exercise price of the stock option. This targets the solution (tax deferral) to the problem (owing tax at exercise before liquidity). If the FMV at exercise is equal to the exercise price, then there is no taxable income to report at exercise. Therefore, an extended exercise period is not necessary to defer taxes until liquidity. This solution does not address the problem of high exercise prices; companies with high exercise prices due to high valuations may want to use RSUs instead of stock options to solve the exercise price problem.

Attorney Augie Rakow, a former partner at Orrick advising startups and investors, has another creative modification to the full 10-year term solution. He has advised clients to find a middle ground by extending exercise periods only for longer-term contributors. This addresses the company concern about retention while solving the early expiration problem for longer-term employees. For example, option agreements might allow three years to exercise after departure only if an employee has been with the company for three years. He notes that "it's a good solution for companies that want to let long-term contributors participate in the value they help create, without incentivizing employees to leave prematurely."

Can I Realistically Exercise the Options if the Company is a Success?

Due to the prevalence of early expiration stock options at startups, this becomes an essential question in evaluating an equity offer: “Can I realistically earn the value of vested equity if the company is a success?” If the option grant has a very high exercise price or could potentially lead to a huge tax bill at exercise, it may not be feasible to exercise during an early expiration period at the end of employment, making the value of vested equity impossible to capture. Clients have negotiated the removal of early expiration or other creative structures to solve this problem if it arises in the employment offer.

I hope this post has illuminated the usefulness of a full 10-year term as a solution to the problem of early expiration of startup stock options. For other alternatives to structuring startup equity, see Early Expiration of Startup Stock Options - Part 3 - Examples of Good Startup Equity Design by Company Stage.  See also Early Expiration of Startup Stock Options - Part 1 - A $1 Million Problem for more information on the issue.

Thank you!

Thank you to JD McCullough for editing this post. He is a health tech entrepreneur, interested in connecting and improving businesses, products, and people.

Thank you to attorney Augie Rakow, a former partner at Orrick advising startups and investors, for sharing his creative solution to this problem.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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Startup Stock Options - Post Termination Exercise Period - A $1 Million Problem

Working for startup stock options? An option exercise extension can save you from a $1M problem.

Negotiating a startup stock option offer? An option exercise extension can save you from a $1M problem. Photo by Pixabay.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

Originally published March 28, 2017. Updated March 17, 2023.

Early Expiration for Startup Stock Options

The startup scene is debating this question: Should employees have a full 10 years from the date of grant to exercise vested options or should their rights to exercise expire early if they leave the company before an IPO or acquisition? This is called a post-termination exercise period or PTEP.

This is Part 1 of a 3-part series. See Early Expiration of Startup Stock Options - Part 2 - The Full 10-Year Term Solution and Early Expiration of Startup Stock Options - Part 3 - Examples of Good Startup Equity Design by Company Stage. See also The Menu of Stock Option Exercise Strategies for more on option exercise planning and startup offer negotiation.

The standard in the past has been that startup stock options are designed with an early expiration period. They must be exercised by whichever comes first:

  1. 10 years after the date of grant or

  2. 3 months after the last date of employment.  (We’ll call this an “early expiration period.")

If a stock option is not exercised by this deadline, it expires and the individual forfeits all rights to the equity they earned. In some cases, this period is shorter, such as expiration 1 month after or even the day of last employment.

If an employee leaves a startup - by choice or involuntary termination of employment - and has to exercise stock options within an early expiration period, he or she has the following choice:

  1. Pay the exercise price and tax bill with savings or a loan;

  2. Find liquidity for some of the shares on the secondary market (which is complicated, not widely accessible, and sometimes prohibited by company or law) to pay for the cost of the exercise price and tax bill; or

  3. Walk away and lose the vested value.

Startup Stock Options’ $1M Problem

This can be a $1 million problem for employees at successful companies because the tax bill due at exercise is based on the value of the shares at exercise. Either ordinary income or alternative minimum taxable (AMT) income may be recognized at exercise. This income will equal the difference between the option exercise price and the value of the shares at the time of exercise. The value of the shares is usually called fair market value (FMV) or 409A valuation.  These values are generally set by an outside firm hired by the company. The company may try to set these valuations as low as possible to minimize this problem for employees, but IRS rules generally require that the FMV increases with investor valuations and business successes.

The more successful the company has been between option grant and option exercise, the higher the tax bill will be. For a wildly successful company, the calculation might look like this:

Here’s an example:

Exercise Price = $50,000

FMV at Exercise = $4 million

Gain (either Ordinary Income or AMT Income) Recognized at Exercise = $3,950,000

Hypothetical tax rate = 25%

Taxes Due for Exercise = $1,027,000

Total Exercise Price + Tax Cost to Exercise = $1,077,000

REMEMBER: FMV at exercise is not cash in hand without a liquidity event. Therefore, if the option holder in this example makes the investment of $50,000 plus the tax payment of $1,027,000, they might never realize the $4 million in stock option value they earned, or even reclaim the $1,077,000 exercise price + tax. The shares may never become liquid and could be a total loss. For someone who goes into debt to exercise and pay taxes, that might mean bankruptcy. So, even if they can come up with $1 million to solve the early expiration problem at exercise, they may have wished they had not if the company value later declines.

Investor-types frame this as a simple investment choice - the option holder needs to decide whether or not to bet on the company by the deadline. But many people simply do not have access to funds to cover these amounts. It’s not a realistic choice. The very success of the company they helped create makes it impossible to exercise the stock options they earned.

Although these numbers may seem impossibly large, I regularly see this problem at the $1 million + magnitude for individual option holders. The common demographic for the problem is very early hires of startups that grew to billion-dollar valuations.

Why Now? Later IPOs, Higher Valuations, More Transfer Restrictions

Early expiration of stock options is a hot issue right now because successful startups are staying private longer and staying private after unprecedented valuations. These successful but still private companies have also been enforcing extreme transfer restrictions.  These longer timelines from founding to IPO, higher valuations between founding and IPO, and transfer restrictions are causing the early expiration of stock options to affect more employees.

1. Later IPOs = more likely early expiration applies before liquidity. The typical tenure of a startup employee is 3-4 years. As companies stay private longer, employees are more likely to leave a company after their shares have vested but before an IPO. If they have to exercise within the early expiration period but before an IPO, they must pay taxes before they have liquidity to pay the taxes.

2. Higher valuations = higher grant prices. Exercise prices for stock option grants must be set at the fair market value (“FMV” or “409A Value”) of common stock on the date of grant. If an individual joins a company that has had some success in raising funds and in business, the FMV at grant will be higher. Therefore, departing employees are more likely to have hefty exercise prices to pay within an early expiration period. With delayed IPOs they are unlikely to have access to liquidity opportunities to cover exercise prices.

3. Higher valuations = higher tax due at exercise. Total tax bills at exercise are more likely to be high as the company valuations are high because taxable income (either ordinary income or alternative minimum taxable income) is generally equal to FMV at Exercise - Exercise Price. With delayed IPOs, employees are unlikely to have access to liquidity opportunities to cover tax bills.

4. Extreme transfer restrictions = no liquidity prior to IPO or acquisition. In the past, private company stock could be transferred to any accredited investor so long as the seller first offered to sell the shares to the company. (This is known as a right of first refusal or ROFR. The market for pre-IPO stock is known as the secondary market.) Some companies are prohibiting such secondary market transfers and similar structures such as forward sales or loans that had historically allowed employees of hot companies to get liquidity for the shares to pay for exercise costs and tax bills at exercise. Some companies add these transfer restrictions after issuing the shares and even push the limits of the law by claiming that they can enforce new restrictions retroactively.

I hope this post has illuminated the problem of an early expiration period for startup stock options. For more on a solution to the problem, see Early Expiration of Startup Stock Options - Part 2 - The Full 10-Year Term Solution. See also Early Expiration of Startup Stock Options - Part 3 - Examples of Good Startup Equity Design by Company Stage. 

Thank You!

Thank you to JD McCullough for providing research assistance for this post. He is a health tech entrepreneur, interested in connecting and improving businesses, products, and people.

Thank you to attorney Augie Rakow, a former partner at Orrick advising startups and investors, for sharing his creative solution to this problem in Early Expiration of Startup Stock Options - Part 2 - The Full 10-Year Term Solution.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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Part 3: FAQs on the Menu of Startup Stock Option Exercise Strategies

The menu of startup stock option exercise strategies. How to plan ahead to protect your equity stake.

Wondering when to exercise stock options at a startup? Here's the menu of startup stock option exercise strategies including early exercise of stock options and extended post-termination exercise periods. Plan ahead to protect your equity stake. Photo by Kaboompics.com.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

When to exercise stock options?

Thanks for the great feedback on this post: The Menu of Stock Option Exercise Strategies. I’m delighted that people are using it to plan their startup stock option exercise strategies at the offer negotiation stage to save themselves from the unhappy surprises associated with startup stock options.

I’ve had some great questions on the menu and wrote this Q&A in response. Enjoy!

Why don’t you talk more about Incentive Stock Options (ISOs)? The recruiter told me not to worry about my startup stock option exercise at hire because the options are ISOs.

Founders, recruiters, human resources employees and hiring managers often use the “ISO status” of startup stock options to obscure this issue and falsely reassure hires to get them to sign offer letters without a viable option exercise strategy in place. 

There are some benefits to Incentive Stock Options. These are relevant if you are following the exercise as you vest strategy or the exercise at termination of employment strategy. The basic difference is that gains on exercise of ISOs are taxed at AMT rates and exemption amounts rather than the ordinary income rates that apply to NSOs. However, this ISO benefit does not change the fundamental risk associated with startup stock options: If the FMV increases dramatically during your employment, the tax cost to exercise can make exercise impossible even with ISOs! More here on this $1M problem. 

Why do I need to plan for this at the offer letter stage? Wouldn’t the company want to “help” me avoid forfeiting my vested startup stock options by extending the post-termination exercise period if I leave the company?

The post-termination exercise deadline is not often changed after hire. If an individual does not have (or press) the negotiating power before they join to inspire the company to extend that deadline, in the vast majority of cases they will not have that power at the time of termination or resignation. 

My clients often hear founders declare at hire that their companies could not possibly extend the post-termination exercise deadline in the original option contract. In the next breath, those founders promise that their companies would “of course” extend it in the event of a termination or resignation. This is not, in my experience, a realistic promise. 

Why? The “company” in this context is the venture capitalists who likely control its board of directors or the law firms who protect their interests. The post-termination exercise deadline is, from their perspective, a feature not a bug. When companies make offers, they assume that only a small fraction of vested options will be exercised (in large part because of these early termination features). Since this is part of the venture capitalists’ economic calculus and method of maximizing returns for their investors, they’re not in the business of helping people out of it. 

Why do I need to plan for this at the offer letter stage? The company promised they will let me sell some of my equity stake each year through a tender offer.

You will almost certainly not get a written commitment from a company for a right to pre-IPO sales. Access to an employer-sponsored tender offer will depend entirely on a company’s decision to arrange it, investor interest to fund it, and a company’s decision to let any individual take part in it. 

When tender offers are available, they are almost always limited to some small percentage of vested holdings. Given this limited liquidity, most people who have the opportunity to sell a portion of their shares in a tender offer do not use the funds to exercise the remainder of their options. They could, but they do not. 

Why? Once those funds are in the bank, these individuals immediately start to think of the funds as “my money.” It seems to them too risky to take funds that they want to use today to buy a house or diversify their portfolio and invest those funds in the exercise price and associated tax bill to exercise their remaining options. 

This is a personal choice, not right or wrong. I’m offering it here to show what I have seen as a common phenomenon. Individuals are faced with the problem of a huge expense in front of them to exercise their vested options and pay the taxes associated with the exercise. What happens in practice is that if they do successfully cash out some of their shares, they keep the money and are left with the remainder of their options still subject to forfeiture. Then they encounter this forfeiture problem when they either (1) are subject to option early expiration at termination of employment termination or (2) the approach of the end of the original, non-extendable, 10 year term of the option.

Why do I need to plan for this? I’ve heard there are “services” who will help me sell my equity stake on the secondary market or offer me a non-recourse loan to exercise when I get in this situation down the road. 

This method is rarely available. Why? A lot of reasons. Here’s a few:

  • Investor interest is limited to a few choice companies.

  • Information asymmetry. 

  • Company transfer restrictions (which also apply to loans in most cases).

For those who are able to access these sources of pre-IPO liquidity, in spite of these and other challenges, they only operate as a “service” for those who have time and other good choices on their side. Those who are caught without time and other good choices will see offers of deal terms that are obviously made with that vulnerability in mind. Calling this market an option exercise strategy would be like calling a payday loan a monthly budget.

Happy strategizing!

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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The Myth of Startup Employee Equity

Startup equity compensation has incredible power to recruit and retain tech talent. However, the reality of percentage ownership, stock option exercise taxes, and repurchase rights can prevent employees from making equity work for employees.

Working for a startup? Break through the myth of startup equity to make the most of your equity compensation offer. Photo by Startup Stock Photos.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

The shiny myth of startup equity has incredible power to recruit and retain talent. This is the myth:

  • If you have any startup equity, and the company is a success, you will be rich!

  • All startup equity contracts are “boilerplate,” so whatever fine print you sign, you will be rich!

  • You never have to make an investment in or pay taxes on startup equity until you are already rich!

The duller reality of employee equity conflicts with this myth. Here’s my take on this “reality”:

  • The number of shares in the original job offer will determine whether the potential upside will balance the financial risk in joining a startup.

  • The fine print terms affect the potential value of any startup equity offer (especially the consequences of a termination of employment prior to a company exit event).

  • Standard tax structures for employee equity often require individuals to choose between forfeiting vested stock options and making a significant personal investment in the shares (to cover the exercise price and associated taxes) prior to having access to liquidity for the shares. 

Most employees believe the myth, so they do not bother to ask questions and learn more about the reality of their equity offers. In this context:

  • The shiny myth of startup equity does the job of recruiting and retaining employees without any action on the part of the company. Companies can follow the classic sales advice - “Never give someone more information than they need to make a decision.” - and let the myth fill in the gaps. If they don’t ask, why tell?

  • Only those few companies with extraordinarily favorable employee equity programs have any incentive to educate their employees to see the difference between their plans and their competitors’ plans. That incentive may be minimal, though, as such an education may even disincentivize employees from joining startups with favorable programs. The reality of even the most favorable programs cannot compete with the myth of magical riches.

  • Those companies with unfavorable terms in their employee equity programs would have zero incentive to provide such an education. Their financial models could not likely be sustained if their employees were knowledgeable about the terms from the start. For example, one prominent late-stage startup with a 3-month post-termination option exercise deadline relies on a model that only 15% of vested options will be exercised. As my colleague commented, the terms that bust the myth would be a feature, not a bug, for such a company.

I would love to hear that I am wrong in my assessment. I would much prefer to be sharing success stories of company-side equity education programs and explaining why startup companies actually do need to educate their employees in order to effectively recruit and retain them with equity. Please comment below!

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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Part 2: The Menu of Startup Stock Option Exercise Strategies

Wondering when to exercise stock options? Here's the menu of startup stock option exercise strategies including early exercise of stock options and extended post-termination exercise periods. Plan ahead to protect your equity stake.

Wondering when to exercise stock options at a startup? Here's the menu of startup stock option exercise strategies including early exercise of stock options and extended post-termination exercise periods. Plan ahead to protect your equity stake. Photo by Ali Pazani.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

When to Exercise Stock Options?

Before you accept a startup stock option offer, you will want to have a strategy in place for exercising the options. This will save you from the unhappy surprises associated with stock options, such as forfeiting vested options, golden handcuffs, or unnecessary tax expenses. 

There’s not a one-size-fits-all strategy, but there is a menu of choices.

Strategy #1: Exercise Startup Stock Options at Liquidity

The default for most startup employees is to wait to exercise their stock options until the company is acquired or they can sell the shares (such as after an IPO). They simply exercise the options and sell the shares on the same day. 

The benefit of this default is that they have no out-of-pocket expense to exercise or pay taxes on the option exercise until they are certain they will have a market to sell those shares. It’s a no-risk choice from that perspective.

One downside of this strategy is that a same-day exercise and sale would tax your gains at ordinary income tax rates.

Another downside of this strategy is a lack of career mobility. At most companies, options expire within 3 months of termination of employment. If you are waiting on an exit event to exercise your options, you may be stuck at the company until that exit event occurs. 

If you leave the company voluntarily or are terminated by the company before an exit event, you may be forced into exercising your options prior to liquidity or forfeiting the options when they expire. In addition, options have a final expiration date - usually 10 years from the date of grant. This seems like a long time, but occasionally companies do not have an exit event in this timeframe. This forces the employee to exercise prior to liquidity or forfeit the options when the expire.

One variation of this strategy is to negotiate for an extended post-termination exercise period for the options. If you have, for instance, the full 10 year term of the option to exercise regardless of your termination date, you can use this strategy and still be free to leave the company without forfeiting your options. More on that here.

Strategy #2: Forfeit Vested Startup Stock Options by Not Exercising

Most startup employees do not exercise their options if they leave the company before an exit event because they do not want to invest the exercise price and tax cost and risk losing that investment. Therefore, forfeiture is probably the second most common option exercise choice for startup employees. Why? 

All options have a final expiration date, which is usually 10 years from the date of grant. Most options also expire earlier at a termination of employment. The standard is that employees have 3 months after termination of employment to exercise their options. An expiration date is a forfeiture date. If the option that is not exercised before it expires is forfeited and the option holder can never purchase the shares underlying the option. 

A private company employee facing an expiring option has to make their investment in the shares before there is a public market for those shares. I call this the $1M problem because I regularly get calls from startup option holders who need to come up with $1M to exercise their options and pay the tax cost of exercise. The exercise price of an option may be quite high in itself, especially for an employee who joins later in the startup’s growth. It is the tax cost of exercising, though, that prevents most startup employees from exercising their options. 

Strategy #3: Exercise Startup Stock Options at Expiration, Before Liquidity

Not all startup employees forfeit their options if they leave the company before a liquidity event. Many invest the exercise price and pay the associated tax cost when they leave the company so they can acquire the shares they worked to vest. 

The exercise of an option is a taxable event, so the option holder recognizes taxable income based on the difference between their exercise price and the FMV on the date of exercise. That might be taxed as AMT for ISOs or as ordinary income for NSOs. Either way, it can result in tax bills in the millions of dollars for the exercise of a valuable option. More on that here. 

The tax on an option exercise is due whether or not there is a market to sell the shares to cover the tax bill. Some people call this “phantom income” or a “dry tax charge,” but it’s very real. I’ve heard horror stories about people losing their homes (and moving in with their in-laws) because they exercised their options and incurred this tax expense but did not have a market to sell the shares. In some cases, those shares later were cashed out at a high value in a company exit event which in the end made the risk of investing the exercise price and tax bill a very wise choice. Sometimes, though, the investment of the exercise price and tax bill is lost, since the shares can end up either being worth less than the exercise price or worth less than the taxable value of the shares at exercise.

To avoid this scenario, some startup hires negotiate for an extended post-termination exercise period for the options. This allows them to follow Strategy #1 - Exercise at Liquidity and also have career mobility to leave the company before an exit event and still take advantage of their options. More on that here. 

Strategy #4: Early Exercise Stock Options (Prior to Vesting)

An “early exercise” is an exercise of unvested stock options. You pay the exercise price to the company and file an 83(b) election with the IRS. The shares are still subject to vesting, as the unvested shares can be repurchased from you if you leave the company prior to your vesting dates.

Early exercise of stock options is a popular tax planning maneuver, as it starts your capital gains and, perhaps, Qualified Small Business Stock (“QSBS”) holding periods. This sets you up for the lowest possible tax rates when you sell your shares. It may also help you avoid the tax cost of exercise. If you early exercise immediately after grant, while your exercise price is still equal to the FMV of the shares, you have a $0 tax cost to exercise. 

Early exercise stock options are not available at every company, but it is worth considering if it is available to you. It may also make sense to negotiate for the right to early exercise as part of your offer negotiation if it is not offered to you. I have also had clients who ask for this right to be added to their options well after they join the company, especially if the company valuation is about to explode and they want to early exercise before the tax cost would make any exercise impossible. 

The downside of early exercise of stock options is investment risk, as you have to pay the exercise price (and, perhaps, some taxes at exercise) out of pocket before you have any visibility into whether the value of the shares will go up. Early exercise is very common and an easy choice at early stage companies where the FMV and, therefore, the exercise price is low. It’s a less obvious choice when the company is at a later stage and the exercise price of stock options is significant. 

Strategy #5: Regularly Exercise Startup Stock Options as They Vest

The final strategy is to exercise startup stock options regularly as they vest. This is the least popular but (in many cases) the most favorable strategy. 

It’s unpopular because it requires both attention and money, which are both in high demand for startup employees. It’s favorable because it provides for some of the same benefits of early exercise; it starts your tax holding period and allows you to avoid the golden handcuffs that come with unexercised options as the tax cost to exercise increases over time.

The downside of this strategy is, of course, the investment risk of paying the exercise price and tax cost of exercise. There is no guarantee that startup stock will ever become more valuable than your exercise price, or that you will be made whole for the taxes paid to exercise.

How does it work? First, you would need to stay apprised of the current FMV of the company’s common stock and upcoming corporate events that might increase the FMV of the common stock. Since the FMV of the common shares on the date of your exercise will determine the tax cost to exercise, you will need to know this in order to make a thoughtful exercise decision. 

Second, you would regularly consider whether or not to exercise your vested options. Most people approach this by meeting with their tax advisor or financial advisor on a regular basis to calculate the expense of exercising their vested stock options. This would be done annually or more frequently if the company is anticipating an event that would increase its FMV. If you have ISOs, this would include an analysis of how many options you can exercise tax-free by staying under the AMT exemption amount.  If you have ISOs or NSOs, it would include an analysis of the total tax cost to exercise as well as the financial costs/benefits of exercising. 

Finally, you would pay the exercise price and associated tax cost (if any) to exercise the vested options.

Conclusion

I hope this menu inspires you to choose a strategy before you accept a startup stock option offer. It’s worth the time and attention to understand your choices and come up with a thoughtful plan of action before you invest years of your time to earn startup stock options.

Attorney Mary Russell counsels individuals on startup equity, including:

You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.

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