piaw.blogspot.com/2009/01/stock-compensation-at-startups.html
Piaw's Blog 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. What's the difference between 10,000 options at $600/share and 40,000 options at $150 a share? Typically, the percentage compensation goes something like this: Table 3-1. Typical Stock Compensation Title Percentage of company VP of Engineering 05% and up Senior Engineer and above 01% and up Entry-level Engineer 005% 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. 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. 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 1/36^th 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). 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 1/10^th 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 (ie, 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 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. 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. 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. 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 ...
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