Thursday, January 01, 2009

Stock Compensation At Startups

Typically, startups offer stock options to employees (especially engineers—who can't obviously be paid through a commission). The obvious numbers involved are the number of options, the strike price, and the vesting period. The number of options and the vesting period is typically known before you take the job, but the strike price can change between when you take the job and when you start and when the options are priced. Typically, the offer letter will contain language such as, “I will recommend to the board that you receive 10,000 options to purchase company stock at the prevailing market price.” There's nothing suspicious about this—I've never heard of a company that did not live up to such promises in the offer letter.

Here are the variables in stock compensation that you should think about.

Number of Options

This is the top-line of options compensation—it represents the amount of equity you own in the company. Many people focus on the number of options they get as though the absolute number means something—it doesn't. What matters is the percentage of the company you actually own. As such, this number only means something when you also know the number of outstanding shares in the company.

To emphasize this, one of my friends joined Commerce One back before it did an IPO. She was offered 20,000 options but the company had so little revenue that at the IPO, the investment bankers reversed-split the stock, so she only had 10,000 options. 6 months after the IPO, the stock had gone to $600/share, and the board decided to split the stock 4:1, so now she had 40,000 options at $150/share. What's the difference between 10,000 options at $600/share and 40,000 options at $150 a share? Exactly nothing.

Typically, the percentage compensation goes something like this:

Table 3-1. Typical Stock Compensation

Title

Percentage of company

VP of Engineering

0.5% and up

Senior Engineer and above

0.1% and up

Entry-level Engineer

0.05%

Note that these numbers are typically adjusted by the stage of the startup (and thus the amount of risk you're taking by joining the company at this stage) as well as the generosity of the founders and the board/venture capitalists involved in the company. Google, for instance, was known as being very generous to its employees with options, while Reed Hastings a few weeks after the IPO of Pure Software, Inc., told me that his big regret was not spreading more of the stock around. My advice to founders is to spread the stock around—having motivated employees participate in your success will be something you'll be extremely proud of.

Now, that percentage of the company you own is not fixed. For instance, as new investors add money to the company, the earlier employees (and investors!) get diluted, so their percentage ownership of the company goes down—this is perfectly normal, and is to be expected, so if you feel that you're not getting a fair shake in the scheme of things, please do not forget to add in a dilution factor, especially if you're early stage. A study I read once indicated that dilution in Silicon Valley is about 1% of the company per year, but for startups, that tends to change dramatically as new money comes in. If the company is successful, the valuation of the company will increase at each funding round, so the dilution is usually not a big deal. Hardware startups, however, require huge infusions of capital after the design phase is over and the company has to fund production, so in those cases a big dilution event could pre-date launching the product. This is one of many reasons why so many companies have gone to outsourcing their production, so their upfront costs are reduced. Obviously, if a company's schedule slips or customers don't show up as expected, then further rounds could be "down-rounds", so the dilution could be substantial in those cases as well.

Vesting Period

The vesting period is the time it takes for you to own all the rights to your stock-options. The Silicon Valley period is 4 years with a one year “cliff.” That means if you leave the company within a year of joining, you forfeit all rights to any options at all. After the first year, the standard is that each month another 1/36th of your options continue to vest. That means if you got 10,000 options and left the job after 3 years, you get 7500 options when you leave. Note that most option agreements tell you that you have a limited period of time after you leave to exercise those options, so if you think the company has a good chance of success, don't quit your job and forget to exercise those options. It also means that if you really hate your job after 11 months, grit your teeth and stick around for another month just in case the company turns out to be valuable.

I have occasionally heard of 5 year vesting periods (usually also with 1 year cliffs). These are usually far more common outside Silicon Valley, where the average employee isn't as savvy about stock-options. I generally advise against accepting such offers in Silicon Valley (unless, you're absolutely convinced that this company will be extremely successful—such as being profitable).

Price

The next obvious variable is the price. Since most startups are not traded publicly, this price is set by the board of directors. The board of directors takes into account several factors, including the revenue (usually meager, but can be substantial at a late stage startup), the product development cycle, partnerships that might be occurring, as well as the most important factor, employee morale.

One would think that a big factor in the price would be that of investors who put in money (usually venture capitalists, but sometimes big companies, as in the example of Microsoft investing in Facebook at a $15 billion valuation in 2007). After all, typically the lead investor at every round usually sets the valuation of the company. The reality, however, is that the internal valuation (as expressed by the stock option prices that new employees get) is usually set at 1/10th of the price that the previous lead investors got. This difference reflects the sweat equity that employees put in. There's no startup in Silicon Valley that will risk having valuable employees walk out just because they got taken to the cleaners on price—in fact, even in cases where the company did a complete reset (i.e., zeroed out early investors' equity and revalued the company at a lower price because the business model has completely changed), employees would usually get new options and are somewhat protected from such events in order to retain them. (Think that such resets almost never happen in the case of successful companies? Think again—Veritas was one such example)

Ultimately, however, price does not matter as much as the amount of equity you got, and I wouldn't sweat it too much.

Pre-Exercise Option

This is now a standard feature of Silicon Valley contracts, and if it's not in your options package you need to negotiate for it. Basically, this lets you exercise your options (even the unvested ones) at the provided strike price. This matters because of the huge difference between long term capital gains taxes and short term capital gains taxes. Short term capital gains taxes are taxed like income, leading to tax rates of up to 40% on a federal basis, and as much as 50% for Californians (where most startups are based). By contrast, long term capital gains usually gets favorable treatment—as low as 15% during the Bush tenure.

The catch is that when you buy the stock, the difference between the current market price and the price you paid is immediately taxed as income. Note that if you join a company and immediately exercise the options before the price goes up, no tax is due, so that's the best time to do it. (At an early stage startup, it might make sense to wait since you know that the stock isn't going to go up any time soon)

This is such a massive tax-break that during the dot-com bubble of 1995-2000, many folks took insane risks in order to try to get this tax-break, by pre-exercising their stock options when their company stock was at a high, and then finding themselves unable to pay the tax due immediately the next April. Again, the solution here is to exercise early, before these things become headaches, or, if you're at a risky company whose stock just did amazing levels, forget about making that extra 25% and just sell—you don't need to compound your risks.

The way the pre-exercise clause works is this—you'll buy the stock and own it like any other stock-holder. That means that if the company goes under you're out the money, just like any other investor. However, if you leave the company before the options vest, the company has a period of time (usually between 60-90 days) during which it can buy back the stock from you. (There's an apocryphal story in which a well-known company's stock administration department was so disorganized that even though an employee had only worked there for a year, the company forgot to buy back its stock so the employee got the benefit of four years of vesting for a year's worth of work!) In any case, there's an argument to be made that if you don't believe in the startup you're working for, you have no business being there, and conversely, if you do believe in the startup, then exercising the stock makes sense, as the cost of doing so is usually low.

Qualified versus non-Qualified stock options

Tax-law distinguishes between ISO (Incentive Stock Options) and NQO (Non-qualified stock options). There are minor tax differences between them, so I'll summarize them in the table below:

Table 3-2. ISO versus NQO


ISO

NQO

Holding Period for long term capital gains

2 years from grant + 1 year after exercise.

1 year after exercise

AMT implications if exercise price lower than current stock price

Timing-based AMT—you get an AMT tax-credit

Not-timing based. All difference is taxed as income.

One kind of option is not better than the other, since their tax-treatment is only slightly different. However, if a company used to give out ISO and recently switch to giving out NQO, then what you want to do is immediately exercise your options as quickly as you get them—it's a signal that the company is expecting a liquidity event soon, since the non-qualified options have a favorable tax-treatment for employees who are getting their options close to the IPO/buy-out date.

AMT Implications

Typically, when you exercise your stock options, if there's a difference between the strike price and the current market price, tax becomes due. In the case of ISO, all the tax due is AMT tax. This means that if your AMT tax is lower than your regular income tax, you owe nothing. Conversely, if your AMT tax for that year is higher, you pay the difference, but you get an AMT credit that you can use in future years to lower your taxes when you do sell your stock.

For NSO, there is no confusion—any difference is paid as income tax, and you get your stock cost basis set at the current market value. You do not get any AMT tax-credit because it is not considered timing-related.

Accelerated Vesting (change of control)

This is an increasingly common clause in stock options packages, but the amount by which the accelerated vesting happens varies dramatically from company to company, so it makes sense to pay attention to this clause.

Accelerated vesting is usually an executive-protection clause—it's not unusual for some members top management to lose their jobs in the case a company gets bought out, and so to ensure that they don't scuttle such deals (which are usually good for shareholders), in the event of a buy-out, their options vest at an accelerated rate ranging from 6 months to 2 years (yes, that's two free years of work vested immediately upon the buy-out—really sweet, I don't see that very frequently). Since stock option packages generally aren't any different between executives and rank-and-file, employees get the same package by default.

While I wouldn't quibble much about accelerated vesting as long as there was something, I would try to make sure that such a clause exists in the stock option agreement—if a big company you dislike immensely chooses to buy the startup, you want the option to walk out if the work environment becomes extremely unpleasant, and this is a tool to ensure that you can.

It is interesting to note that options holders and stock holders can get different treatment in the case of a buy-out, and this is generally another reason you want to exercise your stock options early—you will usually get better treatment as a stockholder than as an option holder, and these include voting rights and early notification of proposed buyouts, since your votes have to be counted in such proposals, while options holders don't need to be notified since they don't actually own the stock.



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