Stock options and employee equity

To my surprise, a lot of people that I interview at Acquia don’t understand stock options or have never heard of it. This blog post explains what stock options are about. It is a very technical topic but for the sake of this post, I am going to keep it really simple and make some over-simplifications.

In essence, a stock option is a right given to an employee to purchase stock at some point in the future at a set price.

When a company is founded, the founders own 100% of the company. When they raise money from investors, they give them a share of the company's stock in exchange for money. In addition to that, most institutional investors will require that you establish an "option pool" which usually accounts for 10% of the company. So if you sold 30% of your company to an investor for 2 million dollars, and you set aside 10% for the option pool, the founders still own 60% of the stock and have 2 million dollars to work with.

Having an option pool is very common for a venture backed startup, and fairly uncommon for most small companies. At Acquia, which is a venture backed company, we give our full-time employees stock options on top of a competitive salary. These options come from our option pool.

If you are an employee of a startup, stock options are a big deal as you are going to receive stock options as part of your compensation. It is a big deal because it means you have the option to be a shareholder and to share in the gains. It's a big part of the startup culture, and an important reason why top engineers prefer venture backed startups.

So what exactly does that mean for you as an employee?

When you join a startup as an employee, in addition to your salary, you might be granted 10,000 stock options at a strike price of $1 per share. Those options are taken from the stock option pool that is set aside especially for employees. In our example above, all employees together can own up to 10% of the company.

When the company is founded, the stock is basically worthless. The founders, the employees and the investors will want to steadily increase the value of the company, and by extension, the value of the company's stock.

At the time of an exit, the stock is hopefully worth $100 per share or more. So if you were granted 10,000 options at a strike price of $1 per share, you can buy 10,000 shares for $10,000. However, at that point, the shares are immediately worth $1,000,000 as over the years, the stock price has increased to $100 per share. In other words, the 10,000 shares that you got when you joined, can make you a $990,000 profit on top of your salary.

Granted, the value of the company might not always go up, or it might not go up that fast, but it certainly could. Hundreds of Google employees became millionaires overnight when Google went public. Hundreds of Google employees left to join Facebook -- not because they get a better salary but to get some of Facebook's pre-IPO stock options. When a startup is growing and successful, the price will go up over time. At the same time, if the company fails, the employee equity will be worthless.

The reason startups use stock options is because it allows them to attract and retain high-quality people at reasonable salaries. You can choose to go work for a startup for $85,000 per year in salary and 10,000 stock options granted over 4 years, or you can choose to work for a company for $90,000 in salary and get no stock options at all.

Do you want to take the reduced salary and some risk and swing for the fences, or you do you prefer predictability without the potential for a big upside?

My first job out of college I worked for a venture backed startup that granted me two rounds of stock options -- both grants were rendered worthless as the company didn't survive the bubble in 2001. Even so, I never regretted the choice to go work for this startup. I still got paid a fair salary, I learned a lot and just loved the start-up culture that we had created.

I firmly believe there is an entrepreneur tucked away in many of the best people. For those people, the daily satisfaction of working with high-quality colleagues in a fast-growing company, and the ability to share in the company's success as a shareholder, is worth a lot more than a bigger salary and predictability. I knew that was true for me when I was 21, and I know it is still true now that I'm 31.

Comments

Steve (not verified):

Can I please have my options backdated?

http://en.wikipedia.org/wiki/Options_backdating

November 16, 2010 - 17:10
Lathan (not verified):

Wow what luck!

I have just been offered stock options in a start up and reading this makes me feel a lot better about the proposal.

The only other majour issue for me than you never touched on was what risk am I now open to? Let's say the company goes bust and owes $40 million and I own 1%? dose that mean I am now liable to pay back that 1%. It's the only thing I'm a little afraid of.

It's really my lucky day, thanks Dries.

November 17, 2010 - 00:43
onaz (not verified):

No risk whatsoever.

The only risk you have is losing your stock option investment money and the anticipated future profits. You'll never be liable for any losses in case of bankrupcy. Nor are the company founders for that matter (well, unless they've backed company loans with personal money).

November 17, 2010 - 07:34
Tom Erickson (not verified):

No liability Lathan!

Shareholders in an incorporated company (Inc) might lose their investment, but do not share in the company's liabilities. As an option holder, you have only invested your time, up until the point you exercise your options. At that time, you need to pay the exercise price to convert your options to actual shares in the company.

Your risk if the company fails is the money you pay to exercise your options.

Good luck!

November 17, 2010 - 11:29
Vesa Palmu (not verified):

Stock options are just that: Only options to purchase stock with a preset price. You will not be a stock holder before you use them to purchase company stock. As long as you have only options you will not have right to vote on anything or any other benefits/liabilities stock holders might have. Don't worry, the risk with stock options is only that they might not be worth anything.

This is however based on my experience with European legislation, so you might want to double check this.

November 17, 2010 - 11:59
Anonymous (not verified):

In some countries there's a risk that you pay tax on profit even though you haven't realized it yet: so you are granted 10,000 share options, and this is treated as a taxable event even though you haven't received any money yet. In USA, and the UK this isn't normally the case. The way options are treated also may depend on the scheme/mechanisms under which they are granted. IANAEISO. Check with a reliable source in your country.

November 25, 2010 - 19:20
Mike (not verified):

Although, I think Dries highlights one of the great reasons for wanting to work at a startup, aside from compensation, "the daily satisfaction of working with high-quality colleagues in a fast-growing company", this post does seem to be tied to compensation in a major way.

I wanted to highlight some arguments made against the "big upside", How to Discuss Stock Options with Your Team & Is it Time for You to Earn or to Learn?.

November 17, 2010 - 03:30
Peter (not verified):

Hi,

what if the company never goes public (like Facebook :)?

November 17, 2010 - 09:45
Dries:

There might be another liquidation event such as the sale or acquisition of the company. In that case, your shares might be sold to the acquirer (and you get the money), or they might transfer into shares of the acquirer (which could be public company shares that can be sold).

A company that never goes public or that doesn't get acquired might also decide to pay a dividend to its shareholders.

Third, there is a pre-IPO market for shares too, and you might be able to sell your shares that way. For example, pre-IPO Facebook shares are actively being traded for as high as $80 a share.

November 17, 2010 - 13:21
Philip Paeps (not verified):

You forget to mention that companies like to put restrictions on when you can turn your stock options into stock. Also, if you sell your stock, it's subject to be taxed in not-entirely-fun ways.

Not that stock options are all bad, but there are some more downsides than "the company might not ever be worth something" and it would be good to mention those too.

November 17, 2010 - 13:11
Dries:

As I wrote at the top of my blog post, stock options is a very technical topic. It is impossible to cover all the details in a single blog post. In fact, there are books written on the topic of employee equity, classes thought on the subject, etc.

Let me try to reply to both remarks; (i) stock option restrictions and (ii) tax implications. These are valid remarks that might warrant a longer follow-up blog post. For now, let's kick it off with this comment to see where this might go.

First, stock option plans vary from company to company. Every company tweaks their stock option plan relative to their situation and desired outcome. For example, in most cases, employees do not gain control over the options for a period of time. This period is known as the vesting period. Once the options are vested, they usually can be exercised. Different companies have different vesting schemes. The vesting period could be considered a restriction, but it is an extremely common one because it protects the company, and by extension all of its employees and shareholders.

(Maybe I need to do a follow-up blog post on the topic of 'vesting' because this might not be clear to some? If you had different restrictions in mind, I'd love to hear more about your thoughts.)

Second, it's hard to write about the tax implications of employee equity as it depend on the tax jurisdiction the employee falls under (e.g. it differs from country to country, state to state) as well as on the employee's personal situation. For example, when I moved from Belgium to the US, I learned that the IRS treats capital gains very different from how the Belgian tax authorities treat capital gains. Surprisingly you're better of in Belgium.

Buying and selling stock is usually subject to income taxes or capital gain taxes. On top of that there might be special legislation around stock options to incentive entrepreneurship or to stimulate the economy -- the US currently offers temporary exemption of capital gain taxes in certain situations. In other words, everyone that gets stock options should talk to their accountant to educate himself/herself on how to manage tax liabilities the most efficient way as to minimize your tax bills.

November 17, 2010 - 19:14
Dries:

It's great to see people are genuinely interested in discussing this topic. As I wrote in my blog post, many of the most talented people I know, have an entrepreneur hidden inside them. At the same time, I wasn't sure what reactions to expect from a blog post like this. I'm pleasantly surprised.

We can talk about technology all day, but sometimes it is nice to talk about our work situation, professional career and entrepreneurship. Sounds like I should do a couple more blog posts on startup topics. It's a fascinating world after all.

November 18, 2010 - 17:30
Jeff Geerling (not verified):

+1 to this. Drupal stuff is awesome, but being 'open source' about your experiences with a startup—especially one as large as Acquia—always makes for an intriguing read.

November 18, 2010 - 19:27
Shyam (not verified):

Happy Birthday :)

November 19, 2010 - 10:12
Dries Coucke (not verified):

Back in 2003, I joined eBay and was granted some stock options as well. At that time, eBay employees earned a significant amount of money thanks to these stock options. Same story at Accenture. My learnings:

1. Yes, you can make a considerable amount of money
2. Tax regulation can spoil the fun (e.g; In Belgium, tax has to be paid upfront, even when your options remain "under water").
3. In some countries, you need to keep stock options for several years before vesting. (e.g. Italy)
4. Most companies require you to vest the options when you leave
5. Worst of all are the "closed windows" when quarterly results are about to be published: all trade by employees is forbidden. Stock price was often exceptionally high during these closed windows.

Main conclusion: yes, they have huge upward potential, especially in Silicon Valley. If you're a clever employee, you combine them with call options. Reality is that most of my former colleagues that were awarded stock options never gained any money from them.

November 21, 2010 - 00:39
Michael Prasuhn (not verified):

It really has to be the right combination of technologies, company leadership, timing, options, and so on to be worth it to a potential employee. I've worked in a few startups where I basically ignored the stock options for a number of reasons, including:

  1. Lack of competitive product. The company didn't seem to be in a market where any significant innovation would be possible, based on the leadership and products they were working on.
  2. Vesting period too long. I'm not sure what is normal here, but 4-5 years seemed a bit long for a technology startup, I don't know too many folks that work in startups that tend to stick around that long, and if they do, their skills are sometimes considered as starting to stagnate.

In these cases I ended up spending some time at the company anyway, but only because I was satisfied with the salary at the time, and assumed that either the company or I wouldn't be around by the time any options were vested.

November 22, 2010 - 23:37
Dries:

My experience is that the typical vesting period is four years using monthly vesting with a one year "cliff". The one year cliff means that you don't vest for a year and then "catch up" by vesting 25% of the stock options on the one year anniversary. Subsequent vesting happens monthly. That seems to be the industry standard in technology start-ups.

November 23, 2010 - 15:17

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