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:
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.
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.
Part 3: FAQs on the Menu of Startup Stock Option Exercise Strategies
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.
Part 2: The Menu of Startup Stock Option Exercise Strategies
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.
Have an Offer Letter from a Startup? The Equity Issues are Between the Lines
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? Learn more about the fine print terms of an offer letter. Plan ahead to protect your equity stake.
If you have an Offer Letter from a startup, you may notice that it’s light on information about stock options. You may see a few sentences noting that (1) the company will recommend to the board that the grant be made at the first market value on the date of grant; (2) the option will vest monthly over four years with a one-year cliff; and (3) the option will be governed by the company’s equity incentive plan and your stock option agreement. It sounds simple. But the key issues are hidden between the lines.
Change of Control Protections for Unvested Shares
A standard vesting schedule does not provide protection for unvested shares in the event the company is acquired. If you are joining in a senior position or as an early stage employee, consider negotiating for a double trigger acceleration upon change of control to protect the right to earn unvested shares. The most robust double trigger language would provide that 100% of unvested shares will accelerate if you are terminated or constructively terminated as part of or at any time following a change of control. See this blog post for more information on change of control terms for startup equity offers.
Clawbacks for Vested Shares
The equity incentive plan and stock option agreement are usually not provided with the Offer Letter unless requested, as the official equity grant is not made until after the start date. However, these agreements contain important details about the grant, so it makes sense to review them before agreeing to the number of shares or signing the Offer Letter.
For example, the equity incentive plan and stock option agreement may give the company the right to forcibly repurchase shares from the employee after termination of employment, even if they are vested shares of restricted stock or vested shares issued upon exercise of options. See this post for some examples of how those clawbacks may be drafted. Clawbacks dramatically limit the value of the equity, as the most significant increase in the value of startups has historically been at the time of an exit event. If this term, or any other red flag term, appears in the form documents, it makes sense to negotiate these out of the deal or provide for alternative compensation to make up for the potential loss in value before signing the Offer Letter.
Tax Structure
The Offer Letter may not include the terms of the tax structure, but if you have any leverage on those terms the Offer Letter negotiation is the time to address them. The right tax structure will balance your interests in total value, low tax rates, tax deferral, limited tax risks and investment deferral. This balance is different at each company stage. For example, at the earliest stage startups you may be able to meet all those goals with the purchase of Restricted Stock for a de minimis purchase price. At mid-stage startups you might prefer to have Incentive Stock Options with an extended post-termination exercise period to defer the investment until a liquidity event. At late-stage startups you might prefer Restricted Stock Units for a full value grant. See this blog post on Examples of Good Startup Equity Design by Company Stage and this blog post on The Menu of Stock Option Exercise Strategies.
Grant Timing
The company will set the exercise price at the fair market value ("FMV") on the date the board grants the options to you. This price is not negotiable, but to protect your interests you want to follow up after your start date to be sure that the board makes the grant of the options soon after your start date. If they delay granting you the options until after a financing or other important event, the FMV and the exercise price will go up. This would reduce the value of your stock options by the increase in value of the company’s common stock during that time.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.