There’s a good saying in the poker-playing community, “If you don’t know who the sucker is at the table, it’s you.” Given work compensation (cash or stock) is likely the #1 source of wealth for the vast majority of people, I think it’s important we have a thorough discussion on stock options so you don’t get ripped off.
To provide some background as to why I think stock options are mostly for suckers: 1) I am currently the CEO of a privately held online media company who has the ability to grant options. 2) I’m a consultant for a startup where I could get paid in options in lieu of cash for three months worth of work. 3) I’ve been an employee of a couple large financial firms and received stock (not options) as part of bonus compensation from 1999 – today (deferred compensation until 2015 due to severance negotiation). 4) I’ve worked crappy jobs growing up that not only paid me a poor hourly wage of $4 an hour, but also gave me no options or stock.
For those who haven’t been following this site since 2009, my modus operandi is to thoroughly write something against what I plan on doing in order to make sure I’m not missing the obvious. For example, “The Dark Side Of Early Retirement” was written in May, 2010, almost two years before I actually pulled the plug on Corporate America. I still think all the negatives to retiring early in the post are valid. But I’ve learned there are some great positives too about breaking free early.
Working for startups vs. traditional companies will likely make you poorer than richer because most startups fail, and most startups pay you below market rate compensation. Cash is way more valuable to an unprofitable startup than to a company with tremendous cash flow. No cash, and the startup will die due to unmet financial liabilities. Options, on the other hand, aren’t really worth anything until there is some liquidity event.
The CEO could say that each share is worth $100, but nobody really knows. Her job is to sell you the vision with tantalizing options that aren’t currently worth much to get you to work for cheaper. Your job is to make an informed decision on the likelihood of the CEO’s vision turning into reality.
Some startup CEOs make mistakes by not only paying below market compensation, but also hoarding their equity so much that they aren’t able to recruit the right people to help build their company into something extremely valuable. After all, 10% of $1 billion is worth much more than 90% of $0.
Before you accept options as compensation please ask the following simple questions:
* What is the current fully-diluted total shares outstanding?
* What is the exercise price of each option?
* What is my vesting schedule?
* Is there a cliff? If so, what is it?
* Is the company currently raising funds, and at what price?
* Do the venture capitalists have a minimum take if the company is bought?
* Will my unvested options become fully vested if the company is bought out?
The CFO, CEO, or person in charge of granting compensation should be able to answer these questions in a relatively straightforward manner. Getting 100,000 options sounds fantastic, but not so much if the exercise price is at $10 and the company recently raised outside investment at $2 a share. The stock has to go up 500% before you break even! Furthermore, if there are 1 billion shares outstanding, you only have ownership of 0.01% of the company.
Don’t be a sucker by not at least understanding the exercise price, the number of shares outstanding, and your vesting schedule.
STOCK OPTIONS FOR GAMBLERS & HOPELESS OPTIMISTS
So here I am a sucker, a gambler, and a hopeless optimist for accepting stock options as payment for my consulting work. My rationale is that it is rare for a part-time contractor to even have the choice to get compensated in options. The only way I can invest in a private company is if I invested in a venture capital fund who invested in the company, or if I knew the CEO for a long time and she invited me to invest. In other words, even if one has the money to invest, not every investor will be accepted. There is too much liquidity chasing too few deals at the moment.
Of course, there is no free lunch. And my option compensation terms will be adjusted accordingly as a non-full-time employee. I mentally expect my options to be worth $0. But for the 5% chance the options could be worth a multi-bagger, I’ve decided I don’t want to get left behind with no options if that was the case. For the next three-month contract, I have the option to revert back to cash or a combination of both options and cash as compensation.
I want to highlight some great insights by HerEveryCentCounts, a fellow Bay Area tech startup employee who has spent a lot of time analyzing compensation as both a consultant and full-time startup employee in multiple early-stage companies.
Here is her response to my post on Equity vs. Cash compensation. It should be very relevant to anybody who is compensated with options.
THINGS TO THNK ABOUT
1) As a consultant, your shares should not have a vesting schedule, but instead be offered monthly in lieu of (or as part of) pay. Once your shares vest each month, you should be able to buy the shares. Having a cliff as a month-to-month consultant doesn’t make sense.
2) What is the real value of those shares today? Sure, the investors may say that they are worth $2 a share (example) but what does that mean? It is in the best interest of the investors and board to make the shares look very attractive to employees. How can they do this? There are many tricks that these companies have up their sleeves. A common trick is to split the stock so there are many more shares (or simply issue a boat load of shares). This doesn’t actually change the value, but it enables the business to give out “more” shares to new employees even though they are in total worth the same as a smaller amount before the split. As long as you know what the shares are worth and the total outstanding shares, you can make a fair judgement call on the situation.
3) Even if you’re granted shares that are supposedly = to the cash value you would be paid (i.e. $5000 / mo in options vs cash) you aren’t actually getting the stock. You have the right to BUY the stock for $5000 each month. <–— I think many people get surprised by this fact. You only make money on the difference between your purchase price an a liquidity even that may never occur.
4) As a FT employee you might not even be able to buy it right away, but as a consultant with no vesting schedule you should be able to. If you don’t then depending on the rules after 90 days you stop working for the company you could lose your right to exercise those options. That means poof all of your earnings are gone.
5) When you exercise options you have to pay the difference between the strike price (what they were worth when you got them) and the price they are worth when you exercise them. Of course this price is meaningless because you can’t actually sell the stock. This is what really sucks for employees. For example an employee could have a strike price of $1. The company could raise more funds and have a valuation that brings the shares up to $2 per common share. The employee has put in many years of service at the firm and decides for his career he must leave. He has 90 days to buy those options and he must pay taxes on the $1 difference per share he exercises. That’s not so bad if the shares are worth $10 each in the long run, but more often then not the company cannot maintain its growth and suddenly the shares are going backwards in price.
It will take many, many years to know if they will be worth anything or if you will have to take a loss on the shares entirely. Even if you had a very low strike price (i.e. came in Series A round or pre-A) that is still based on some made up valuation but some guys on Sand Hill Road (Silicon Valley VC HQ) who are running numbers in their favor. The CEO/founder has some clout in negotiating terms that benefit him if the company starts to turn sour, but I’ve never heard of a CEO negotiating terms that help his employees. This is not necessarily a bad thing — if the employees feel too safe why would they work to make the company so successful (i.e. long hours that a startup requires.) That said, few realize how the CEO can walk away with millions of dollars even if the company is run into the ground and the common employee has lost money on exercising their options. Funny how that works.
6) This is not to say that stock options are terrible in all cases. Clearly there are companies that do well and where early employees end up being able to afford a house in the nicer areas of Silicon Valley — not the finest neighborhoods of SF mind you, but at least an entry-level house in Palo Alto or a reasonable ($1.5M-$2M) condo in the city. It’s really lottery-ticket-level-stats if you think your options will get you into a $20M house — but it’s always nice to dream.
7) What I’ve learned — most importantly — is determine if the company you are working for (and getting stock options at) has a fundamental business model that makes sense (or is everything vaporware?). Are customers willing to pay for the product? If it’s a recurring revenue business model, are the customers renewing (or if it’s too early to see renewals, do you honestly believe that the founding team and product team understand their market enough and care enough to make the right calls in order to drive long-term customer satisfaction?) This formula doesn’t work for every business (clearly an Instagram being picked up for $1B by Facebook wouldn’t fit the formula) but in most cases as an intelligent individual you can ask yourself — 1) is this company able to get customers, 2) is this company able to keep customers, and 3) is this company able to grow their products/offerings enough to get customers to buy more?
If you think your company is an acquisition target… are there enough big businesses out there who would care about the company and its offerings? If an IPO is the target then that’s often a very long journey and it takes a team that really is in it for the long run instead of a quick flip. Here you have to look at the motives of the founders — are they already wealthy? Do they want to prove they can do it again? Do they want to build a public company after a series of successful acquisitions? Look at who is running the company and why and you will have your answer. This will tell you a lot about the real value of the options.
8) Even then there are a whole host of other ways to screw employees out of whatever they think their options are worth. Most of the time an acquisition isn’t a true success and employees can not have access to the fruits of their labor. Executives have clauses written into their contracts protecting them but the common employee or consultant does not. <—- For example, a VC may have a clause to get a guaranteed 2X return on their invest if the company is sold. Let’s say a VC invests $50 million into the company, and the company is sold for $200 million. The VC gets $100 million back, and the remaining $100 million is split among employees and the VC. In other words, there’s less of a split for employees than expected. Another example is if an employee is two years into a four year vesting schedule and the company is bought. The employee gets the lift for two years worth of options but can very easily lose his/her remaining two years worth of options if the vesting schedule isn’t accelerated. The employee is at the mercy of the founders who are negotiating the deal.
9) I firmly believe it’s better to earn shares as a consultant in a business than as an employee. Why? You can earn options monthly with no vesting (vesting is what I think of as pirate handcuffs) and if the company starts to tank you can leave without it being a big ordeal. What’s more you can DIVERSIFY across multiple startups… which maybe isn’t the best if you happen to miss working for one startup that will IPO for 10 years straight, but diversification is a way better strategy to hit the options jackpot. Plus, if you are consulting for a company that really seems to have its shit together you can make the call to work their full time once you’ve dipped your toes in the water.
However, remember that when you exercise your shares you are buying stock. Putting over $15,000 into one super small cap high risk stock that was illiquid and locked into that stock for many years to come seems very risky when compared to purchasing $15,000 in Apple stock at $150 a share for example. But that’s what many people do. Buying stock in the company you are working for felt “cheap” like part of your compensation – a privilege and you’d be a fool not to buy the shares for so low (even though you are on a vesting schedule).
Instead of putting 10% of their net worth into buying options, one could also put 10% of their portfolio into any other high-risk stock AND also have the option to trade out of it if the company starts to bomb. In this case you’re stuck. That’s what I think people don’t fully understand, and why it’s really unfortunate that companies trick employees into thinking stock options are so great. They can be — but really they are 9 times out of 10 decent for the executive team and crappy for everyone else, even in a “successful” outcome.
DIFFERENT SCENARIOS FOR YOUR COMPANY’S SHARE PRICE
1) Company could go belly up, stock is worth $0.
2) Company could be bought in an acqui-hire, stock is worth less than the strike price you paid for it, but at least you can say it was acquired by some fancy name company.
3) Company could be bought in exchange for shares in a new private company with the option to trade your shares for shares of this new much better private company or take a much lower cash payout, except in order to trade for shares of the new private company you have to be an Accredited Investor. This basically means if you’re rich already ($1M in networth or you make something like $250,000 a year) you’re allowed to take the “risk” of trading in for shares of the new private company whereas if you’re not rich yet you can’t do this.
4) Company could be in a good position to sell to a company, but public company says they aren’t buying unless the company gets rid of its entire team that you’re on because they just don’t need more people in that role. You get laid off and are forced to decide whether to buy your shares, but you actually don’t have any visibility into the acquisition in place. For all you know you get laid off because the company is losing money and doing poorly. You have to make a call whether to buy the shares after being laid off (and being bitter about this) when you’re not in a good mental state to make a clear and wise decision.
5) Company could IPO (woohoo)! When the company goes public employees are locked up for a period of a few months (I think it’s usually 6) before they are allowed to sell. The stock explodes on day one and goes up up up but you cannot sell. A few months later the company reports on less than stellar earnings and the stock tanks. Now you’re allowed to sell. Yippee. That was a hell of a ride, and not a pretty one.
6) Company is doing really well and either gets acquired or goes public for a really good valuation, and its sales are actually meeting those numbers. Employees see their shares increase in value significantly and are able to buy these shares and pay tax on the difference. Employee wants to exercise their shares ASAP because the valuation is going to go up a lot and it’s a sure thing! The taxes they pay on the shares are HUGE but who cares because in a few months the shares are going to be worth a lot more. But then, oh no, something goes wrong. The economy tanks. The industry isn’t what it was a month ago. The deal/IPO falls through. The company valuation goes down. The employee is out of all that tax they paid on the stock and possibly also the valuation is worth less than what they paid for it. This happened a lot in the tech bubble crash. – HerEveryCentCounts
DON’T EXPECT A THING
A hugely successful startup will cure all problems. But most companies either fail or just muddle along with no liquidity event for years. A non-event is essentially what most employees will therefore experience, but most of these employees aren’t writers who will tell it like it is in a post such as this.
One thing I want to point out is that there are essentially three ways to exercise your options:
- Exercise Early with Cash – You have to come up with the cash value of your options, which might not be possible for many employees. But you start the clock early to receive more favorable tax treatments if you hold for over a year due to long-term capital gains tax of 20%, assuming your normal income tax rate is higher.
- Wait to Exercise – The most conservative move where you wait to exercise (if you can) when there is a liquidity event. A lot of people during the 2000 dot-bomb days exercised too early, paid taxes on the phantom difference, and saw their shares plummet.
- Cashless Early Exercise – The middle of the road strategy where you sell your shares to cover your cost, instead of ponying up cash. The only way this is possible is if the current share price is higher than your exercise price.
If you’re expecting to get rich off of options, you’re a fool. Run your life as if nothing will ever happen. Continuously diversify your time and your investments into companies which you think will succeed. After that, watch your cash flow needs and hope for the best.
Photo Credit: WikiImages