Year End Newsletter - Stock Option Counsel, P.C. - Winter 2022
Hello Startup Community!
Thanks for another fascinating year in the startup space. 🥂 Happy Holidays & Cheers to 2023 🥂
In today's newsletter, we have a weather report on 409A valuations and a quick primer on evaluating startup equity offers.
409A Valuations. Pitchbook published a fantastically nuanced piece on recent 409A valuations coming in lower than the prior 409A valuations. This reflects one force of the market shift - startup valuations changing based on those of comparable public market companies - as well as, perhaps, another - startups' ability to hit their own revenue targets and other key metrics.
Pitchbook notes that different companies are responding to these lower 409A valuations in different ways, including:
Lowering their FMV (which would be the expected result) so that their future option grants would have a lower strike price and existing option holders would have a lower tax bill for exercising options
Ignoring the lower 409A valuation and choosing not to adjust their FMV to "keep morale strong"
Repricing underwater stock options based on the newly lowered FMV
As the broader market shifts, the expectations of players within the startup space are starting to adjust as well. The most recent preferred price/share may no longer be a good proxy for current common stock value for candidates evaluating offers or for buyers and sellers on the secondary market.
Evaluating a Startup Offer. If you're a candidate new to the startup world, the Wall Street Journal would say that you are not alone as startups take advantage of the recent shift in the market for talent. As one founder noted, "A few years ago, there was no way we could’ve attracted candidates like this."
If you're evaluating a startup offer for the first time, here's a few resources to get you started:
The Gold Standard of Startup Equity provides three criteria for evaluating a startup offer:
Does the number of shares balance the risk I'm taking?
Do I keep my vested shares if I leave the company?
Is the equity structured favorably from a tax perspective?
Looking to Join a Top Startup? discusses:
How to evaluate the number of shares in a startup offer
The key contract terms that affect the value of a startup equity offer
Our three-part series on option exercise strategies illustrates:
Why you need to have an exercise strategy in place before signing an offer letter
The menu of choices for stock option exercise strategies and
Frequently asked questions about the menu
Good luck!
Stock Option Counsel, P.C. - Legal Services for Individuals. Thank you for your enthusiasm for my practice and blog. 🥂 Happy Holidays & Cheers to 2023 🥂
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.
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.
The Myth of Startup Employee Equity
Working for a startup? Break through the myth of startup equity to make the most of your equity compensation offer. Photo by Startup Stock Photos.
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 shiny myth of startup equity has incredible power to recruit and retain talent. This is the myth:
If you have any startup equity, and the company is a success, you will be rich!
All startup equity contracts are “boilerplate,” so whatever fine print you sign, you will be rich!
You never have to make an investment in or pay taxes on startup equity until you are already rich!
The duller reality of employee equity conflicts with this myth. Here’s my take on this “reality”:
The number of shares in the original job offer will determine whether the potential upside will balance the financial risk in joining a startup.
The fine print terms affect the potential value of any startup equity offer (especially the consequences of a termination of employment prior to a company exit event).
Standard tax structures for employee equity often require individuals to choose between forfeiting vested stock options and making a significant personal investment in the shares (to cover the exercise price and associated taxes) prior to having access to liquidity for the shares.
Most employees believe the myth, so they do not bother to ask questions and learn more about the reality of their equity offers. In this context:
The shiny myth of startup equity does the job of recruiting and retaining employees without any action on the part of the company. Companies can follow the classic sales advice - “Never give someone more information than they need to make a decision.” - and let the myth fill in the gaps. If they don’t ask, why tell?
Only those few companies with extraordinarily favorable employee equity programs have any incentive to educate their employees to see the difference between their plans and their competitors’ plans. That incentive may be minimal, though, as such an education may even disincentivize employees from joining startups with favorable programs. The reality of even the most favorable programs cannot compete with the myth of magical riches.
Those companies with unfavorable terms in their employee equity programs would have zero incentive to provide such an education. Their financial models could not likely be sustained if their employees were knowledgeable about the terms from the start. For example, one prominent late-stage startup with a 3-month post-termination option exercise deadline relies on a model that only 15% of vested options will be exercised. As my colleague commented, the terms that bust the myth would be a feature, not a bug, for such a company.
I would love to hear that I am wrong in my assessment. I would much prefer to be sharing success stories of company-side equity education programs and explaining why startup companies actually do need to educate their employees in order to effectively recruit and retain them with equity. Please comment below!
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Company-Side Education Programs on Startup Equity - Feedback from Newsletter Subscribers
Here’s a quick primer on how to negotiate stock options or RSUs in a startup. It's up to individuals to educate and empower themselves when company-side education programs are lacking. Photo by Alena Darmel.
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 asked my newsletter subscribers to share their experiences with startup company employee equity education programs. Thank you for all your responses! I love being in touch and hearing your feedback.
See below under My Takeaways for a quick primer on how employees can empower themselves by taking the initiative to learn about startup equity and ask their companies for the information they need to make informed decisions.
Individuals reported these company programs they found very helpful:
Company all-hands meetings followed by both (1) smaller working groups led by the CEO/CFO using real world tangible scenarios to explain and provide context and (2) one-on-ones with senior management.
Training sessions with the company’s CFO.
Carta, including blog content, presentations, Equity 101 posts, and online calculators. “Very good interface with clear information.”
Individuals reported these company programs they found somewhat helpful:
Company-wide information meeting on stock options, but not provided until years after the employee joined the company.
Carta as stock administrator. This allows employees to “have more access and run the calculator more frequently. But it doesn’t speak to the non-price issues like post-termination exercise periods, forced share repurchase,” etc. Also, “Carta maximizes for startup friendliness, and here employee friendliness runs counter to that goal.”
ShareWorks as stock administrator. The “account includes the value of your options based on the latest valuation. From a user experience, [though,] it is clunky like most financial software products.”
Individuals reported these company programs they found not helpful or harmful:
Company education program on stock option exercise by a stock broker who was “in it for himself and not the employees. … The education they were offering was to inform the newly wealthy employees how to “invest” their new found cash. It is not a good strategy to use someone like that for that purpose … I lost about $1M of the money I earned from the startup. It was disastrous. If companies host an individual, make sure they are fiduciaries and not brokers.”
Company-wide information meeting with general information and many disclaimers, which was “not that helpful for making actionable decisions. … I think the presentations backfired because most either didn’t understand options any better than they did prior to the meeting and those that did realized their options weren’t that valuable (which was the opposite motivation of the CEO).”
In a geographic area where “most employees aren’t stock option aware …, although we granted stock options to all employees, most ignored them because they were difficult to understand. And HR was unable to answer any questions about options because they didn’t understand them. … In the case of recruiting and offers -- the lore was more important than the facts.”
Recruiters who “fail to disclose the material issues, and sometimes state that the equity situation is more favorable than it actually is.”
Individuals reported these wish-list items they had not yet seen:
“If this were my project, I would use a framework of virtual recorded introductory education sessions that give the basics of the compensation program, and a one-on-one follow up to cover any lingering questions. I would build out a self-help knowledge base that covers common lingering questions and/or use that info to improve the education sessions.”
“I like the idea of a 3rd party to provide the trainings, mixed with key staff or founder interaction to build trust.”
Examples, simplicity, transparency and opportunities for lots of Q&A in small groups. A library of content that addresses common questions, concerns and misconceptions would also be very valuable.
“It would be great if our law firm had established programs to walk us through the process.”
“What employees really want to know is -- what is the value of my options under various realistic scenarios. One approach might be several if-then scenarios and then employees can decide which one of those hypothetical scenarios most applies to them.”
“Options seem to be presented as a commodity component to most offerings with a presumed windfall. … It’s important to manage expectations of what the value is and how to think about that; how to act, when, why.”
An educational program would need to provide an “overview, some tools for employees to calculate future sums/ exit projections (dream a bit), and cover common tax issues, maybe an overview of company/venture process (what the near future could mean for equity holders), and gotchas like: what happens to my vested equity if I have to leave the company.”
Services providers reported these as service offerings they had available to companies:
Note: If you are a service provider in this area with an offering I have not included, please send me an email with a description of your services so I can add it to the list.
Dan Walter, FutureSense. Dan advises companies on executive pay, equity compensation, incentive compensation, and pay for performance. He says that employee education “is a normal piece of our deliverables for nearly every company we work with.” I’ve seen him speak on these topics and he has, as promised, “a unique ability to help anyone understand even the most complex and technical details in ways that are approachable and memorable.”
Bruce Brumberg, myStockOptions.com. Bruce’s site, myStockOptions.com, is the “premier source of web-based educational content and tools on stock compensation for plan participants, financial advisors, companies, and stock plan providers.” They license their educational resources to companies for their programs.
Tom Bondi, CPA, Armanino, LLP. Tom offers company-side employee stock/equity training programs to companies with from 25-500 employees, where the companies wish to give back to their employees with knowledge they are not able to offer.
Financial Advisors who are available to companies in the run-up to an IPO or acquisition to educate the company’s employees.
Carta’s Tax Advisory. Updated February 2023: This add-on to Carta’s cap table service allows startups to help their employees make tax decisions around their equity. Employees of subscribing companies have access to one-on-ones with tax advisors such as: Ask a Quick Question (15 minutes), Understand Equity Tax Basics (30 minutes), Create Tax Scenarios (45 minutes) and Discuss Tender Offer Participation (30 minutes).
My takeaways:
Some company-side education programs are helpful to employees in navigating their equity. However, it is up to individual employees to empower themselves by taking the initiative to learn about startup equity and ask their companies for the information they need to make informed decisions.
Here’s a quick primer on how individuals can do this (based on this blog post):
Number of Shares. The offer letter may include the number of shares, but this number is certainly not all you need to evaluate and negotiate the offer. I encourage candidates to ask questions about the equity package and number of shares until they have the information they need to make an informed decision. More on evaluating the number of shares in an offer letter here.
Equity Grant Form Documents. The equity incentive plan and form stock option agreement contain important details about the equity grant, so it makes sense to request and review them before signing the offer letter. These agreements may give the company clawback rights for vested shares or other terms that may dramatically limit the value of the equity offer. If these red flags appear in the form documents, it makes sense to negotiate to remove them from your individual grant or add additional compensation to make up for that loss in value.
Tax Structure. The right tax structure for an option or RSU offer will balance your interests in total value, low tax rates, tax deferral and investment deferral. This balance is different for each individual and at each company stage. You will want to have a tax strategy in mind before accepting the offer letter, so you can negotiate any necessary terms to enable that strategy as part of the offer letter itself.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Newsletter! Request for Feedback: What Makes a Great Company Education Program on Startup Employee 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.
Hello Startup Community!
Here’s your quarterly update on startup equity from Stock Option Counsel, P.C. Thanks for a great year!
Request for Input - Company Education Programs on Equity Compensation. Several companies and venture capital firms have asked me how they can best educate their new hires on their equity compensation programs. I’d like to ask for your input so that I can share a list of best practices. Would you please take a moment to send me your ideas and experiences?
I’m curious to hear:
How have companies educated you on your stock options, RSUs, etc.?
Have you had access to live Q&A sessions? On-demand video trainings? Online calculators?
What has worked well? Not worked?
Who presented training sessions and answered your questions? The finance team? The legal team? Outside consultants?
Have company equity portals, such as Carta or Shareworks, included educational content? Was it helpful? How could it have been improved?
What would make a top-of-the-line employee equity education program?
Please send me any feedback you have! I’m at info@stockoptioncounsel.com.
Many thanks in advance for your input. I really love being part of this community, and hearing back from members of this mailing list means a lot to me.
Thanks for a Great Year. I'd like to thank our clients, blog readers and newsletter subscribers for a great year. Thank you!
I'm looking forward to 2022 to continue our mission of empowering individuals to make the most of their startup equity opportunities.
Happy Holidays and Cheers to 2022!
Best,
Mary
Mary Russell | Attorney and Founder
Stock Option Counsel, P.C. | Legal Services for Individuals
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Summer 2021 Newsletter - Stock Option Exercise Strategies
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Hello Startup Community,
It's Summer 2021. There's a million things to do and think about right now. And, yet, I invite you to pause, take a moment, and ask yourself: "What is my strategy for exercising my startup stock options?"
Why a Strategy? I wrote this menu of stock option exercise strategies to help startup employees get familiar with the complexities of stock options and choose a strategy for exercising. Taking the time and attention this requires will help avoid the unhappy surprises associated with startup stock options such as these examples:
Forfeiture at Termination. Sales executive drove sales and company value for four years and was terminated a few months before a $1B company exit. He could not afford the $1M exercise cost (to cover the exercise price and tax cost of exercise) within the 30-day post-termination exercise deadline, so he was forced to forfeit most of his vested options. He made approximately $500K at the exit; his former colleagues with similar option grants each made $10M.
Golden Handcuffs. Early hire at a future unicorn did not early exercise his options or exercise his options as they vested. He wanted to leave the company after four years when he was fully vested, but he could not afford the $2M cost to cover the exercise price and tax cost of exercise. Therefore, he had to stay at the company for several more years while he waited for an acquisition, frustrated that he was not able to move onto his next opportunity.
Tax Expense. Early startup hire waited to exercise his options (with a total exercise price of only $5K) until after the company's IPO. He had to sell the shares on the same day he exercised in order to cover the tax cost of exercise. Since he had not held the shares for a year before sale, his gains were taxed at ordinary income tax rates of over 40%. If he had early exercised the options for $5K at hire, he would have qualified for QSBS tax treatment on his gains, resulting in 0% federal tax rates on his gains and saving him >$1M in taxes.
Happy strategizing!
Stock Option Counsel, P.C. - Legal Services for Individuals. Thank you for your enthusiasm for my practice and blog. You can learn more - including testimonials - on the website.
“As a female leader in Silicon Valley, I’ve found that negotiating on my own behalf is hard. In some cases, I have felt uncomfortable asking for what I want, even when I know it’s rational and justified. Mary took time to understand my goals, provided me with expertise to give me confidence in my asks and supported me with feedback along the way. Mary was a terrific partner! She understood that the process was, for me, about getting to a win-win with my future employer and making sure we all got what we wanted in the end. A terrific example of women helping women to negotiate in a style that works for us. Thank you, Mary! ”
Megan Hanley, CMO, Equity Offer Counsel
Please keep in touch!
Contact. You are welcome to contact Stock Option Counsel, P.C. - Legal Services for Individuals for guidance on your startup equity, including:
Founder interests at incorporation, financings and exits
Job offers, equity grants and employment agreements
Executive compensation design
Acquisition terms and post-acquisition employment agreements
Or check out our blog and social media for great posts on startup equity for founders, executives and 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 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.
Part 1: Why You Need a Startup Stock Option Exercise Strategy
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 Andrea Piacquadio.
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?
Startup stock options can be extremely lucrative or extremely disappointing. The biggest disappointments are not from companies that never succeed, but from employees of successful companies that are not able to take advanteBefore you accept a startup stock option offer, you will want to have a strategy in place for exercising those options. This up-front attention will save you from the unhappy but common surprises associated with startup stock options, such as these recent examples:
Forfeiture at Termination. Sales executive drove sales and company value for four years and was terminated a few months before a $1B company exit. He could not afford the $1M exercise cost (to cover the exercise price and tax cost of exercise) within the 30-day post-termination exercise deadline, so he was forced to forfeit most of his vested options. He made approximately $500K at the exit; his former colleagues with similar equity grants made $10M.
Golden Handcuffs. Early hire at a future unicorn did not early exercise his startup stock options or exercise as they vested. He wanted to leave the company after four years when he was fully vested, but he could not afford the $2M cost to cover the exercise price and tax cost of exercise. Therefore, he had to stay at the company for 3 more years while he waited for an acquisition, frustrated that he was not able to move onto his next opportunity.
Tax Expense. Early hire at a future public company waited to exercise his options with a total exercise price of $5,000 until after the shares became publicly traded. He had to sell the shares on the same day as the exercise to cover the tax expense of exercise. Since he had not held the shares for a year before sale, his gains were taxed at ordinary income tax rates of over 40%. If he had early exercised the options, he would have qualified for QSBS tax treatment on his gains, resulting in 0% federal tax rates and saving him >$1M in taxes.
In the Part 2, you will see the menu for startup stock option exercise strategies to save yourself from these unhappy surprises. In Part 3, you will see a Q&A on FAQs re stock option exercise strategies.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
SPAC Wonderland - Winter 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.
Hello Startup Community!
Happy New Year! Before we move on from 2020, I wanted to answer some FAQs on SPACs as they relate to startup employee equity.
SPACs. The special-purpose acquisition company - or SPAC - has become a popular path to liquidity for venture capital startups. Virgin Galactic, DraftKings and Nikola Motor Co. (among many others) have gone public via SPAC, and there are many other such deals in the pipeline for 2021. If you're looking for more information on the phenomenon, I would suggest the WSJ's article Why Finance Executives Choose SPACs: A Guide to the IPO Rival.
In addition, I've answered some questions frequently asked by employee equity holders at startups on the SPAC acquisition process:
Q: If my company is going public through a SPAC, when can I sell my shares?
Some companies provide an opportunity for immediate liquidity at the closing of the transaction. This is known as a secondary offering or tender offer, and will allow you to sell some portion (say, 10%) of your holdings as the merger closes and the company's shares become publicly traded. This sale is to a designated buyer at a designated price.
If your company's SPAC is not designed to include such a tender offer, you will have to wait until the lockup on sales expires to sell your shares.
Q: Why can't I sell all my shares if the SPAC deal makes the company's stock publicly traded?
When you accepted your stock options or purchased your shares, you agreed that you would be bound by a lockup for some period following the company's public offering. This is a standard term in private company stock documents. It is designed to ease the company's path to the public markets by limiting the quantity of shares available to the public after the company's shares become publicly traded.
Q: When will I be able to sell my shares?
After the lockup expires. The traditional lockup length is 180 days. However, SPAC transactions often have a variation to this standard. Some require employee stockholders to agree to a longer term, such as one year. Others have eased the traditional 180 day period by allowing for earlier sales if the company's stock achieves a targeted price for a certain period within that 180 day period.
Q: What should I do to prepare for the SPAC?
Think of it just as you would an IPO. If you have any questions about your legal rights to your shares or options or the terms of a tender offer, reach out to your attorney. If you are making option exercise or stock sale decisions, reach out to your accountant and/or financial planner. You're always welcome to reach out to Stock Option Counsel for guidance.
Podcast. Thank you to Aaron Phillips of the Green Financial Planner Podcast for having me as a guest this month. The episode - Top Priorities To Consider When
Stock Option Counsel, P.C. - Legal Services for Individuals. Thank you for your enthusiasm for my practice and blog. You can learn more - including testimonials - on the website.
“Mary is a great resource and was very easy to work with. She was very thorough and helped me negotiate my worth. I recommend that any potential startup employee (at any level) work with Stock Option Counsel to make sure they understand their contracts and offers. ”
— Kevin Beauregard, Vice President - Engineering, Equity Offer Counsel
Please keep in touch!
Best,
Mary
Mary Russell | Attorney and Founder
Stock Option Counsel, P.C. | Legal Services for Individuals
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 - Examples of a Clawback Clause for Startup Stock
Working for a startup? Learn how a clawback clause, forfeiture term or repurchase right limits the value of startup equity. Plan ahead to protect your equity stake.
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 is a Clawback Clause?
Startup hires expect that they will be able to keep their vested shares if they leave the company before an exit event. That’s not always the case. Learn more in Part 1 of this series - Clawbacks for Startup Stock - Can I Keep What I Think I Own - about how a clawback clause limits the value of startup equity.
In this post, we will share some examples of a clawback clauses or clawback provision that would allow startups to take back vested shares or options.
What is an Example of a Clawback Clause?
Equity Incentive Plan I
The company reserves the right to include clawbacks for vested shares upon an individual's termination of employment:
Repurchase Right. The Company (and other designated Persons) may repurchase any or all of the shares of Stock granted to a Participant pursuant to an Award or acquired by the Participant pursuant to the exercise of a Stock Option upon such Participant’s termination of employment with, or Service to, the Company for any reason to the extent such a right is provided in an Award Agreement or other applicable agreement between the Company and the Participant.
Such terms could be included in any agreement with the individual, such as a Stock Option Grant Notice, a Stock Option Agreement, a Stock Option Exercise Agreement, a Termination and Release or Severance Agreement, a Restricted Stock Agreement, an RSU Agreement, an Employment or IP Agreement, or a Stockholders' Agreement.
Equity Incentive Plan II
The company reserves the right to implement a policy in the future to clawback vested or unvested shares, and you’re agreeing that such a change will apply retroactively to your shares:
Clawback Policy. The Awards granted under this Plan are subject to the terms of the Corporation’s recoupment, clawback or similar policy as it may be in effect from time to time, as well as any similar provisions of applicable law, any of which could in certain circumstances require repayment or forfeiture of Awards or any shares of Common Stock or other cash or property received with respect to the Awards (including any value received from a disposition of the shares acquired upon payment of the Awards).
Stock Option Agreement
The company reserves the right to change its bylaws in the future to clawback vested or unvested shares, and you’re agreeing that such a change will apply retroactively to your shares:
Right of Repurchase. To the extent provided in the Company’s bylaws in effect at such time the Company elects to exercise its right, the Company will have the right to repurchase all or any part of the shares of Common Stock you acquire pursuant to the exercise of your option.
These two terms allowing retroactive changes push the limits of Delaware law on company repurchase rights. However, I advise my clients to negotiate these out of their documents before joining a company to avoid litigation at a later date.
Restricted Stock Unit Grant Notice
In order to vest RSUs, the time-based vesting requirement (the "Time Condition") must be met, and the Company must have an IPO or a Change of Control (the "Performance Vesting") prior to the 7 year expiration period of the RSU. This is a normal structure for a startup RSU grant due to tax planning. However, in this example, if the IPO or Change of Control does not occur by the individual's last date of employment, the RSUs are cancelled and never vest:
Vesting Conditions. Any Restricted Stock Units that have satisfied the Time Condition as of such date shall remain subject to the Performance Vesting set forth in Section 2(b) above, but shall expire and be of no further force or effect on the first to occur of (a) the date on which the Grantee’s Service Relationship with the Company terminates, or (b) the Expiration Date.
Employment and Confidentiality Agreement
The company reserves the right to terminate vested options in the event of a breach of the agreement:
Breach of Confidentiality Agreement. If the Optionee breaches the provisions of the Confidentiality Agreement, then any outstanding Options held by such Optionee at the actual time of such termination shall thereupon expire, terminate and be cancelled in respect of all vested and unvested Option Shares.
Breach of Non-Competition and Non-Solicitation Covenant. If the Optionee breaches the Non-Competition and Non-Solicitation Agreement, then any outstanding Options held by such Optionee at the actual time of such termination shall thereupon expire, terminate and be cancelled in respect of all vested or unvested Option Shares.
While these two examples from employment and confidentiality agreements apply to restrictions on exercising options, similar terms may also apply to repurchase or forfeiture of vested shares for violations of such agreements even after termination of employment. More on this here from the National Association of Stock Plan Professionals in June 2023.
Other Clawback Clauses
These are only a few examples of how clawbacks might appear in an equity offer. There are more ways they can appear in the fine print. And, practically, an option exercise deadline acts as a clawback as well. Having only 3 months to exercise options is a standard market term, but it often acts to prevent employees and executives from exercising their vested shares. More on this in:
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!
Thank you to JD McCullough for editing this post. He is a health tech entrepreneur, interested in connecting and improving businesses, products, and people.
Clawback Clause for Startup Stock - Can I Keep What I think I Own?
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Updated October 19, 2020 for a recent clawback event in the news.
Everyone loves a gold rush story about startup hires making millions on startup equity. But not all startup equity is created equal. If a startup adds a repurchase rights for vested shares (a.k.a. a clawback clause or clawback provision) to its agreements, individuals may lose the value of their vested equity because a company can force them to sell their shares back to the company in certain situations, such as if they leave their jobs or are fired prior to IPO or acquisition. Other examples of a clawback clause are forfeiture (rather than repurchase) of vested shares or options at termination of employment or for violation of IP agreements or non-competes.
Image from Babak Nivi of Venture Hacks, who warns startup founders and hires to “run screaming from” startup offers with a clawback clause for vested shares: “Founders and employees should not agree to this provision under any circumstances. Read your option plan carefully.”
How a Clawback Clause Limits Startup Equity Value
In a true startup equity plan, executives and employees earn shares, which they continue to own when they leave the company. There are special rules about vesting and requirements for exercising options, but once the shares are earned (and options exercised), these stockholders have true ownership rights.
But for startups with a clawback clause, individuals earn shares they don’t really own. In the case of repurchase rights for vested shares, the company can purchase the shares upon certain events, most commonly after the individual leaves or is terminated by the company. If the individual is still at the company at the time of an IPO or acquisition, they get the full value of the shares. If not, the company can buy back the shares at a discounted price, called the “fair market value” of the common stock (“FMV”) on the date of termination of employment or other triggering event.
Most hires do not know about the clawback clause when they negotiate an offer, join a company or exercise their stock options. This means they are earning equity and purchasing shares but do not have a true sense of its value or their ownership rights (or lack thereof).
Clawback Clause “Horrible” for Employees - Sam Altman of Y Combinator
In some cases a stockholder would be happy to sell their shares back to the company. But repurchase rights are not designed with the individual’s interests in mind. They allow the company to buy the shares back against the stockholder’s will and at a discounted price per share known as the “fair market value” or “FMV” of the common stock. As Sam Altman (now CEO of OpenAI) wrote when he was the head of Y Combinator, “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.”
The FMV paid by the company for the shares is not the true value for two reasons. First, the true value of common stock is close to the preferred stock price per share (the price that is paid by investors for stock and which is used to define the valuation of the startup), but the buyback FMV is far lower than this valuation. Second, the real value of owning startup stock comes at the exit event - IPO or acquisition. This early buyback prevents the stockholder realizing that growth or “pop” in value.
What is an Example of a Clawback Clause?
Famous Example - Skype Shares Worth $0 in $8.5 Billion Acquisition by Microsoft
In 2011, when Microsoft bought Skype for $8.5 billion (that’s a B), some former employees and executives were outraged when they found that their equity was worth $0 because of a clawback in their equity documents. Their shock followed a period of disbelief, during which they insisted that they owned the shares. They couldn’t lose something they owned, right?
One former employee who received $0 in the acquisition said that while the fine print of the legal documents did set forth this company right, he was not aware of it when he joined. “I would have never gone to work there had I known,” he told Bloomberg. According to Bloomberg, “The only mention that the company had the right to buy if he left in less than five years came in a single sentence toward the end of the document that referred him to yet another document, which he never bothered to read.”
Both Skype and the investors who implemented the clawbacks, Silver Lake Partners, were called out in the press as “evil,” the startup community’s indignation did not change the legal status of the employees and executives who were cut out of millions of dollars of value in the deal.
Recent Example - Tanium, funded by Salesforce Ventures and Andreessen Horowitz, claws back employee shares
More recently, Business Insider reported that Tanium, funded by Salesforce Ventures and Andreessen Horowitz, has forced employees to sell their shares back to the company at FMV after their employment is terminated.
The employees interviewed by Business Insider were not aware of that their contract included this clawback when they accepted their offers. “'Surprised' was my initial reaction," one such employee said. "I had not heard of that happening before. To me it felt like a gut punch. One of the reasons for working for the company is dangling the carrot of eventually going public or eventually getting acquired so employees would monetarily benefit from that.”
How Does a Clawback Provision Work?
Hypothetical Example #1 - Company Does NOT Have Clawback Clause for Vested Shares - Share Value: $1.7 Million
Here’s an example of how an individual would earn the value of startup stock without repurchase rights or clawbacks. In the case of an early hire of Ruckus Wireless, Inc., the value would have grown as shown below.
This is an example of a hypothetical early hire of Ruckus Wireless, which went public in 2012. It assumes that the company did not restrict executive or employee equity with repurchase rights or other clawbacks for vested shares. This person would have had the right to hold the shares until IPO and earn $1.7 million.
This is an example of a hypothetical early hire of Ruckus Wireless, which went public in 2012. It assumes that the company did not restrict executive or employee equity with repurchase rights or other clawbacks for vested shares. This person would have had the right to hold the shares until IPO and earn $1.7 million. If you want to see the working calculations, see this Google Sheet.
These calculations were estimated from company public filings with the State of California, the State of Delaware, and the Securities and Exchange Commission. For more on these calculations, see The One Percent: How 1% of Ruckus Wireless at Series A Became $1.7 million at IPO.
Hypothetical Example #2 - Company Has Clawback Clause for Vested Shares - Share Value: $68,916
If the company had the right to repurchase the shares at FMV at the individual’s departure, and they left after four years of service when the shares were fully vested, the forced buyout price would have been $68,916 (estimated). This would have caused the stockholder to forfeit $1,635,054 in value.
In this hypothetical, the individual would have lost $1,635,054 in value if the shares were repurchased at their termination. If you want to see the working calculations, see this Google Sheet.
No Surprises - Identifying a Clawback Clause During Negotiation
As you can see, clawbacks dramatically affect the value of startup stock. For some clients, this term is a deal breaker when they are negotiating a startup offer. For others, it makes cash compensation more important in their negotiation. Either way, it’s essential to know about this term when evaluating and negotiating an offer, or in considering the value of equity after joining a startup.
Unfortunately this term is not likely to be spelled out in an offer letter. It can appear in any number of documents such as stock option agreements, stockholders agreements, bylaws, IP agreements or non-compete agreements. These are not usually offered to a recruit before they sign the offer letter and joining the company. But they can be requested and reviewed during the negotiation stage to discover and renegotiate clawbacks and other red-flag terms.
What is a Typical Clawback Clause?
For examples of typical clawback clause language, see Part 2 - Examples of Clawbacks for Startup 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.
Early Exercise of 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.
Planning for your startup stock options? Consider an early exercise of stock options to protect your equity stake from taxes and forfeiture.
Most people learn the hard way about the complexity of exercising stock options at a startup. If you can spare a few minutes of attention, this post will teach you about early exercise - the easy street of startup stock option exercise strategies.
Early Exercise Stock Options
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 before the options vest.
Early exercise makes you the owner of the shares in the eyes of the company. The shares are still subject to the options’ original vesting schedule, though, as the unvested shares can be repurchased from you if you leave the company prior to your vesting milestones. The repurchase price for unvested shares is usually the lower of your exercise price or the fair market value (“FMV”) on the date of termination.
Early exercise with an 83(b) election also makes you the owner of the shares in the eyes of the IRS. That means you start your capital gains and, perhaps, Qualified Small Business Stock (“QSBS”) holding periods, which sets you up for the lowest possible tax rates when you sell your shares.
Tax Benefits of Early Exercise of Stock Options
If you early exercise while your exercise price is equal to the FMV of the common shares, the exercise itself is not taxable and therefore defers all taxation until you sell the shares and have cash gains to use to pay the taxes.
This may seem like overkill on planning, but the tax bill for a later option exercise can snowball surprisingly quickly and make it impossible to exercise vested stock options. More on this here: Startup Stock Options - Early Expiration - The $1M Problem. Early exercise can, therefore, act as a forfeiture-avoidance strategy as it can defer taxes until sale of stock and, therefore, save people from prohibitive pre-liquidity tax bills for exercise.
When to Early Exercise Stock Options
Since options are granted with an exercise price equal to the FMV on the date of grant, it’s a safe bet to early exercise immediately after grant to be sure you can do so without a tax cost.
The most common approach is to negotiate for the right to early exercise in the grant at the offer letter stage, and then join the company and wait a while before early exercising. This allows employees to get some visibility on the company’s possibility of success and their own fit within the company. So long as the early exercise is completed while the FMV is still equal to the strike price, the early exercise is tax free.
If you early exercise (or exercise vested options) after the FMV has increased above the exercise price (such as after a round of funding following your grant date) you will have taxable income on the difference between the FMV and the exercise price in the year of exercise. (The tax rates depend on whether you are early exercising NQSO or making an qualifying early exercise of ISOs.) This might seem unappealing, as you would of course prefer to defer all taxes until sale of stock. However, some people choose to early exercise even if they have to recognize income on that early exercise in order to be taxed at exercise on the current FMV rather than paying higher taxes on a later exercise based on a higher FMV.
Investment Risk of Early Exercise Options
The downside of early exercising startup 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 in the future. That’s why early exercise is very common and an easy choice at early stage companies where the FMV and, therefore, the exercise price is low. For instance, a first employee might be able to exercise 1% of the company for, say, $5,000. It’s a less obvious choice when the company is at a later stage and the exercise price of stock options is significant. For instance, some startup stock options packages have a $1M+ exercise price.
Some key hires of later stage startups with higher option exercise prices negotiate for the right to early exercise (or exercise vested options) with a promissory note instead of cash. Instead of paying their significant exercise price with cash, they deliver a promissory note to the company. This is a promise to pay the exercise price at some date in the future. There is some complexity to this to address with your advisor if you are considering this path.
Negotiating the Right to Early Exercise Options
Early exercise is not available at every company. Therefore, if you want to early exercise you will need to negotiate for this right during your offer letter negotiation or after you join the company.
For example, some early Uber employees negotiated to add the right to early exercise to their existing stock option grants. This allowed them to early exercise their unvested options (and exercise their vested options) before the FMV of the shares skyrocketed, so that the tax bill for the exercise was only in the tens of thousands of dollars.
Despite the out-of-pocket cost for the exercise price and taxes, this was a wise exercise choice for a few reasons. First, if they had waited and exercised after the FMV skyrocketed they would have had to pay far more in taxes to exercise - in some cases more than $1M. More on that issue here. Second, if they had failed to early exercise and ended up leaving the company prior to the company’s IPO, they would have had to come up with those astronomical tax payments before they had a market to sell the stock. This is because the company had only a 30-day post-termination exercise deadline and an absolute prohibition on sales of stock prior to IPO. Third, many of these employees purchased their shares while the company was QSBS eligible and then held the shares for the 5-year QSBS holding period. This qualified them for 0% federal tax rates on up to $10M in gains on the sale of their shares.
ISOs v. NSOs and Early Exercise Stock Options
If you are early exercising stock options, it is more favorable to have the options granted as NQSO rather than ISOs. If you early exercise ISOs, you have to hold the shares for two years before sale for long-term capital gains tax rates on your gains. If you early exercise NSOs, you only have to hold the shares for one year for capital gains treatment. Therefore, if you are planning to early exercise immediately after the grant, you will want to ask the company to make the grant as a NQSO rather than an ISO.
If you are not planning to early exercise, you may not want to include the right to early exercise in your documents. That’s because of the $100K limitation on ISOs. ISOs are a tax-favored stock option that are subject to certain limits under the tax code. Only $100K in exercise price of stock options can become exercisable in any given year and qualify as ISOs. So if you have a $400K exercise price grant that is intended to be ISOs, all $400K of the options will be ISOs if you do not include the right to early exercise. If you do include the right to early exercise, all $400K will become exercisable in the first year and so only $100K of the options will be ISOs. The remainder will be NSOs which are less tax favored.
Don’t Forget the Section 83(b) Election
If you early exercise unvested stock options, you file a Section 83(b) election with the IRS within 30 days of the exercise. The consequences of a missed 83(b) election can be very, very unappealing. If you don’t have the attention necessary to follow through on that, don’t early exercise.
When to Exercise Stock Options
As you can see, early exercise of stock options is not the best choice in every situation. To learn about the best structures for a variety of cases, see Examples of Good Startup Equity Design by Company Stage. For a comprehensive analysis of when to exercise stock options, see this three-part series:
Part 2: The Menu of Startup Stock Option Exercise Strategies
Part 3: FAQ on the Menu of Startup Stock Option Exercise Strategies
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Proposed in the U.S. Senate - Changes to Startup Employee Equity Taxation - CEO and Worker Pension Fairness Act
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
If national politics take a strange turn and an unlikely new tax bill proposed in the U.S. Senate last month becomes law, individuals can expect a huge tax hit on NQSOs and startup RSUs. NQSOs would become taxable at vesting on the spread between the exercise price and the FMV. Currently, the exercise - rather than the vesting - of a NQSO is the taxable event. RSUs would become taxable at their FMV when time-based service milestones are achieved. Currently, taxation on RSUs in specially-designed private company plans (such as Airbnb and Pinterest) is deferred until an IPO or company acquisition.
There is an exception in the bill for those grants that qualify for Section 83(i) - which was intended to allow for deferral of taxation on private company stock until it becomes tradeable. But Section 83(i) as enacted is very limited and not workable in practice. Therefore, startup employees can expect that their NQSOs and RSUs - as they are currently designed - would be taxable even if they are not able to sell the shares to cover the tax bill.
So what will happen in practice? Startup employees with valuable equity grants would either pay high taxes out of their own savings (if they have them) before their shares are tradable or walk away from valuable equity opportunities to avoid this tax expense.
This would also change the world of equity compensation design, as tax is the underlying rhythm of all employee equity. The best practices as of today would become obsolete. In practice, I predict that this bill would result in an unexpected and very anti-employee consequence in future equity compensation design: more company clawbacks on time-vested shares.
More clawbacks? The same clawbacks that experts have called “horrible for employees” and encouraged people to “run screaming from” in a job offer? Yes. A clawback is the right of a company to take back time-vested shares if an employee leaves the company prior to an acquisition or IPO. This term dramatically reduces the value of startup equity, as most individuals who work at startups in the early stages do not stay at those startups all the way until the acquisition or IPO.
Why would more clawbacks be the result of this proposed bill? If companies design their NQSOs and RSUs so that employees are required to remain in service until the later of the date of an acquisition/IPO or their time-based vesting schedule, those employees would not be taxed under this new bill when they meet their time-based vesting requirements. In that workaround, though, employees would forfeit their time-vested shares if they leave the company prior to the acquisition or IPO. That means that employees would have to stay in service until that exit event to have a payout and, therefore, that far fewer early stage employees would have paydays in startup acquisitions and IPOs.
It would be hard to believe that these are the results intended by the bill, but from my perspective this is the most likely outcome for employee equity grants. Thoughts?
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.
Silicon Valley Wins Big With Tax Break Aimed at Small Businesses: An eight-figure IPO windfall can mean a zero-digit tax bill
"If you planned well, you ended up with a phenomenal result," says Mary Russell, an attorney at Stock Option Counsel in Palo Alto, Calif., who advises tech employees on their compensation. "If you didn’t, you were in a really tight, messy spot." Photo by Mikhail Nilov.
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 and Stock Option Counsel, P.C. in Bloomberg Business this week:
“While venture investors and founders, who can afford top-notch tax advice, are using [the Qualified Small Business Stock tax provision to take advantage of 0% tax rates on startup gains], tech workers might not be as lucky. The rules are complicated, and it can be easy to miss out. For example, early employees needed to have exercised options at a time when their startup was still under $50 million in assets. ‘If you planned well, you ended up with a phenomenal result,’ says Mary Russell, an attorney at Stock Option Counsel in Palo Alto, Calif., who advises tech employees on their compensation. ‘If you didn’t, you were in a really tight, messy spot.’”
For more information about planning for option exercises, see The Menu of Stock Option Exercise Strategies. 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.