[The Beast1]

As the title suggests, how do stock options in a start up work?
How does vesting work? How about capital gain? I've done a little research, but i'd like to hear from some more seasoned folks on how these work.

I ask because I might be signing onto a viable start up soon and this was mentioned as part of the compensation.

As always, I appreciate the help.

[TheFinalEpic]

They are usually excessively long term options on the stock price of a company. So for a start up, that will sometimes be contingent on milestones for the company, and eventual IPO. They will be at a certain "strike price" so everything above that strike will be pure profit. I'm not sure if they are like traditional stock options for batches of 100 shares.

An example: Company XYZ is hiring you with a salary of 100k per year plus 10,000 shares in the company plus 1000 call options at a strike of $5. Those stock options are contingent on the company reaching $35 million in sales, producing X thousand widgets per quarter, and other milestones. Once those milestones are reached, you are able to cash in 1/3 of your options. However, that depends on what the stock is trading for on whatever exchange.

Theres a good example about Elon Musk and the 1.4 billion dollar windfall he can achieve by reaching milestones as Tesla's CEO. Here's the link

https://www.bloomberg.com/news/articles/...milestones

I'm not fully aware of how stock options work for employees as I've never been in that situation, however I trade options on a daily basis and have a base understanding for that.

[fortysix]

Hey.

I work in the industry so feel free to ask some questions once you get your contract. Here is a basic introduction:

1. Structure

The way that we typically structure employee stock options is we give employees options to purchase x% of the Company. However, the stock options aren't all given immediately - instead, we give them out over a certain vesting schedule. In the industry, the normal vesting schedule is a 4 year vesting schedule with a 1 year cliff - this means that you get 25% of the options after you work for the company for twelve months, and then you receive remainder each month over a period of the following three years. The vesting schedule is in place so that you don't receive all the options and then flake or stop working. It also means that the company can fire you "for cause" (like if you just stop coming in to work) and then you only get the options that have vested up to that point. If you want, you can always try to negotiate the vesting schedule to a shorter time frame (like no cliff, over 2 years). Also, make sure you understand the situations under which a company can fire you and stop your option vesting schedule - there is sometimes room for negotiation here. Finally, make sure you understand when the options "start" vesting - you can receive an option, but it may not start vesting for like 6 months, thereby further extending your vesting schedule.

There are tons of other little things that employees can negotiate in their option agreements - for example, you can ask the company to include a provision saying that if the company has a liquidity event, like an IPO, the vesting schedule goes away and you immediately get all your options up front.

2. Strike Price

The strike price description of the poster above me is fairly accurate, and you usually can't really negotiate this. Emerging companies have to have a formal valuation company come in once a year and "price" the strike price for all of their options to make sure they are at market value (this is mandated by IRS / treasury regulations, so no way around this). We typically give options out at the lowest strike price possible, because we want to incentive employees to slave away.

3. Advisers vs Employees

Advisers and Employees can receive different kinds of stock options. "Advisors" or "Consultants" can only receive something called "non-statutory" stock options, which receive less favorable tax treatment. Employees can receive "statutory" stock options or "ISOs," which provide you with more favorable tax treatment. Make sure you understand this distinction and make sure you receive ISOs (if you are an employee). Sometimes a company will try to give an NSO to an employee because NSOs allow them to make certain favorable tax deductions, play with the expiration dates, or sometimes they just make a mistake because they are re-using their stock option grant forms.

4. Stock Plan
Try to get a hold of the Company's stock plan and review it. Look for the total # of options RESERVED (as opposed to issued and outstanding) for the option pool to determine what % of the Company you are getting (this is called the fully-diluted capitalization of the Company).

5. Exercising the Stock Option
Sometimes companies put restrictions on what happens when you exercise a stock option (for instance, you may only receive "restricted stock" upon exercising the option, meaning that the stock is subject to a vesting schedule just like the options were - you would want to avoid this).

Just thinking about it, if you are joining a startup and options are expected to be a huge chunk of your compensation, it makes sense to hire a lawyer (and not just any lawyer, but one that specializes in stock options / startups and has looked at tons of agreements like this before) and have him review your agreement to make sure you are not getting anything non-standard. This will probably cost $300-$500, but its important to know what you are signing, because there really is a lot of little stuff to negotiate.

[Jack_Smith]

(04-25-2017 06:27 PM)The Beast1 Wrote:  

As the title suggests, how do stock options in a start up work?

By "Start-Up" I assume you mean a Private Equity/Venture backed Start-Up, where the controlling equity is professionally managed capital (i.e. somebody else's investment capital). In these types of companies, it is typical for the investors to set aside 15-20% of the company's equity for an employee stock option program. The purpose of the ISO (Incentive Stock Option) program is to align the incentives of management and key employees with those of the business' owners. The owners' want to build as much value in the company as possible and sell it, either via an IPO or, more likely, to a strategic investor, within 5-7 years. The ISO plan is designed to give key employees a meaningful payout when the company sells, thereby motivating them to work there little asses off to make it happen.

The ISO plan is governed by a contract, many key terms of which you will have little or no leverage to negotiate, and which will, in every instance, put the financial investors' interests ahead of yours. Plans can vary widely. To assess the potential value of ISOs to you, you need to: 1) assess the growth potential of the company; 2) understand the company's realistic exit options and exit pricing; 3) understand the particulars of the ISO agreement; 4) know your equity partners and their philosophy and track record with respect to creating management wealth.

Start Reading here - The Open Guide to Equity Compensation

And here - Fred Wilson's A Beginner's Guide To Stock Options

Also, Fred's A VC Blog is a good read for anyone new to the start-up business.

(04-25-2017 06:27 PM)The Beast1 Wrote:  

How does vesting work?

There are two primary types of vesting - time and performance. Time vesting typically takes place over 3-7 years, with an equal portion of your shares vesting annually. ISO plans with performance vesting clauses require that you and/or the company reach certain performance milestones in order for vesting to take place. Often this requirement is in addition to the time vesting requirement.

(04-25-2017 06:27 PM)The Beast1 Wrote:  

How about capital gain?

ASK YOUR TAX ACCOUNTANT.

That said, the last time I had an ISO plan, options did not qualify for the preferred capital gains rate. We used to exercise our options as they vested each year and purchase the underlying shares, thus availing ourselves of the preferred capital gains rate on any shares that we had held for over one year at the time of the sale of the company.

(04-25-2017 06:27 PM)The Beast1 Wrote:  

I ask because I might be signing onto a viable start up soon and this was mentioned as part of the compensation.

The devil is in the details. Most often these do not pay out, as the company fails to sell for a sufficient price, ISO holders get screwed by lock-up or other clauses, or get paid out in the (sometimes shitty) stock of the acquiring company. It is important to look at the experience, track record and quality of the Founder and the Private Equity sponsors. If they have fucked over employees before, they will do it again, and vice versa.

[Hypno]

Its not that hard.

Options work like this. Take a company, and estimate its value. If someone just put in $10 million of venture capital money for 10% of the shares, then that implies a $100 million value.

Now picture a pizza. The pizza is the company. Its worth $100 million theoretically (because its a private company and there is not an established public market for the shares). Every slice of the pizza is a share. Lets say there are 10 milion share, so that implies a value per share of $10. The option gives you the right to buy the stock at the strike price which typically is the price on the date of grant, sometimes a premium above that price but almost never a discount. If the company grows in value to 300 million, each share is worth $30 so your option is worth 30-10-20. That's how it works.

Vesting - typically 3-4 years, some times pro rata, sometimes cliff (cliff means you don't get anything til the end; pro rata means a portion vests each year). Vesting is important because in a startup it might not last 3 years. Typcially if the company is sold it vests immediately (acceleration).

The sort of conditions FinalEpic mentions are not typical in the US and are custom negotiated for key employees. FortySix' description is more relevent.

Taxes. - Don't worry about this. But if they offer you restricted stock and give you paperwork for a Section 83(b) election, do it even though it means paying some taxes now.

Dont' worry about the other stuff FortySix discusses. The stock plan is standard. You don't want ISOs and few companies offer them; reason why is you have to exercise and hold for a year, and are at risk of the stock going down. Remember, this is a company that is probably not public yet, so they won't be offering ISOs. Finally, post vesting retention requirements are rare and if imposed are typically required by law (e.g. securities law transfer restrictions.

Final word of advice - options are very speculative. You could make a killing, but 4/5 VC companies don't make it. Just because you get stock doesn't mean you can sell that stock. I'm not trying to discourage you, but go into it with your eyes wide open.

[Pollito]

Some good replies already. One thing I might add is to understand what your rights are, if any, with respect to any vested awards you might have in the event of your termination -- voluntary or otherwise. The company may allow you to exercise vested awards at that time, or it may not. If the termination is involuntary without cause, you may be able to exercise and then put them back to the company (i.e., force the company to purchase the resulting shares from you). Or it may not, but this is something you should understand up front so you can take it into consideration if another opportunity comes up in a few years, or god forbid you're told to pack your shit and leave by EOD.

Aside from that, as some of the other posts mentioned, the company can place all kinds of restrictions or requirements on exercising. You can be forced to exercise as they vest (in a "cashless" exercise where you simply receive their intrinsic value and don't have to put up cash to pay the strike price); or conversely, you may only be permitted to exercise vested awards in very specific circumstances.

Another point [CONSULT YOUR CPA] is that option vesting isn't a taxable event. Depending on whether they're qualified or non-qualified, they may be taxable at time of exercise. So, you shouldn't have to come out of pocket to pay tax on cash you never received, assuming this is under IRS jurisdiction, but again consult a qualified tax professional.

Also, obtain an understanding of the valuation methodology they will use to determine share price periodically. Ideally it won't be set by the board (who will likely fuck around with the valuation) but will instead be based on the work of a third party specialist. Not to say management can't or won't fuck around with the inputs they provide to the specialist, but at the very least their work will be subject to independent review and will be somewhat objective. Adding on that, if you are permitted the ability to exercise vested awards whenever you want, find out how often the stock price will be determined and how the price will be communicated to you.

The Beast1, you only mentioned options but is there any restricted stock or anything else on the table? Because those are different animals than options and will be subject to some different considerations.

[fortysix]

(04-25-2017 09:08 PM)Hypno Wrote:  

Taxes. - Don't worry about this. But if they offer you restricted stock and give you paperwork for a Section 83(b) election, do it even though it means paying some taxes now.

Dont' worry about the other stuff FortySix discusses. The stock plan is standard. You don't want ISOs and few companies offer them; reason why is you have to exercise and hold for a year, and are at risk of the stock going down. Remember, this is a company that is probably not public yet, so they won't be offering ISOs. Finally, post vesting retention requirements are rare and if imposed are typically required by law (e.g. securities law transfer restrictions.

Final word of advice - options are very speculative. You could make a killing, but 4/5 VC companies don't make it. Just because you get stock doesn't mean you can sell that stock. I'm not trying to discourage you, but go into it with your eyes wide open.

Just want to quickly post and say that this is seriously HORRIBLE advice. Every startup in Silicon Valley offers ISOs and anyone that advises you not to worry about ISOs is a fool. If your startup doesn't offer ISO shares it is a bullshit startup.

The difference between an ISO and an NSO is that in the case of an ISO, you can defer the taxable event of "receiving" the stock option to the time that you exercise it. That means that your stock option "basis" for ISO options is calculated as of the day that you exercise the option. On the other hand, your stock option "basis" for NSO options is the day that you receive the stock option. This has serious implications for when you later sell the underlying stock during a liquidity event.

If you receive an NSO @ your tax basis is $0.01, because that's the fair market value of the stock option @ the time you receive it, and you later exercise the option and sell the stock option during a liquidity event @ a fair market value of $5.00, you pay tax on the difference between $0.01 and $5.00. That's A LOT of tax. Especially when you are in higher tax brackets. Life changing amounts of tax.

If you receive an ISO, you can defer the tax basis calculation to the time that you exercise the stock option - by the time you exercise the ISO, hopefully, the fair market value of the stock will be $4.00. So when you later sell the stock, you pay tax on the difference between $4.00 and $5.00. See the difference?? Thats a life changing difference.

If you ignore the ISO/NSO distinction and your startup goes public, you will pay an extra couple million dollars in tax on the spread between the strike price and the fair market value of the shares when you exit. Law firms and CPAs go out of business for fighting malpractice claims when they make these mistakes.

In order for a company to offer ISOs to employees, it just needs a stock plan that complies with IRS 409a regulations (which is not difficult to do if you know what you are doing- it just involves things like limits on vesting schedules and limits on timeframes to exercise the option).

[Hypno]

(04-25-2017 10:40 PM)fortysix Wrote:  

Just want to quickly post and say that this is seriously HORRIBLE advice. That means that your stock option "basis" for ISO options is calculated as of the day that you exercise the option. On the other hand, your stock option "basis" for NSO options is the day that you receive the stock option. This has serious implications for when you later sell the underlying stock during a liquidity event.

If you receive an NSO @ your tax basis is $0.01, because that's the fair market value of the stock option @ the time you receive it, and you later exercise the option and sell the stock option during a liquidity event @ a fair market value of $5.00, you pay tax on the difference between $0.01 and $5.00. That's A LOT of tax. Especially when you are in higher tax brackets. Life changing amounts of tax.

If you receive an ISO, you can defer the tax basis calculation to the time that you exercise the stock option - by the time you exercise the ISO, hopefully, the fair market value of the stock will be $4.00. So when you later sell the stock, you pay tax on the difference between $4.00 and $5.00. See the difference?? Thats a life changing difference.

First of all, you shouldn't make employment decisions based on taxes on appreciation that happens in only 1 out of 10 VC backed companies.

Second, forty-six is confused on how the tax is calculated.

With a NQSO, you pay ordinary income on the spread between fair market value and the exercise price if an when you exercise. In other words, you control the timing of the tax. Usually people wait until they are ready to sell the shares to exercise and trigger the tax.

With a ISO, you have the theoretical advantage of a lower capital gains tax rate rather than ordinary income. However, in most cases this is illusory for 3 reasons. First, the stock has to appreciate. Second, you are still subject to the Alternative Minimum Tax. Third, to get the capital gains tax treatment you have to exercise the option (i.e. come out of pocket for the exercise cost) and then have to hold for at least a year. You still pay tax on the spread between the exercise price and the fair market value, its just that the rate hopefully is lower. The real problem is that during that one year time period you are at risk for the stock price to go down, and if it does you don't get a refund of the taxes you already paid.

https://en.wikipedia.org/wiki/Incentive_stock_option

Realistically, in a company that is not public yet, you should be thinking about whether the company will ever increase in value and go public. Because if they are not public, how are you ever going to realize the value of the option? In other words, if you exercise your shares, to whom will you sell them? This is a far more important consideration than taxes. If your company gets bought out, your options likely will accelerate and pay out, but you likely won't be able to exercise and hold to satisfy the ISO conditions. Its only if they go public that ISO status is relevant, and even then its a poor gamble.

Some of these points are made in greater detail here:

https://maxschireson.com/2011/08/23/star...explained/

[Easy_C]

(04-26-2017 12:18 PM)Hypno Wrote:  

Realistically, in a company that is not public yet, you should be thinking about whether the company will ever increase in value and go public. Because if they are not public, how are you ever going to realize the value of the option? In other words, if you exercise your shares, to whom will you sell them? This is a far more important consideration than taxes. If your company gets bought out, your options likely will accelerate and pay out, but you likely won't be able to exercise and hold to satisfy the ISO conditions. Its only if they go public that ISO status is relevant, and even then its a poor gamble.

Some of these points are made in greater detail here:

https://maxschireson.com/2011/08/23/star...explained/

That's why you want to structure in some additional provisions that are designed specifically for companies going through the VC process.

Typically if it's not publicly traded the way you lose equity is from another private investor buying out your shares.

You might want to ask for an anti-dilution provision. Most commonly this means that once the firm receives additional VC investment, your share count is increased so that you still maintain the same % ownership that you originally had in the firm.

[Hypno]

Dilution is a definite risk but only people who put new money in get anti-dilution protection. You can ask for it, but while you are at it ask for a pension, company car, corner office, etc.

In terms of how likely they are to go public, find out how many rounds of private equity they have done. Get on the SEC's EDGAR and look for Form D filings which tell you how much they raised. you can also google this. If they have had repeated financings, that is a good thing since the repeat investments validate the company and are usually at higher price per share. The later you join a company, the less risk but also somewhat less upside protection. Also, look at the track record of the founders - is this their first company or are they proven serial entrepreneurs.

You have to look at the equity as a kicker. You take less salary but hopefully not that much less. In exchange you have some very speculative upside. Now, the folks hiring you probably have real money in the company and they are true believers. But that might be divorced from reality.