More Things You Don’t Know About Stock Options

I’ve generally found that every time I have dealt with stock options I’ve learned something new, and usually in somewhat painful ways.  It’s one of the few areas where I actually hope I’ll someday understand every aspect and stop learning, but changes to how options are handled and complicated (and changing) tax laws promise to make stock options a topic that will never be mastered.

In my most recent experiences, I learned a few things that I don’t seem to be common knowledge, even by many people that have been in the stock option rodeo for a long time.

Companies Can Outlive Their Stock Plans

The stock options granted to employees, directors, advisors, or other parties are done so pursuant to a stock plan that is typically created around the time of incorporation.  When one receives an option grant, the grant will reference the stock plan and a copy of the plan should be made available to the recipient of the grant.  These stock plans have a lifetime, with 10 years being pretty common, and the ability to exercise options typically expires with the stock plan.

And for what I’m guessing is more than 99% of Silicon Valley companies, the 10 year life of the stock plan is irrelevant because, within 10 years the company most likely fails or has a major restructuring of the cap table (making the options worthless), gets acquired, or goes public (resulting in some conversion or liquidity of the options).  In almost every case the stock options either get flushed down the toilet or become liquid within 10 years.  But, there is a less common scenario… a company substantially increases in value and remains private and independent, celebrating 10 years and outliving the initial stock plan.

In this situation, most people granted options under the original stock plan need to exercise or forfeit their stock (there is typically a way to handle current employees as a new plan is adopted).  And, that’s the big gotcha.  When granted stock options, a lot of people will chose to not exercise their options until there is a liquidity event, so they don’t risk any up-front expense and only purchase when they can immediately sell the stock for the gains (this strategy eliminates up-front risk, trading for a less favorable tax liability later, assuming the company doesn’t fail).

So let’s put some numbers behind this… Ned joins the advisory board of a startup company during the seed round and gets 100,000 options valued at $0.01 (one cent) each, so Ned can purchase these 100,000 shares for a total of $1,000, but doesn’t do so at the time of the grant.  Against all odds, the startup does well, survives 10 years without a liquidity event and the shares are now worth $1.25 each – 125x return!  Ned gets a call and is told that the stock plan is about to expire and he must exercise his options or lose the grant.  The good news is, $1000 to get $125,000 in stock is a pretty good deal.  However, that purchase is going to be a taxable short-term gain of $124,000 (10% – 39.6%, depending on Ned’s total taxable income, so up to $49,104 to be paid in taxes).  But, the company is still private so there is not necessarily a market where Ned can get liquidity, so in rough numbers Ned just spent $50,000 in cash to buy $125,000 in stock that can’t be sold – that doesn’t sound all that bad, but there are a lot of factors that prevent it from being an easy decision.  Another big rub for many is, instead of the company getting the money from the stock purchase, it goes to the government.

While there are plenty of stock option scenarios that present a similar dilemma,  the stock plan end-of-life scenario is unique in the lack of flexibility – even if the company and grant holder want to find a solution, there isn’t a clean way to update paperwork or give extensions for exercising at the end of the stock plan’s life.

There is a very easy way to avoid this early on… if Ned exercised when he received the grant, he would have paid $1,000, the fair market value for the stock, with no tax consequence, and 10 years later he would already own that stock, now worth $125,000 (but still not liquid).

My best advice (worth everything you just paid for it, so consult a lawyer or tax expert before following it) is to exercise as early as possible, especially in a startup where the stock barely has value.  Your time is the most valuable thing you have, so if you’re willing to bet on the startup by investing your time, you should be willing to bet some cash, too.

Most Job Seekers Don’t do the Math

At this point in my life I’ve overseen more than a thousand job offers, and one aspect that surprises me is how frequently prospective employees don’t ask for the information necessary to understand the value of the stock options offered as part of their compensation package (sometimes as a very material component of that package).  I’ve had conversations where job seekers told me another company offered them twice as many options as I was offering (seeking more from my offer), but they didn’t know the total options in either company or recent valuations, so they didn’t understand the percentage of ownership (if you’re offered 1 share of Berkshire Hathaway or 1000 shares of Apple, you’ll make $117,000 more taking the Berkshire Hathaway).  Seeing so many people not doing this math has lead me to joke that my next company will start with one trillion shares of stock so that I can offer more stock than every other company.

Employees not understanding this component of their compensation creates an interesting challenge for an employer… I believe companies should help employees understand the value of stock options and the various nuances of how options work.  However, I also believe that it wastes a limited resource to provide stock options when an employee doesn’t value them.  I like everybody to have a stake in the outcome of the company, but options should be weighted so they are the most valuable to the recipient, and other forms of compensation should be used when options are not valued.

If you’re interested in the details about understanding stock option compensation and what questions to ask when comparing offers, there are some detailed guides I reference below.

Small Business Stock Capital Gains Exclusion

Another (very pleasant) surprise I learned about was Section 1202,  which excludes from gross income at least 50% of the gain recognized on the sale or exchange of qualified small business stock (QSBS) that is held more than five years.  The latest amendment to Section 1202 provides for 100% of any capital gain (up to $10 million) to be excluded if the small business stock was acquired after September 27, 2010.

Section 1202 is surprisingly not well known – four Bay Area tax advisors I contacted were unaware of it when I referenced it.  Fortunately it was mentioned in Piaw Na’s book, An Engineer’s Guide to Silicon Valley Startups, where the talented and helpful Chad Austin discovered it and shared the knowledge.

I won’t go into details, but if you sell startup stock that you held for 5 years, this can be a material tax savings for you.  This is yet another reason to exercise early, since you need to hold the stock, not the options.

Great Resources for Learning About Stock Options

If you’re looking for a comprehensive overview of stock options – I suggest the very excellent Introduction to Stock & Options by David Weekly, or the also very excellent The Open Guide to Equity Compensation by Joshua Levy and Joe Wallin.



Did I get it wrong?  Is there another stock option gotcha that I missed?  Please leave a comment!

In Defense of Not Doing a Startup

Recently (and quite accidentally) I talked an entrepreneur into abandoning his year-old startup.  That wasn’t my intention – we had planned an hour long meeting where I was acting in an advisory role on the product and pitch deck, but the meeting ended up taking over three hours and getting to a very hard question, “why do you want to do this?”

The pivotal moment in our discussion was when it became clear to me that the CEO saw the company as a way of obtaining some short term financial success, and that the startup demands were unlikely to be compatible with what he expressed and being important to him for his personal success.  After walking through the various likely outcomes and startup life expectations, he recognized there were better ways to achieve the personal success he wanted.  The discussion was tough – it’s hard to confront letting go of a dream, especially after sacrificing a year of sweat equity, but as we concluded our discussion he shared that he felt a great sense of relief.

All Hail the Startup

In most of the news and feeds I follow the startup is celebrated, almost so much that it can feel like the act of creating or being a startup is disproportionately more important than the significance of achieving a successful business.  More importantly, the glorification of startup life can lead people to feel discontent with a career path that may actually be far better for delivering personal satisfaction.

Startup Cheerleaders

For the most part we recognize and celebrate successful startups, and with the exception of the startups that have a prominent rise and fall, the majority of startups that exist, struggle and fail are below the radar.  It’s pretty easy to read industry news and think everybody with a startup is on the fast track to a win.

There are also several blogs and speakers working as cheerleaders for those that would take the risks to change the world.  Most respected in this group are serial entrepreneurs that have had the good fortune to have a successful exit from a previous startup, which becomes a shining example that success is possible, and the reason they continue the startup path.  These thought leaders are great for inspiration, but it is also good to have the context that the previously-successful entrepreneur risk is substantially different than the new entrepreneur, both in terms of their chance of success on their next startup, and the likelihood that they are risking a small fraction of their wealth.  If you are new to starting a company, you are likely “all in”.

A Startup is Not a Reliable Path to Wealth

It is easy to look around at the stories of the startup millionaires (or even better, billionaires) and think that starting a company is a good way to ensure a retirement in your twenties.  If the ability to retire is your goal, you’re probably better off working at established companies.  If your goal is to retire with a billion dollars then yes, a startup (or lottery ticket) provides that opportunity, with very slim odds.  Looking at my contact list, almost all of the people that are financially well-off got that way by joining companies well past the startup phase.  However, my very few contacts with obscene amounts of f-you money did obtain it from being very early at companies with large liquidity events.

As an example, one friend easily ranks in the top 5 engineers I’ve encountered in my career and any company would want him as the technical founder.  After four years of doing the startup grind of 60-hour weeks, he ended up with a lot of great experience and a bunch of stock that was worth pennies.  He made the decision to join a very large, more well-established company and forgo the dream of vast riches for continued technical growth and reasonable work-life balance.  What he didn’t understand at the time, but told me later, was how much a big company would pay for good technical talent.  For people of his caliber the total compensation is well over a million dollars a year and as a result he has a reliable path to retirement in his early forties.  His story isn’t the glamorized Silicon Valley success… you won’t see him featured in a PR-driven TechCrunch article, but you might see him enjoying life on a beach with his family.

In contrast, another friend lived the entrepreneurial startup life for 15 years, is well-known and highly regarded in the startup community (yes, you know his name), and most people assume he’s achieved financial success as a result.  Two years ago he had a company that came very close to being favorably acquired, but the acquisition fell through.  The company was later dissolved and over a dinner one evening he expressed the frustration of being in his mid-thirties, driving a 15-year old car and not being able to afford a house.  He has since joined a large Internet company, owns a house and is even able to comfortably support two children and some relatively expensive hobbies.

But wait, Brett… so you have a few friends that did better taking a traditional career path, but I see all of these Silicon Valley 20-something millionaires all over the Interwebs… what makes you think that won’t be me?

It might be you, and I am sincerely happy for anybody that is able to achieve financial success by building a company.  Let’s look at the (extremely general and simplified) math to see expected outcomes…

Some Quick Startup Lottery Math

To make things simple, we’ll assume your startup is just you and a single co-founder, so you each have 50% of a company.  And using this Quora response as reference for founder equity, after completing your Series B, you and your founder share 40%, making your ownership 20%.  The average price of successful liquidity is hard to assess (many sources suffer from survivorship bias, excluding many failed startups) but $30M at Series B would probably be considered generous (there are many examples way higher, far more examples way lower).  A $6M piece of that pie is pretty appealing.  Now we adjust for the risk… again, 90% startup failure rate is generous, especially considering Y Combinator companies representing the hand-picked cream of the crop fail at 93%.  Risk adjusted, you’re now looking at $600K as your upside, so assuming you’re able to go from zero to liquidity in three years, it’s $200K per year (of course this is on top of your well-below-market startup salary).  That doesn’t sound too bad except when you remember, you have a 90% chance of ending-up with only your well-below-market startup salary and your chair.  Again, these are generous assumptions and there are plenty of examples of successful acquisitions in the hundreds of millions where founders received substantially smaller percentages of the purchase price.

Google Director Salaries

And let’s compare that to the alternative, joining a large Silicon Valley company…  It’s fuzzy math, but I’m going to assume that the person that is capable of leading a startup with the generous odds in their favor also has the experience to get a good leadership role at one of the big companies.  According to Glassdoor, the average Director at Google has a base salary of $247K and total compensation of $399K (on a side note, most colleagues I talked to believe the Glassdoor compensation is extremely inaccurate based on first-hand observations, and Directors are frequently making 2-4x what is presented).  Using the same 3-year time frame we assumed would get to liquidity at the startup, the expected outcome is closer to $1.2M.  There are a ton of arguments to adjust these assumptions, but none are going to change the lottery-ticket nature of achieving big liquidity from a startup.

So yeah, the odds of financial success may be working against me, but what about getting to experience the glamorous life of a startup founder out to change the world?

Startups Overshadow your Personal Life

For everybody that asks me what it is like to run a startup, I tell them to read The Struggle, by Ben Horowitz.  I first read The Struggle as part of Ben’s book, The Hard Thing About Hard Things, and I immediately handed the chapter to my wife and said, “you always ask what it’s like to run a company… it’s this!”

A day in the life of a startup founder

A startup is a significant commitment and your business is typically dealing with an environment of extreme uncertainty; startups are either creating something new or believe they can do something better than an established business.  In this environment, and typically with limited resources, working longer and harder provides more opportunities to eliminate the uncertainty.  Assume working nights and weekends are sort of a regular necessity.

And as a leader in a startup, you will always have another challenge or problem driving head-on towards you.  The world owes you nothing, plenty of other companies are fighting hard to take the market that you need to succeed, and the odds of survival are very much not in your favor.  This means business will almost always be imposing on your mind share that you would normally dedicate to things like dinner, sleep, exercising, vacation, relationships, family time, and bathing (assuming you are able to work any of these into your startup life).  Your startup will permeate all aspects of your life.

Finally, there is the emotional toll of a startup.  The successes feel amazing, but they are typically few and far between the challenges and setbacks.  Failure is the expected outcome, and each failure wears you down a little bit, creating uncertainty and making you second guess your capabilities and fitness as a startup leader.  You feel the weight not just for yourself, but for the people that follow you, also making the sacrifices.  And, if you’re unlucky enough to be the CEO, you’re in the lonely position where there is almost nobody you can share your struggles with… you can’t push things down into the company and frequently the board above you is a bad choice as a counselor for issues of personal uncertainty.    

After writing all of this out, I am beginning to understand how I accidentally talked somebody out of their startup.

But… There are Many Great Reasons

I don’t hate startups.  All of my career I have either created startups or joined them at or near founding, and I expect to do it again.  I would hate to feel responsible for taking passionate entrepreneurs and shuffling them into beige and gray office spaces in corporate America.  If you understand the likely financial outcome, and you are in a place where your personal life can sustain the needs of a startup, and you are emotionally prepared for the struggle, there are great reasons to do a startup.

If you are early in your career, the economics and life impact may make more sense.  Your ability to get a job at one of the big name companies may be more difficult, and if you do you’re probably looking at the lower end of the salary spectrum.  The difference between your startup pay may not be that significant in your day-to-day life (especially if you are fine eating rats and ramen).

Startups are also a great way to learn before you earn.  Large companies have established processes and roles that have been optimized for business performance, you are less likely to get a breadth of experience or have an emphasis on innovation.  Startups frequently require everybody to have multiple roles and find innovative solutions to problems.  Learning how to deliver results with limited resources in environments with great uncertainty is a skill that will be valuable for a lifetime.

Working at a startup (even a failed one) can also often allow faster career progression than just joining a big company out of college and following the typical path of advancement.  As an example, a Software Engineer (SWE) hired right out of school at Google would be an L3.  Assuming about 3 years for each promotion, it’s 15 years until Director, L8.  If you’ve proven yourself and established solid startup experience, five years later you might be L6 material (your mileage might vary).

The Best Reason

I believe the best reason for doing a startup in the burning need to build something you are passionate about, and an organization like an established company or non-profit isn’t the best way to create it.  Maybe your passion is a product or maybe it’s a culture, but it keeps you up at night and every time you return to the idea you become more passionate about making it real.  It’s an idea you think it would be so meaningful that you would find the journey of pursuing it to be hugely rewarding.  You’re not thinking about the exit, you’re thinking about the satisfaction that comes from building the thing that drives your passion.

Do it.  Build it.  Make it happen.


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