Starting Up & Right: Episode 03 - Intro to Employee Stock Options

RUNTIME: 34:29


Trae Nickelson: Hi there. Welcome to Starting Up & Right. I'm Trae Nickelson. Your co-hosts with me as always is Ryan Keating. Hey there, Ryan.

Ryan Keating: Trae, hello.

Trae: It should be a fun episode. In the last episode, we got the opportunity to speak with Mark White, a startup attorney. One of the subjects we discussed was management of the cap table, which led into discussing stock options, and red flags and how we manage stock; that led into the conversation as well of how Carta has taken a lot of the drudgery out of managing the cap table and freed you up to talk to people about stock options and cap tables.

Today we want to follow that up with... you have a presentation that you've given pretty successfully. Why don't you reiterate that? How has your role changed? What's your current role considering all the technology used in dealing with stock options in particular this episode?

Ryan: Sure. It's a good question and we've seen software platforms, in particular, something like Carta, really become widely used in the last say five years. That has changed a couple of things. It's been a great technology solution. It's really simplified a lot of the logistics of granting options and having the board approval and tracking the amount of option pool that's available, when vesting happens, it does, it tracks everything really well. It's really eased the process of having options approved and even received by the recipients but one thing we have noticed that it's created a void is the conversation that would normally have taken place with this specific option recipient.

Think of it as the employee at the startup that has received an option grant when they joined, it used to be that we would print out on a hard paper a copy of the option grant, sit down with that individual and walk them through, "Here's the number of shares you have. Here's what your vesting period is. Here's what it means if you were to leave or if you wanted to purchase after your first hurdle, a 12-month hurdle is crossed." That conversation doesn't really happen anymore because the recipient is now notified via Carta, they go into Carta or other, and they receive that option.

For the most part, they have access to reading through the agreement, but they don't benefit really from that conversation about,  “what does it really mean to me?”.

Trae: That makes sense. I would imagine in that process, they're coming onto a new job, potentially a lot of questions don't get asked, I would imagine, that probably need to get asked. I think this presentation that you're going to show us today is one that you've put together, in particular, to speak to that employee. Founders are definitely our audience here, and founders need to understand two sides of stock options, but they may often assume that their employees understand stock options as well as they do. That's not always the case. This is part of that conversation that you have with the employees, with the team.

Ryan: That's right. We've been asked to put this presentation together a number of times for our clients. It's really, as you've pointed out, to speak to the employees to speak to the people that are recipients of the company's stock option. There is a separate conversation, as you pointed out, that takes place with the founders, with the board. That's more along the lines of - how large should our option pool be? How do we match our option pool to our hiring plan? What amount of options should we be thinking of granting to specific positions at specific stages of our company's growth? That's a separate conversation which we have with our clients.

This is entirely focused on what does it mean to hold an option grant within this startup is what we'll be speaking to.

Trae: Perfect. Well, with that, let's shift gears here. The screen is going to change a little bit, but we'll come right into that presentation. Just pretend like you're talking to a small team of employees at a promising new startup.

Ryan: Okay. Trae, this is the presentation or a version of the presentation that we have put together to speak to our clients specifically their employees. I'll run you through this and I know we have some questions at the end as well. Introduction to employee stock option plans. As we mentioned this is a conversation for the optionees, the holders, separate from a conversation that we would have to even design the option pool and what size it should be.

The first question we get is what is an option? The term option literally suggests that you have the right but not the requirement to purchase the shares at a future date, so it's completely up to the holder. They can let these options go unpurchased and they don't own them or they can decide to purchase them throughout their vesting period. Bottom line is it's the right to purchase stock in the company at a predetermined price, and that's important. We'll come back to what it means to have a strike price and how is it determined.

Why do companies offer stock options? The main reason is they want to attract and retain talent. It's especially in a startup one of the main motivations for people to come into a startup is they want to grow the business, they want to participate in the growth and the value creation and everybody hears stories of course about how stock options become very valuable as you start with a company and they grow and get acquired or eventually go public. Not to mention, it really aligns the founders, the investors, the employees. It aligns everybody within the same incentive which is the better the company does, they all are participating in that creation of value.

Then a topic that we talk about a lot with our clients is you really as a startup you have two forms of currency. You have cash and you have stock. The earlier you are in a startup's history, you usually see that stock is more readily available than cash, and as a company matures and grows and becomes cash flow positive and starts to stock up cash reserves, that relationship will change where now stock is something you want to hold on to more, and cash is maybe more readily available. Early-stage companies, very early-stage companies perhaps even, will spend a lot more in terms of the stock amount that they might award employees than say later stage companies.

As a company goes through those funding rounds or stages of growth that will change. This next slide that I like to show it's a fun example of stock options. This is a pretty well-known story where a graffiti artist back in I want to say 2006 or '07, way before Facebook went public and is the company we see today, agreed to basically paint the Facebook office for I think it was something about $60,000 cash. Instead, he opted to take stock options in Facebook.

Certainly, we could all say in hindsight we would have done the same thing, but at that point in time, and there wasn't a lot of you don't know, there's a lot of unknown. That's one of the things inherent with an option is you're betting on the future, but he made a good bet and his options, then this was back when this article was published I think in, looks like 2012. His options were worth $500 million. You can imagine with how Facebook is doing today if he still holds those options, they're worth quite a bit more but that's a fun example that a lot of people are aware of and obviously a good outcome for that graffiti artist.

When we talk about stock even before we get to options, real quick, there are generally two forms of stock options in a startup. That's assuming you're a C corp. Other companies that are LLCs et cetera, that's a whole other topic, we can at a later date where you don't really have stock options you have more membership units or ownership units. For what we're talking about today in your typical C corp early-stage company you have two forms of stock. You have common stock and you have preferred stock. When we're talking about option grants, they are options to buy common stock in the business.

The preferred stock is reserved for investors, generally your VCs at this early stage. The difference which just in a nutshell as it says here is preferred stock has certain things around liquidation and anti-dilution and voting rights. Common stock is pretty straight forward. They are the last to get paid after preferred, after debt and that's what your options are made up of. There is always going to be when you receive an option grant, there is an equity plan that goes along with that to say here's exactly what the common stock is entitled to in terms of does it have voting most of the time? No. Does it have any other rights associated with it and that will be spelled out in the equity plan?

When you receive a stock option grant, there's two different varieties. Very simply and this starts to get into tax and I do want to caution that when it comes to tax and individual tax treatment, every person should really consult with their tax advisor. It's a very unique situation in terms of your tax situation, but in general, you have incentive stock options called ISOs. Those are intended for employees and they have advantages on a tax basis. You can exercise your option to actually own the stock and then based on the time that you hold that stock and the time that you sell it you can actually have long-term or short-term capital gains.

Just like if you owned any stock, let's say you went out and bought a share of Google or Apple. If you hold that stock for a year, and then sell it, whatever you've made on that stock will be taxed at a smaller tax amount. If you buy that stock in Apple and sell that stock, say a week later, you're going to pay a higher tax rate called short-term capital gains. For an ISO, you can exercise your right to buy the shares and not sell them, and if you're that holding period extends 12 months then you're paying long-term capital gains when you end up selling the shares.

NSOs on the other hand, first of all, the main issue is NSOs are only for advisors and vendors. An advisor or vendor that's not an employee cannot have an ISO. You use NSOs for your board of advisors, perhaps vendors that are willing to take some cash and stock especially early on again when you need to use your equity as currency is a very common scenario, the graffiti artist is a great example. Facebook say would rather have given him stock than parted with $60,000 at that point in time, and it worked out for everybody but that's not an uncommon situation that you'll see vendors get into especially early stage. They will often take some options, some upside in the company in exchange for some of their cash or all of their cash on their invoice.

When you are an owner of a stock option and even as you exercise that stock option and you now own the actual stock, the question comes up a lot is how do employees actually cash in? The most common way is that the company gets acquired or goes public, and in that case, there's an actual buyer for the shares. If you're still an employee or you're still vesting, usually what happens is you buy and sell that stock in the same transaction. Essentially you're just taking the difference between your predetermined purchase price and the sale price that the acquirer or the IPO is creating.

Other ways to do it and this is becoming more common. As we see companies basically stay private longer. Facebook is another great example. Facebook and a lot of other large companies like Facebook, they tended to take more venture capital and go to public markets later. You might have had a 10-year holding period if you were an early Facebook employee where you have these shares, and they're yours and the company is obviously doing well but there's no market to sell. These platforms like EquityZen is a good example. They've popped up and essentially what they do is they allow you to sell your private share or your shares in private companies.

Now it's subject to what your option allows you to do or what the equity agreement allows you to do. Some equity plans will say that the company has the right to buy them back, some plans will say that you can transfer them but the company has to approve. This is something you need to check, but if you're not able to cash in on these because of the liquidity event, then you can oftentimes again find a platform that buys these otherwise privately held shares.

Another example and this is usually for early employees or mainly founders. They can sell some of their holdings into the next round of financing, but that's in general for the employees that are holding these option grants that's not something that's readily available. The terms of the option grant. A lot of this will follow if you have an option in your option holder this will follow right down the main page in terms of all the number of shares, the dates, the vesting date, and we'll walk through this right now. This is the conversation that we would normally have when we would sit across the table and present the option grant to the recipient.

A lot of our questions come up on here which are the very specific details of the grant and what does it mean to the holder of the grant. First of all, the number of shares. Just as it says, it's going to tell you how many number of shares the total option grant covers. The exercise price. The exercise price also called the strike price is the price that is set on those shares for the entire length of that grant, so that price will never change. Ideally, what you see is you get the price issued at the time that the grant is approved, and then as your vesting takes place and you're earning your shares say over three or four years, the value of the company increases.

Even though the value of the company is increasing your price doesn't change, this is the benefit. This is why you want to be an option holder. You have the ability to buy into the company when there's more value created but at a price that was tied to the value when your option was approved. This is how the graphic designer from Facebook was able to turn a $60,000 grant into half a billion dollars because the value of Facebook increased but he was still able to buy his shares at that same price.

The grant date. This is the date that the board approves the grant. For any grant to exist the board has to meet now they can do it over something like Carta and say, "Yes, these grants are all approved." That grant date is not going to necessarily tie to your hire date or even your vesting date, it's usually the day closest to your start date that the board meets to approve grants.

Now one thing specific about the grant date is the exercise price or the strike price has to be that current price as of the grant date. It's not tied to your vesting date which can be when you started, it has to be tied to the date of the grant. The vesting commencement date is often your hire date. Again, this can be weeks even months, before it's actually granted by the board, but that's when your vesting begins. You'll get credit for vesting even if it again it takes place weeks or months before the grant date.

Now the vesting commencement date and the vesting schedule are important. This is basically what you actually own. When you receive an option grant, let's say it's for 100 shares, often times the vesting schedule, the standard vesting schedule as we call it here I think in the slide, it's a four year vesting period which basically means, if you leave after two years, you're only halfway through that vesting schedule. Of those 100 shares, you would only have the right to buy 50 of those basically, if you left right at your two year anniversary.

Another piece of this is most startups, they will have what's called a cliff at the beginning, a one-year cliff. In other words, if you leave on month 11, you don't have any shares vested, but as soon as you hit your one-year anniversary, automatically 25% of your grant is vested. Usually, after that cliff, you move into monthly vesting where every month you'll get 1/36th of the remaining until the full four years in our example, the full 100 shares will be available to you to buy if you want to.

The final piece that you'll see on your grant is the option expiration date. Just as this name implies this is how long the option is good for. You'll notice that it will usually say 10 years. This would suggest that if you received your options and 10 years later, you're still an employee at the startup, and they haven't gone public, and there hasn't been some other liquidity event, you're going to have to decide if you want to exercise your option or not. Usually what happens is, if the employee leaves the company they change jobs or they move on, you have a 90-day period to determine if you want to purchase the shares that have vested. Let's say that you leave, in our example, after two years, and you had 100 shares in your total option grant so after two years you have 50 that have vested. What that means then is usually over the next 90 days you have to decide if you want to purchase all of those 50 shares, any lesser number of that 50, 10, 30 you can buy whatever you want or none. But after 90 days, your right to buy those vested shares is gone.

That is an overview of really what we cover with our clients and specifically again the recipients of the options the employees at our clients. All of these terms you'll see as an option holder when you log into Carta when you receive your grant so this gives a little more understanding of what you're looking at and what your rights are. Usually, at this point, we take questions from our clients. We have the employees that listen to this and sit through this and they have some specific questions which I think we might even have some.

Trae: All right, Ryan, that was great, thanks. As this is normally the question and answer section, we are not live with an audience, but we do have some commonly asked questions, and I have a list here of what may have come up, but some of these are questions of course that you covered maybe, you'll get a chance to dive a little deeper. I'm sure that happens a lot where you actually have to answer a question that you actually covered. I'll do the same here, let's see. All right, Ryan... 

What happens to my vested shares if I leave before my vesting schedule has ended?

Ryan: Okay, good question. If you leave before the full let's call it four years are up and so you haven't completely vested your shares, you have the right to buy the vested portion. Again, let's say you leave two years into your four-year vesting period you have now 50% of your grant that has vested and you have to make a decision. Oftentimes, you have to make this decision with not a lot of information because the company's private you may not have access to understand if they're fundraising or if there's an acquisition in the future. You really need to make a decision to decide if you want to put money toward buying your vested shares.

Sometimes this can be a significant amount, it all depends on obviously your individual situation, but what you need to do is look at the number of shares that have vested. Again, if we say that you leave right at two years it's very simply half of your grant, and then the strike price per share and if you multiply those two things that's what it would cost you to buy the entire amount of your vested shares.

As I said in the presentation, you can decide to buy 10% of that, no percent of that, you could walk away and just say, "I'm done," and you don't have to do anything. It's literally your option, you still think of the term option, it's your right, not your obligation to buy these shares. You need to make a decision and you usually again have 90 days from the day you leave to decide if you want to write a check to buy some or all of those vested shares.

Trae: All right, What happens to my stock options if the company is acquired?

Ryan: Okay, if your company is acquired while you're still an employee and your options are vesting, usually what happens is whatever shares you have vested are going to be acquired by the acquiring company. How it impacts you, it's essentially called a cashless transaction or cashless exercise because you're selling your shares to the acquirer at the same time that you're exercising your option to buy them.

Let's say that you have the right to buy them for $1 and the acquirer wants to come in and buy the company at $2 a share. Essentially, the cashless portion is that you just receive that difference. You receive the dollar per share without really having to technically write a check to buy them first you just get the difference you get the increase in value per share. Now that leads to a question about what happens with my unvested shares when there's an acquisition? Usually, your unvested shares will get returned back to the pool and now the acquiring company needs to figure out how to incentivize you to stay in the new business.

A lot of times you'll see that new company come in with new stock option grants, new reasons to keep you to stay, almost always, especially in startups. Part of the reason to make the acquisition is the team, they want you to stay. The acquiring company will come in most often and say, "Hey, you've cashed out on these options but here's new options in our new company." They want to incentivize you to stay. Sometimes what you'll see is there's acceleration, investing specifically when an acquisition takes place. It could be based on your position in the company.

We'll see very senior people even have sometimes acceleration that will accelerate their entire vesting clause and oftentimes what's called a notion called a double trigger. Where if the acquiring company all of a sudden wants the head of sales to relocate to the East Coast or wants the head of sales now to step down to being a senior salesperson. It's effectively called termination, your role is changing not because of cause. Certain triggers like that you'll see built into some employment letters where that will result in acceleration of shares that haven't quite vested just based on the passage of time.

Trae: Ryan, Can you explain to me what early exercise means?

Ryan: Early exercise really is what it sounds like. It gives the holder of the option the right to buy their shares early, really to own them before the vesting period would normally say that you can buy them. This is often reserved for early employees or very senior employees. If you see a startup that's got 50, 60, 70 people, they're probably not offering early exercise anymore. What it results in, and this is a term a lot of people ask about.

If you decide to early exercise, which is to again buy your shares before they're vested, two things happen. One, you have to file what's called an 83b. An 83b is a document with the IRS and there is no forgiveness on this. It is a very strict, you got 30 days to get this in. If you decide to buy your shares early you have to make sure you complete that 83b. This is another area where a platform like Carta has just made a tremendous difference for the good. It used to be a very hit or miss if employees because it's the employee's responsibility even though the company really tries to ensure they don't miss that 83b submission.

A lot of times it would get missed. Carta, you can't miss it. It really forces you to stay in there. The reason that an option holder would want to take advantage of early exercise if it's offered is very simple, it allows you to own the stock earlier. If you think about the tax treatment. As with any investment like we talked about, if you hold that stock for more than 12 months before you sell it, you get to pay at the long term capital rate tax. In a cashless transaction like we talked about where it's usually a buy and a sell in the same moment, your holding period is less than a day. Clearly, you're going to be paying term capital gains.

If you can time it right and you have the access to early exercise and you take advantage of it, you essentially start your 12-month holding period clock at that point. Where if the company gets acquired a year later or two years later you are in long-term capital gains which is at a smaller tax bracket.

Trae: I'm receiving my stock options at a strike price. What is that price? How does that get set?

Ryan: The strike price is usually established by what we call a 409A valuation. The 409A valuation is a very technical accounting term that the recipients don't really need to worry about, it's set in advance. It basically represents the fair market value of the common stock at the time that the grant is issued. In a startup for the most part that price will stay for 12 months because unlike a public company where the value is efficient and buyers and sellers are setting the price daily literally throughout the day, a privately held startup company might only see a change in value at the next funding round.

Until then, there's not a lot of ability to measure the dynamic change of the value. When you have a strike price set by this 409A valuation, it's generally good for 12 months. I say generally because if you do a 409A and then six months later you raise a new round of financing, that takes precedent, that is a much better indication of your current value. Absent a funding event, you're going to have the same fair market value price for those 12 months. If you're receiving a grant in month two and your cube mate or your now work at home mate is receiving a grant in month six chances are you could have the same strike price.

Trae: In my grant, it tells me the number of shares that I'm potentially receiving after vesting. What should that number mean to me? How do I think about that number? How do I value that number?

Ryan: Yes, that's a good question. In itself, the number means very little. It's really what is that number as it pertains to the full number of shares that are available? We call that a fully-diluted shares outstanding. A simple example would be let's say that I'm the recipient of a grant for 100 shares and there's only 1,000 shares in total, that means I have a grant for 10% of the company.

However, if I have a grant for 1,000 shares and there's 100,000 shares outstanding fully diluted, that's only 1% of the company. The number of shares in itself is very hard to gauge, you really need to ask the question and an employee has the right to ask and really they should. Is okay, great number of shares I understand thank you, but how many are out there? You want to know what the percentage ownership is that you're receiving because otherwise it's really hard to understand if 100 is a good amount or is 1,000 a good amount, you really don't know unless you understand the fully diluted shares.

Then as a company grows, you're often going to be subject to dilution. Even if you receive your grant and you have say 0.5%, that could change if the company goes through subsequent funding rounds because what happens is more money comes in which means more shares have to be sold. Again, it's that bottom number that total available number will increase which means the number of shares you have now is a smaller percentage, but that's not necessarily a bad thing.

People get really anxious about dilution but I always try to remind people that dilution generally means that someone else wanted to put their money into the business, it's a good thing. Without dilution, it's really hard to increase value. What you want to look at is the total value of the company and how your ownership pertains to it. Just because you're getting diluted and your percentage of ownership maybe is going down, what you want to see is that's just the flip side of the fact that the value of the company is increasing even greater.

Dilution is not necessarily a bad thing and actually for a company to be successful, you are going to move through some dilution rounds as they bring in that growth round of capital or ultimately that final mezzanine round of capital or even going public. It means you're going to be diluted but it means you're going to have a more valuable number of shares that are in your grant.

Trae: That ties in with what you mentioned earlier about stock options are designed to align everybody and their incentives. You got to keep in mind everybody's getting diluted from the founders to the previous investors that it's all a good thing in general, for the most part.

Ryan: Yes, dilution is only a negative thing if it goes along with a decrease in value of the overall business.

Trae: Right. Aligns everybody to keep building value in the business.

Ryan: That execution and that's very aligned, everybody's aligned to execute together.

Trae: Right.

Ryan: That's great.

Trae: All right, thanks, Ryan. Very informative, very helpful, founders that are watching this, I would just urge you don't assume that your employees understand stock options as well as you or your founding team. They do need a conversation, they do deserve a conversation. Ryan, thanks for a little bit of that conversation today. We'll see you on the next episode.

Ryan: Thanks, Trae, appreciate it.