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).
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:
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.
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.
“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.
VIDEO Startup Stock Options: Negotiate the Right Startup Stock Option Offer
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.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.
The Increasing Burden on Startups to Convince Good Candidates to Join - Q4 Newsletter - Stock Option Counsel, P.C.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Happy New Year, Startup Community!
Here's our latest update from the world of startup equity on a new service from Stock Option Counsel and excerpts from a fascinating discussion at Hacker News on the increasing burden on startups to convince good candidates to join.
Tell Your Boss. We now offer on-site programs at later-stage startups to help employees and executives plan for future liquidity. Our CPA and financial planning partners present in groups or individual power sessions. This is a huge help to startup HR and finance executives who are restricted from providing individual advice to their employees and executives. Let them know this service is available so they can offer it as a benefit to you!
Startups' Increasing Burden in Hiring Top Talent. We counsel individuals on negotiating their startup job offers. We see on a daily basis that startups have to make meaningful and well-designed equity offers to recruit talent from big tech. Here's some excerpts from a fascinating conversation on this topic at Hacker News:
Waving a fraction of a percent in equity in front of candidates simply does not work anymore. … Coming into 2020, I think startups’ best bet is to [be] transparent and honest with candidates about all risks involved when joining a startup and factoring all this into the amount of equity they offer which should be something considerable. - Zain Amro, a software engineer based in Berkeley, California, from his blog
I believe [Zain's] post does a very good job of bringing the elephant in the room into the discussion. The current structure of equity compensation for early-stage startup companies is simply not enticing enough to get people to choose that over the salary and predictable path of BigTechCos. ... We should ... give more equity to early employees and have favorable terms around vesting for these employees and better timing around the loss of options after leaving a company. … Ensuring your early employees will be taken care of means they'll work harder for your company and this will increase the chance you'll survive long enough to see an event that makes anyone a return on their investment. - Grimm1 at Hacker News
This is easy. Offer relatively competitive TC with a real potential upside to the equity package and a work environment that's attractive. BigCorp is mired in politics and decision-making that's grounded in risk mitigation. Do something legitimately interesting and folks will come. Give them some agency and the ability to really get things done and they'll stay. - halbritt at Hacker News
What’s a more democratic funding model to spread net innovation? - bhl at Hacker News
There are already 372 comments in the discussion. I hope it grows in 2020!
Stock Option Counsel, P.C. - Legal Services for Individuals. Thank you for all your enthusiasm for my practice and for the Stock Option Counsel Blog. It's been another great year. I will continue to send quarterly updates on important topics in the market for startup equity for individual founders, executives and employees. Please keep in touch and have a very happy 2020!
Best,
Mary
Mary Russell | Attorney and Founder
Stock Option Counsel, P.C. | Legal Services for Individuals
(650) 326-3412 | mary@stockoptioncounsel.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.
Founders' Stock Red Flags - Keep Your Law Firm on Your Side
Lately, I’ve seen startup law firms yielding founder rights to future investors by proposing incorporation documents that are detrimental to founder interests. Photo © Aleksvf | Dreamstime.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.
I help founders protect their personal equity interests, from incorporation through financing and exit events. Lately, I’ve seen startup law firms yielding founder rights to future investors by proposing incorporation documents that are detrimental to founder interests. These choices are being made by company counsel and signed by founders before a company has investors.
Here are some of the red flag terms I call out for my clients:
Requiring board approval for transfer of shares;
Adding Company repurchase rights for vested founder shares upon termination of employment;
Using stock option structure rather than restricted stock at founding;
Setting the purchase price of shares higher than necessary;
Adopting a stock plan for future employee grants that has off-market, anti-employee terms;
Failing to provide for any vesting acceleration related to a change of control, or limiting double trigger acceleration of change of control to apply only if the termination event is within 6 or 12 months of the change of control rather than at any time after it; or
Adding Company rights to terminate unvested shares or options at the time of a change of control.
I’ve seen some of these terms even from classic Big Law startup-focused firms in recent months. Limits on founder shares are often negotiated between founders and investors at the time of financing – not before. This is usually done through a stockholders agreement, such as a ROFR Agreement or Voting Agreement. It is premature for founders to restrict themselves – or for a company’s law firm to restrict founders – by adding pro-investor terms to the incorporation documents.
The founder’s task is to communicate to company counsel that they want standard, pro-founder terms in the incorporation documents and provide feedback if they see that company counsel has added pro-investor terms have been included before negotiation with investors.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
*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.*
Considerations for founder restricted stock purchase agreements.
Underwater Startup Stock Options Due to Lower 409A Valuations After Mutual Fund Markdowns
Photo: Bobby Mikul. Startup employees may find their stock options are underwater as startup valuations decline. - Mary Russell, Stock Option Counsel
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
QUORA Question: Do recent markdowns by mutual funds of private tech company valuations impact the strike price for options granted to new employees?
MARY RUSSELL Answer:
Yes, I am seeing this in my practice. Companies that issue stock options generally set the strike price at the fair market value on the date of grant, with such value determined with an outside valuation performed every year or six months. These are known as "409A valuations." Some companies which have seen markdowns in their stock, and some other companies in the startup world, are showing their 409A valuations decreasing in their most recent outside valuations.
This is relevant for new hires and existing employee optionholders. For new hires, it may make sense to agree to delay an option grant until a new valuation if the company expects the next 409A valuation to come in at a lower price than the current 409A valuation.
For existing employee option holders, a lower 409A valuation may cause outstanding options to be "underwater." An underwater option is an option with a strike price that is higher than the current value of the shares. In the case of underwater options, it may make sense to ask the company to reprice the options so employees can take advantage of the lower valuations.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Is the Battle for Talent Delaying Unicorn IPOs?
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Frederic Kerrest, Chief Operating Officer and Co-Founder of Okta lists recruitment as one of a few factors that influenced their choice to delay their IPO.
“There’s a few reasons specifically that we thought about when we went through the calculation [of taking another private financing rather than having an IPO]. Five or ten years ago, companies like us would have gone public at this point instead of doing this financing round, because it’s about the same amount of money you would raise in a typical IPO.
First of all, it’s interesting for potential employees who want to come join the company. The opportunity to join a pre-IPO company is something that’s interesting to them, even if it’s just 6 or 9 months before.”
“Do you think it’s harder to hire certain folks if you were public as opposed to being pre-public?”
“I think it’s a slightly different kind of person who wants to join a pre-public versus a ... public company. They have different profiles, they’re looking for different things. They’re looking for different things in terms of the company, in terms of the job, in terms of other things. ”
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Reddit to Share Stock with Users
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
“What’s new and interesting is that the round was led by an individual — Y Combinator president Sam Altman — and that he, along with the other investors, plans to allocate 10 percent of the equity they are buying to Reddit users.
How exactly that’s going to be managed hasn’t yet been figured out (or, more importantly, approved by bankers and lawyers), but Altman said Reddit may dole out shares using a distributed accounting system, a la the bitcoin block chain.”
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
In the News: Startup Employees in the Dark on 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.
“Mary Russell, an attorney who founded Stock Option Counsel to help employees evaluate their equity compensation, says the first step is for employees to make sure any equity is theirs to keep. Some companies have repurchase rights in their equity agreements that give them a right to buy back shares and options from any employee who leaves; and some give founders or investors broad latitude to change the terms.
“If the company can take back employee shares it dramatically limits the value of those shares,” says Ms. Russell. “It’s the sort of thing an employee needs to know about when they go into a job.” She says it’s as simple as asking whether the company can take back vested shares.”
See Katie Benner's full article, Startup Employees in the Dark on Equity. The Information is a subscription publication for professionals who need the inside scoop on technology news and trends.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Repurchase Rights are "Horrible" 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.
“As an aside, some companies now write in a repurchase right on vested shares at the current common price when an employee leaves. It’s fine if the company wants to offer to repurchase the shares, but it’s horrible for the company to be able to demand this.”
What can you do about it? Ask before you join:
“Can the company take back my vested shares?”
For more from Sam Altman, see his post, Employee Equity. For more on repurchase rights on vested shares, see Clawbacks for Startup Stock - Can I Keep What I think I Own? For more on questions to ask to make sure you have true startup equity, see our post, Startup Equity Standards - A Guide 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.
Links - Best Web Content on 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.Here's links to the best web content on startup employee stock:
1. Risk/Reward
Calculating percentage ownership and understanding fully diluted capital, #1-2 of The 14 Crucial Questions About Stock Options, Andy Rachleff, the Wealthfront Blog
How to use the company's VC valuation to evaluate your equity offer, Video, Stock Option Counsel Blog
How to ask about valuation, #11-13 of The 14 Crucial Questions About Stock Options, Andy Rachleff, the Wealthfront Blog
How preferred stock rights make common stock less valuable, Stock Option Counsel Blog
Knowing your market rate with regards to startup equity, #3-4 of The 14 Crucial Questions About Stock Options, Andy Rachleff, the Wealthfront Blog
How to know how much is enough equity for a pre-Series A startup, Stock Option Counsel Blog
Four factors of how startups decide your salary and equity Mary Russell & Boris Esptein on the Stock Option Counsel Blog
Four factors of how startup decide your equity offer VIDEO Mary Russell & Boris Esptein on the Stock Option Counsel Blog
2. Vesting
Acceleration upon change of control, Gil Silberman on Quora
When acceleration upon change of control does not make sense, Gil Silberman on Quora
What is vesting; what is acceleration upon change of control? #5 & #8 of 14 Crucial Questions about Stock Options, Andy Rachleff, Wealthfront Blog
Does my vesting make sense? Stock Option Counsel Blog
3. Ownership
Can the company take back my vested shares if I leave?, #6 of The 14 Crucial Questions About Stock Options, Andy Rachleff, the Wealthfront Blog
How Skype's repurchase rights gave certain employees $0 of $8.5 billion acquisition payouts, Felix Salmon at Wired
4. Tax Benefits
Three Ways to Avoid Tax Problems When You Exercise Options, Bob Guenley, Wealthfront Blog
Ensuring company compliance with tax rules - and your tax rights - when negotiating an offer, #9-10 of 14 Crucial Questions About Stock Options, Andy Rachleff on the Wealthfront Blog
Incentive stock options, Michael Gray, CPA
Non-qualified employee stock options Michael Gray, CPA
5. Overview
The 14 Crucial Questions About Stock Options, Andy Rachleff, the Wealthfront Blog
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
One-Off Startup Stock Secondary Sale & 409A 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.
Q:Would a sale of private company /startup common stock by a former employee trigger a change in 409A / fair market value?
Short answer:
Not in all cases. It comes down to logic. How significant is the market for this company's stock? Is it enough to really show there is a market? Or that there is a clear value? Probably not, unless it is a company-sponsored sale or a Facebook-type frenzy. But companies do use this as an excuse to prohibit secondary sales or drag their feet on allowing their employees to do them.
Lawyer answer:
Based on the tax code rules, the Board needs to change the fair market value price at which they grant options / employee stock any time a major change has occurred that either reduces risk or materially changes company forecasts. Is a secondary sale of private company stock a material change that would have to be seen by the Board as a sign that the risk of investment in common stock has changed?
There are arguments on both sides of this question.
One one side, the secondary sale of shares of common stock shows that common stock is "liquid," or convertible into cash. The lack of liquidity is a big factor in the riskiness of stock and in the logic of discounting common stock value compared to preferred stock value, so liquidity for common stock would raise the "market" price of common stock. Also, the investor who invested has clearly signaled that he/she thinks the stock is less risky than the prior 409A valuation if he/she pays more than that valuation.
However, there are good arguments on the other side as well. The basic argument is that a one-off sale of common stock does not a market make. When you look at the FMV of publicly traded stock, it is based on many sales and the presumption that anyone who holds common stock can trade at any time. Small sales of private company common stock do not mean that any shareholder could find a buyer or that any shareholder could sell at that price. Another argument is that a single buyer or even group of buyers who do not have access to inside company information do not have enough information to know if the stock is more or less risky than the Board has determined it to be in setting the FMV. So one buyer or small group of buyers acting with limited information would not be the appropriate group to define the risk of the stock and, therefore, its fair market value.
Many thanks to Aranca for the following additions to this analysis:
In addition to 2 key points (# of sale points for the price paid, and profile of buyer + seller) that have been mentioned for assessing reasonability of price paid as reflection of FMV, I would like to add 2 more angles that would need to be evaluated while making the determination:
How many different buyers participated at the price that has been paid for the security: If there have been lets say a couple of parties that have transacted, the applicability for the price paid to be considered as reflection of FMV would be weak. However, if there are several buyers who bought from the seller, the applicability of price paid as a FMV can be high.
What has been the valuation range (if any) / bid-ask spread offered by buyers: If the available buyers give a valuation range which is wide and significantly different from the transacted price, then again the applicability of price paid as reflection of FMV becomes questionable. However, if there are sizable number of buyers providing a tight valuation range, then the applicability of price paid as an FMV can be a good indicator.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Many thanks for the contributions of Dylan Gittleman, Vice-President, ARANCA US and Manpreet Singh, ASA, Manager, Valuation Services, ARANCA US. Aranca is a leading provider of 409A valuation services.
Negotiating Equity @ a Startup – 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.
Negotiating an offer from a startup? Here's some tips.
1. Know How Much Equity You Want
For employees early in their careers, the only negotiable terms for equity are the number of shares of stock and, possibly, the vesting schedule. The company will already have defined the form in which you will earn those shares, such as stock options, restricted stock units or restricted stock.
Your task in negotiating equity is to know how many shares would make the offer appealing to you or better than your other offers. If you don’t know what you want for equity, the company will be happy to tell you that you don’t want much.
Your desired number of shares should be the result of thoughtful consideration of the equity offer. There is no simple way to evaluate equity, but understanding the concepts and playing with the numbers should give you the power to decide how many shares you want.
One way to compare offers and evaluate equity is to find the current VC valuation of the preferred shares in the company. If a VC has recently paid $10 per share for the company’s stock, and you have been offered 10,000 shares, you can use $100,000 to compare to other offers. If another company has offered you 20,000 shares, and a VC has recently paid $5 for their shares, you could use those numbers to compare the offers. For more info on finding VC valuations, see: Startup Valuation Basics or contact Stock Option Counsel.
Remember that the purpose of this exercise is not to have a precise dollar value for the offer, but to answer these questions: How does this offer compare to other offers or my current position? What salary and number of shares at this company would make this a stable, sustainable relationship for me? In other words, will this keep me happy here for some time? If not, it is in nobody’s best interest to come to a deal on that package.
For more information on negotiating equity, see our video: Negotiate the Right Stock Option Offer or our blog with Boris Epstein of BINC Search: Negotiate the Right Job Offer.
2. Look for Tricky Legal Terms That Limit Your Shares' Value
There are some key legal terms that can diminish the value of your equity grant. Pay careful attention to these, as some are harsh enough that it makes sense to walk away from an equity offer.
If you receive your specific equity grant documents before you are hired, such as the Equity Incentive Plan or Stock Option Plan, you can ask an attorney to read them.
If you don’t have the documents, you will have to wait until after you are hired to study the terms. But you can ask some general questions during the negotiation to flush out the tricky terms. For example, will the company have any repurchase rights or forfeiture rights for vested shares? Does the equity plan limit the kinds of exit events in which I can participate? What happens to my equity if I leave the company?
3. Evaluate the Equity’s Potential
Evaluate the company to know how many shares would make the equity offer worth your time. You can start by asking the company some basic questions on their expectations for future growth and the exit timeline.
The higher your rank in the company and the stronger your emphasis on these matters, the more likely you are to speak to the CEO, CFO or someone else at the company who can answer these questions. If you want more resources to help you think like a startup investor, there are great online resources on valuation, dilution and exits for startups.
But don’t place too much weight on the company’s predictions of the equity’s potential value, especially if those values are based on an early-stage company’s Discounted Cash Flows (DCF). Even the experts know that the only thing early stage startups know about financial projections is that they are wrong.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Stock Option Counsel Tip #1
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Use @angellist to research "market" equity for your company size. https://angel.co/jobs #equity #negotiation #startup
Exercising an Incentive Stock Option (ISO)? Should You Hold the Stock?
This is a guest post from Michael Gray CPA. He counsels individuals on their employee stock option tax questions. For more employee stock option tax resources, see Michael Gray, CPA's Option Alert at StockOptionAdvisors.com.
When you have decided to exercise an incentive stock option (ISO) and consider the federal alternative minimum tax (AMT) and the net investment income tax, the benefits of holding stock after exercising an incentive stock option are reduced. The "brass ring" of having the gain from the sale of the stock eligible for long-term capital gains rates (15% or 20%) seems attractive, but the 28% alternative minimum tax rate applies
for the excess of the fair market value of the stock at exercise over the option price ("spread") when the option is exercised. (California also has a 7% alternative minimum tax. Find out the rules for your state.) The minimum tax credit for this tax "prepayment" is hard for many taxpayers to recover, because they are already subject to the AMT, due to deductions disallowed for the AMT computation, including state income taxes, real estate taxes and miscellaneous itemized deductions. That means the "spread" at exercise is probably
going to be taxed at a 28% federal tax rate when the dust settles.
In addition, long-term capital gains are subject to the 3.8% net investment income tax when the taxpayer has high adjusted gross income. That means the total federal tax rate for the initial spread would be 31.8%, versus a maximum federal tax rate of 39.6%. Is an 8% tax benefit worth the risk of exposure to market volatility of the stock? It could fall much more than that.
The main time it makes sense to hold the stock is when the "spread" is low and the option price is low. Then you can probably afford to pay for the stock and AMT (if any) and to take the risk that the value of the stock could fall. When you do this, you forgo the "time value premium" for the option. If you have the alternative of just buying the stock for about the same price without exercising the option, you will probably be in a better position by doing that, because you will still have the options to exercise if the value of the stock increases with no downside risk for the options.
An alternative is to exercise the option and immediately sell the stock, provided the stock is publicly traded or there is a "liquidity event" such as a sale of the employer company. In that case, the gain will be taxed as additional wages, subject to federal tax rates up to 39.6%, but exempt from employment
taxes such as social security and medicare taxes.
These are general comments. You really should meet with a tax professional familiar with incentive stock options (that's our business!) to discuss your individual situation and have tax planning computations done. To make an appointment with Michael Gray, call Dawn Siemer at (408)918-3162 on Mondays,
Wednesdays, Thursdays or Fridays.
This article was published in the September 24, 2014 Option Advisor Alert. Republished with permission.
From The Daily Muse
Attorney Mary Russell, Founder of Stock Option Counsel based in San Francisco, advises that anyone receiving equity compensation should evaluate the company and offer based on his or her own independent analysis. This means thoughtfully looking at the company’scapitalization and 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.
Thanks Ji Eun (Jamie) Lee for the mention in The Daily Muse!
“Is This the Right Company?
Investors buy equity in a company with money, but you’ll be earning it through your investment of time and effort. So it’s important to think rationally, as an investor would, about the growth prospects of your start-up.
Attorney Mary Russell, Founder of Stock Option Counsel based in San Francisco, advises that anyone receiving equity compensation should evaluate the company and offer based on his or her own independent analysis. This means thoughtfully looking at the company’s capitalization and 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.