Jan 24, 2020

Equity 101: Options Primer for Startup Employees

I recently realized that a nearly universal part of our otherwise mostly ad-libbed employee onboarding process is the 2 hours I spend discussing startup equity with each and every person we hire – and even with many we don’t! So, in the interest of helping other founders and startup newcomers, here’s how to explain equity in a digestible way.

For a TL;DR you can skip to the last section.

What even is equity? Since when is “vest” a verb? Cliff sounds bad; I don’t want it. Acceleration sounds good; I want it.

Let’s start with the basics:

Equity means some amount of ownership. If you have equity in the company you work for, or in anything for that matter, it means you own (or will own) a piece of that thing.

Vesting means accruing that ownership over time – usually 4 years in the case of startup equity.

A cliff (usually 1 year) means that your ownership accrual (aka vesting schedule) isn’t purely linear; a 4-year vest with a 1-year cliff means that you actually own nothing for the first year, but then jump to 25% ownership of your total equity grant at 1 year (and then most likely continue vesting linearly per month after that). Sorry if you don’t want it, but this incentivizes you to stick around!

Acceleration means that the vesting schedule can be thrown out the window (i.e., you suddenly accelerate your vesting, usually to 100% ownership) in certain events, usually upon an acquisition. Yes, this is good, and is also helpful to incentivize you to stick around!

The pieces of equity in a company are called shares of stock (or usually just shares). Shares are like tiny, equal slices of a pie: your total ownership percentage of the company will be equal to the number of shares you own, divided by the total number of shares that exist. And the total number of shares out there is called the fully diluted share count.

Simple arithmetic so far, right? Unfortunately, that’s pretty much where the simple part ends. Because that fully diluted piece (unlike pie) can change. Sometimes – hopefully most of the time – these changes are necessary and beneficial for both the company and all of its employees. Sometimes, not so much.

You keep using that word dilution. I do not think it means what you think it means.

Whatever the motive, the process of magically expanding the pie is called dilution. To explain why, lemme switch metaphors for a sec:

Imagine putting a single drop of red food coloring into a glass of water. It turns a light pink, far from fully red, but you can tell it’s in there.

Now, pour the light pink water into a large pitcher, and fill it up the rest of the way from the tap. The redness is barely perceptible now, because it got… you guessed it… diluted!

The redness represents your ownership percentage. You still own the same amount of the company (there’s still the same amount of food coloring in the glass as was there before), but now there’s suddenly… more of the company.

There’s more of the company because the company’s board of directors decided to authorize more shares to be issued. Usually, in the case of startups, they did this in order to sell these new shares to investors during a fundraise.

What?! You can just create more shares? That sounds a lot like how the U.S. Treasury can just decide to print money out of thin air.

Bingo! And without getting into national monetary policy, about which I know extremely little, in the case of startups creating more shares there is at least some justification for this method of dilution.

New investors in the company will generally want to think in terms of a total ownership stake in the company, as in, “I’ll invest $1M in exchange for 10% of the company.”

Let’s say that when these new investors make this offer to buy 10%, the whole pie had already been divvied up. The founders and other early employees already owned a combined 75% (3 slices), and the initial investors already owned the other 25% (1 slice).

So even if everyone wants to sell 10% of the overall company, how do they accomplish that? The short answer is:  make more pie, and sell that to the new investor.

This procedure simplifies cutting someone new in, but it involves a lot of complex calculations and to be honest, I’m still on the fence about whether I believe in the rationale behind the “bake more pie” method. It frustrates me every time I think about it for more than 30 seconds. But this is a discussion of how things are now, not how they should be – so suffice to say, dilution is a common practice in startups today.

Wait, what about options? I got options not shares. Those are better, right?

That depends on your priorities, but in general I’d say it’s better for you in the short-term, yes, but ultimately worth a little less than actual shares.

In any case, you won’t be asked to choose between options or shares; you’ll be offered either one or the other, and with earlier stage startups it will almost always be options. So let’s talk a bit more about what those are.

First off, option is shorthand for an option to purchase a share of stock at a pre-determined price. That pre-determined price is called the strike price. This means that when you have options, you don’t actually own equity in the company yet; what you own is the option to buy it in the future at a fixed price.

Let’s say there are a million total shares in the company today, and 100,000 (10%) of them are reserved for employee options (incidentally, that bucket can be called an option pool or an equity incentive plan, aka EIP). And let’s say you negotiated a 1% fully diluted equity package, meaning you’ll get 10,000 options.

Also, let’s assume the latest investment valued the company at $10M. Since there are 1M shares, that means investors bought their shares at $10.00/share. So, you’re probably thinking:

10,000 x $10.00 = $100K
1% of $10M = $100K
Either way, I just got a six figure equity package!

Yes, and good for you! But also, not exactly. This is where it really starts to feel like black magic, but for very good reason this time: tax avoidance!

The trouble is this: if you receive, as job compensation, something that’s truly, objectively worth $100K, the IRS is going to tax you on that. Heavily. Like, between $40-$50K. That would put a pretty big damper on your excitement about joining a startup, especially when your supposed $100K equity package is not remotely liquid – meaning you can’t sell it for actual cash anytime soon.

So the challenge is to come up with a structure where the company and its founders, investors and employees all genuinely believe that your 10,000 options are worth $100K, but where the IRS looks at it and believes that it’s worth nothing – so that you don’t get taxed on it right now.

Are you saying my options can both be worth $100K and $0 at the same time?

Well, as a backdrop, keep in mind that this whole system is completely made up, so it’s pretty commonplace for two different groups of people to believe two wildly different stories based on the same set of underlying facts.

So if company stakeholders and investors believe your options are worth $100K, how does the IRS look at these same options and value them at $0 (i.e. tax-free)?

First, it’s highly likely for any venture-funded startup in 2020 to actually have two different share prices. The pie slices that investors bought aren’t entirely the same as the regular slices of pie (aka common shares and/or options to buy common shares) that you and I have.  They come with additional terms and protections for the investors, which is why they’re called preferred shares. It’s normal for the preferred share price to be a multiple of the common share price.

In our scenario above, it was really the investors who valued the company at $10M and thereby valued their own preferred shares at $10.00/share. So in order to come up with another lower price for common shares and support the illusion (ahem, excuse me, the rationale) that your shares are worthless for tax purposes, we need to get an independent party to look at the fundamentals of the startup and come up a fair market value (FMV). This is called a 409A valuation, because the government doesn’t take something seriously until it’s got either an esoteric numeric code, or a horrendous acronym.

So let’s say the FMV comes back as $2.00/share. That would mean your 10,000 common shares are valued at $20K, not $100K, and we just made massive progress on your tax bill!

But remember, you have options, not shares. And that’s where the second component of tax avoidance comes into play: if we issue options with the strike price equal to FMV (i.e., $2.00), the IRS sees them as worthless today.

This thinking actually makes sense… sort of. Because again, this “equity grant” is really just granting you an option to buy something for what it’s currently worth! It’s a little bit like saying, “I’m giving you the option to go onto Amazon and buy $100K worth of merchandise, at listed prices.”  Who cares, right? You can do that whenever you want.

But there’s a very, very important difference here: Amazon’s prices are not likely to increase by 10X in the near future, whereas the value of your startup actually might. And if it does, your options guarantee a lock on share price, before the increase.

Ugh… I’m so lost. So how should I think about what my options could be worth in the future?

It’s true, the whole thing is confusing AF. But at least, finally, we can end with a much simpler and more intuitive answer: the value of your options depends entirely on what happens in the future.

Let’s look at a few potential outcomes.

First, we’ll get the downside scenario out of the way: say it doesn’t work out and the startup gets acquired for just 10% of its prior valuation, $1M, i.e., $1.00/share. In that case, your options truly will be worth nothing, because they are said to be underwater: your strike price gives you the option of buying at $2.00/share, when they’re only actually worth $1.00/share… so… yeah, don’t do that.

In this scenario, the company just got sold off for less than the amount invested anyway, so investors will get some of their money back, lawyers will get paid (of course), and then there won’t be anything left for common shareholders (founders) anyway. So in the failure case, there’s no real difference between owning shares and owning options to buy those shares, because the shares aren’t worth a dime.

Next, let’s say your latest investors were right on the money, but the company struggles to grow beyond that size, and in a year, someone picks it up for $10M, i.e., $10.00/share – for all the shares (including common), not just the preferred shares. Here, investors get all their money back but with no gain (they’re selling for the same price at which they bought), and owners of common shares will make the full $10.00/share.

Remember your strike price of $2.00/share? This time you’ll want to exercise your options, because you’re effectively buying them for $2.00 apiece, and then turning around and immediately selling them (to the acquirer) for $10.00 apiece! In practice, you won’t actually need to outlay any cash here; you’ll just make the spread – $8.00/share. So, in this middle-of-the-road scenario, your options turn out to be worth 80% that of shares. Not so bad, considering you never had to purchase them up front, and you avoided any up-front taxes.

Finally, let’s look at a huge success case, 10X the above – the company gets acquired for $100M, or $100.00/share (or goes public). Same math as above; investors make 10X their money, common shareholders net the full $100.00/share, you net $98.00/share, and everyone heads to Vegas. Your winnings (per option) are worth 98% as much as their common share counterparts. Meaning in the event of total success, options are essentially the same as true equity. Also, congratulations, you won!

Written by Evan Schneyer

Co-Founder & CEO of Outlaw

Recent articles

Want more from Inside Outlaw?

Sign up and get the latest on Outlaw features, industry news and expert advice delivered to your inbox.

Fill out your details below