If you've worked for a startup or founded one, then you must have heard of employee
stock options- but I have found a lot of people, both employees and founders,
that just don't get how they work. So much so that 55% of startup employees in the US
never exercise their stock options- which breaks my heart as a founder.
Wich breaks my heart as a funder because of the sacrifice that we funders make to give them the stock and we have to negotiate with investors and everything
Just like any legal startup document, this sounds like it's made deliberately complicated just to
mess with you, but it's not. It's just that dealing with company shares isn't easy, from the legal standing point.
But that's what our 101 series is here for.
Ok, so in case you are totally new to this,
it is customary for startups to offer a stock option pool to crucial employees and hires.
Now many people think these are actual company shares,
and they are not, so let's start by clarifying that.
When founders establish the company, they incorporate it, define a number of shares,
and split it. How many shares each founder gets determines the percentage of the company they own.
For example, if a founder gets 500,000 shares, and the entire company
was registered with 1,000,000 shares, they are getting 50% of the company.
The number of shares they get rarely changes; they don't exchange hands. When investors join,
what happens is new shares get issued. So the 500,000 shares of stock represent
a smaller percentage of the entire company, but that founder still has 500,000 shares.
Now when the company gets established, when you register your corporation
shares are worth nothing. Since the business doesn't really exist, there's no revenue, no IP, then each share is probably
worth as little as fractions of a cent of a dollar, so there are no tax implications in you receiving those shares from this business
The moment a company raises capital,
shares acquire value. Let's say this company raises a $1,000,000 Seed Round in exchange for 20%
of the company. That means that 250,000 new shares get issued for the investor, and the
entire company is officially worth $5,000,000, which means the price per share is now $4.
(We have a more thorough video on this breakdown, I'll link that in the description). The point is,
that's $2,000,000 in value for those shares that the founder owns.
Now, when employee stock option pools are created, a new set of shares gets issued. Again,
shares don't exchange hands; the the company just issues new shares that are going to be used for these pools.
But those shares have value. If the company hired an employee and offered, say, 10,000 shares as
their stock option plan, the effective value of those shares today is $40,000. $4 per share.
In the US, you just can't give someone $40,000 worth of anything and not have
a tax implication. If the company gave the employee those shares,
that would be a taxable income. Moreover, while that is an official investor-verified valuation,
we all know that startups fail, so you'd be paining taxes regardless of the company's fate.
That's why employee stock doesn't work like that. Instead, employees are given
stock options. Stock options are the option to purchase shares of stock at a fixed strike price.
So what the company does is offer the employee the option to buy 10,000 shares at $4 share,
which is the current, fair market value of the share, according to the latest company valuation.
The employee doesn't own any shares, mind you; they just have the option to purchase them.
at a fixed $4 price, regardless of what happened to the company
Let's say that in the future, that company gets acquired. The buyer decides to acquire
the company for $50,000,000, which means they are paying $40 per share.
I'm over super buying a huge journey of multiple rounds of funding, etc. But just kipping simple.
This is where stock options are really exciting. This employee now has the possibility to buy
10,000 shares at $4 a share and then sell them to the buyer for the $40 he's offering,
leaving them with a $36 profit per share- or in this case, $360,000.
This is key about stock options: they are only worth it if the company
increases in value after you receive them. That's why they are such a fantastic incentive
for employees, and with a clever system that doesn't create a tax liability.
Now here's a challenge: stock options can expire. Most plans have an expiration date of 10 years
and also expire if the employee leaves the company. Employees usually have 30-90 days
to decide if they want to exercise (that is, buy) the stock options after they leave.
So let me give you a very real-world scenario. In 2017 Uber had become one of
the most valuable private companies in existence. Estimations ran at around $120 Billion dollars
based on their last actual investor evaluation
So let's take a scenario of an employee that wanted to quit the company. Say they had 0.01%
of the company in stock options and that they were
issued a few years back when the company was valued at $1B.
So the strike price to purchase that stock option package was $100,000. With Uber's
massive fundraising rounds and valuation increase, those shares were now worth $1.2M! So clearly,
you do not want to walk out of that. Stock options can genuinely be life-changing money
for an employee as close that can get to be a funder
The problem was that Uber wasn't planning on going public yet. That meant that the
employee would have to buy the stock and hold it until the company was either sold or became
traded publicly. Few people have $100,000 lying around.
Cases like this sparked companies like EquityBee to launch their financing service.
They essentially provide funding for employees looking to exercise their stock options from
private companies. They do it by raising funding from investors on their platform
looking to benefit from the potential increase in stock value. In return,
the employee pays a % of the stock value in the event of an IPO or acquisition.
If the company doesn't succeed, the employee doesn't pay back anything.
If you own stock options from a private company then EquityBee is a fantastic
option to fund your stock options so that you don’t lose them.
The fact that you only pay if the stock options
actually increase in value, I believe, is a fantastic approach to this.
While the Uber story is real, it's quite an extreme case. This happens often:
the employee has a good stock option grant, wants to leave the company they helped build,
but doesn't have the money to exercise the options.
Now, another rule I often get asked about is Vesting.
Founder shares, as well as employee stock options, often have a vesting period.
For stock options specifically, vesting means that the employee will only acquire the right to a
certain amount of shares in the pool after working for a certain amount of time for the company.
Access to the purchase, not access to shares
A common vesting structure is four years. On a 10,000 share pool, this means that each month
the employee would get access to around 208 stock options. This adds up to 10,000 after 48 months.
Another common rule is a cliff, which requires a minimum amount of time
working for the company. The vesting agreement my
co-founders and I used was exactly this one: a year cliff on four-year vesting.
Using the 10,000 share example, this means by month 11, you have earned 0
shares. On month 12, you get your first batch of 2,500 shares- and after that, you vest monthly,
208 shares per month.
Vesting protects the company from an employee leaving early and back to stock options; remember
this one thing, value is tied to the value that you manage to add to the business with your work.
If the business doesn't increase in value then stock options are really good for aim.
Let us know in the comments if you have any questions; I'll try to get to all of them.
Thanks to the guys from EquityBee for sponsoring
this video. Go check their website in the link below.
By the way, later this month, I'll be flying to Bangalore to shoot a documentary on the
local startup scene, so hit me up on Twitter if you know anyone I should connect with.
Thanks guys for watching we'll see you next week.