I’ve had a bunch of questions of late on option packages. Here is what I know on the subject from my direct experience, talking to other experienced entrepreneurs, lawyers, and picking Joe Kraus’ brain. Thanks to Ken Norton and Dave Hodson for their feedback on early versions of this post.

The Basics

While some public companies are moving away from options [1], any job offer from a private startup should include options. Each option represents the right to buy a share in the company at a specific price, called the strike price. You aren’t given options immediately. They are given to you over time, called vesting, thus motivating you to stick around. The frequency and time period over which the options become yours is defined by a vesting schedule.

Once you own an option you can exercise them by paying the strike price to convert the option into common share in the company. If at anytime you leave the company, your vesting stops and you will typically have 30 days during which you can exercise options you own before they are no longer valid. In recent years many startups have begun offering an early exercise option. This allows you to exercise options before they are vested and potentially improve the tax liabilities associated with options. I’ll cover tax implications in detail later. Once you are in a situation where you can sell company stock, you also will have the option to do a same day sale. In this situation you don’t need to provide the option strike price up front because the option is exercised and stock sold all in the same transaction.

There are two types of options: Incentive stock options (ISO’s) and Non-qualified stock options (NQSO or “non-quals”). The first option pool allocated for employees at a startup are typically ISO’s. So earlier employees will receive this type of option. Follow on option allocations usually are NQSO’s but this is dependent on the startup. The main differences between the different type of options is in the tax treatment of the gain associated with the option. I’ll talk about this in a bit.

Vesting Schedules

The most common option vesting schedule is a four year schedule with a one year cliff. Under this schedule you get nothing for the first year, and on the year anniversary (called a cliff), you get 1/4 of the options. After that you receive the remaining options spread equally over the next three years. I have also seen a vesting schedule with four, one year cliffs. In this case, you receive one quarter of the options each year. I’m not a huge fan of this because it can create a situation where an employee is staying longer than they should waiting for the cliff and can create difficult situations for employees let go late in the year. It can also create a magic date when a group of employees all vest together, followed by a mass exodus.

Triggers and Acceleration

A trigger is an event that changes the vesting schedule. Typically a trigger causes an acceleration of the vesting schedule. The most common form of acceleration is full acceleration where all options simply become yours. Under a single trigger your options accelerate if your startup is acquired. A double trigger requires two events for acceleration to occur. Your startup must both be acquired and your role changes significantly (or you are terminated) at the acquiring company. The double trigger is far more common.

Triggers are put in place to protect the employee. You most commonly hear about single triggers applying to founders [2] and double triggers to executive management. It is easy to think of this as yet another excessive executive perk, but it is in fact a reasonable protection. These roles can change the most drastically in an acquisition, and so it not surprising to see this protection more commonly built into their compensation packages.

The downside of widespread triggers at a startup is it increases the effective acquisition price. A large component of most acquisitions are the people. Acquiring companies most often want to retain the employees of the startup they just bought. If all vesting is accelerated on acquisition, the company has to put together retention packages, in addition to the purchase price. On the other hand, if vesting continues as per the schedule, these retention packages are built into the price. This often nets out to a lower acquisition price. It is also not uncommon for triggers to be removed as part of the terms of an acquisition.

Where most triggers are defined as part of your compensation package, I know of acquisitions where acceleration for all employees was negotiated as part of the terms of the sale. For the reasons mentioned above, this is effectively increasing the price of the acquisition.

To me a double trigger of acquisition and termination seem like reasonable protection. Anything beyond this seems to go against the idea of building a company to last. I’m a big fan of startups that have no triggers, from the founders on down. To me this says “I’m around for the long haul.”

Startup Valuation

Even though a startup’s stock is not traded on the open market, it still has theoretical value. A startup has a valuation which is a rough estimate of what it is worth[4]. Once a startup has a valuation, you divide by the number of outstanding shares, and presto! You have a stock price. This price is typically called the fair market value (FMV) of the stock. When you are awarded options, the strike price of the option is set at the current FMV of the stock. Throughout the life of a startup, the valuation will be recalculated, and typically increase and with it the FMV of the stock.

So while the FMV calculation is fairly straight forward, what you would get in the event of an acquisition is a bit trickier. Shares in a private company are typically broken into preferred shares and common shares. Preferred shares are given to investors and these are given preference over common shares. The terms of this preferential treatment depends on the deal the founders made with the investors. In what I have seen, this can vary widely and significantly impact the value of your common shares. (For more see Brad Feld’s post on valuation.)

What kind of package should I get?

“I am employee number __, joining in the role of ________. The option package they offered includes ___________ options. Is this what I should be getting?”

The first thing you should do is ignore the number of options. The number alone is meaningless because the value is based on the number of total outstanding shares. During the bubble a few startups got hip to the fact that employees liked to see large numbers of options and setup companies with a huge number of outstanding shares. I heard of one early stage startup with 300 million outstanding shares (typically an early stage has about 30 million). Seeing 300,000 options in an offer seemed compelling until you (hopefully) did the math.

The second thing you should ignore is any monetary value anybody attempts to assign to these options. For example, a dollar value might be assigned to help “make up for” the lower salary that sometimes comes with startups. A value is assigned by calculating the percentage of the company your shares represent and multiplying by the current company valuation. I strongly disagree with this approach. The fact of the matter is that regardless of any valuation assigned to a private company it isn’t worth anything until it is sold or goes public. So your options are worth $0. Exactly zero dollars until one of these events occurs. Options don’t even make good wallpaper. It is misleading to think of it any other way — don’t let anybody convince you otherwise.

The third thing you should do is figure out if you trust the leadership team giving you this offer. Do you trust all the founders, not just the one you are talking to? I know of a lead engineer joining a startup as the third employee and receiving less than 1% of the company in options and I know of the same role getting 4% joining as the tenth. The point here is there is no “market rate” option package to measure against. If you work hard, and are under compensated in terms of equity, trustworthy leadership teams will make it right in the end.

The one caveat to assigning monetary value to options is you can do a reasonable assessment what you stand to gain in a reasonable exit situation. Find somebody with experience in startups and have them give you an very rough swag of what your company might sell for if it did well. You want an average, reasonable exit — not a crazy best case “You Tube” like jackpot or a worst case “sell the furniture” slow death. Once you have this estimate, ask yourself if this happened after 3-4 years of hard work, how would you feel? This will most likely be disappointing because you are joining the startup with hopes of being the next big thing, but it is a great reality check. Don’t forget to consider preferred shares, as they can impact this outcome.

I wouldn’t spend a lot of time sweating the other option details. Triggers are worth asking about but not fighting for unless other employees at your level are getting them. The board usually sets a policy so they are applied uniformly so it is rarely a point of negotiation if they don’t offer it up front. As I mentioned above, while triggers can seem like good protection, a lot can change during acquisition or IPO. The acquiring company has a lot of power to modify these terms — I have been told of several acquisitions where employees had acceleration negotiated away. Option vesting schedules are defined by the company option plan and so isn’t negotiable on an individual basis. Your strike price is set by company valuation and is not something that can change. Whether you are getting ISO’s or Non-quals is completely dependent on the startup financial structure so this is also non-negotiable.

So on the whole I’m telling you to go with your gut on option packages and to worry more about the trustworthiness of the company you are joining and much less about the actual numbers.

Tax Implications

This is just meant to convey the basics tax liabilities of options. It is not meant to be a detailed tax analysis of options and I by no means am a tax accountant. Proceed with caution.

Once you understand the tax implications of options, you will have a good feel for one way things went horribly wrong for people in the valley when the bubble burst. Exercising options not only costs money, but can also be considered a gain by the IRS and therefore is taxed, even though you can’t actually sell the stock you own [3]. This gain is the difference between strike price of the option and the price of the stock when you exercise the option. Effectively the difference between what you paid and what you would have had to pay if you didn’t have the option.

If you exercise an option before the valuation of the startup has increased relative to your strike price, there is obviously no gain. This is why the early exercise option is such a great employee benefit. It allows you to exercise options while the strike still matches the fair market value of the stock and not take on any immediate tax liability.

As I mentioned earlier, when there is a difference between the strike price and FMV, the IRS considers it a gain when you exercise the option. How you account for that gain depends on whether it is a incentive stock option (ISO) or a non qualified stock option (NQSO).

In 1969 congress realized there were tax loopholes which allowed the wealthy to escape paying most taxes. Instead of actually fixing the problem they came up with this fun new addition to the tax code called the Alternative Minimum tax or AMT. Think of this as a second complicated way to calculate the tax you owe. So you calculate tax the normal way and the AMT way and pay the higher of the two.

ISO’s have the advantage that the gain associated with the exercise is not recognized as income. That being said, it can be subject to AMT tax. Depending on your tax situation, this can be good or bad. If your ISO gains aren’t enough to qualify for AMT taxes, than you effectively don’t pay taxes on ISO option gains. On the other hand, if you are subject to AMT gains, your taxes just got more complicated. Exercising NQSO’s on the other hand is an immediate taxable event — you typically will pay the taxes at the same time you exercise the option. This is how many people lost more than just the option exercise price in the the bust. They exercised options and held stock in their startup, generating large tax gains (and therefore tax bills). When the startups tanked, they had paid a huge tax bill but never actually realized any gains. This is why tax gains associated with options have been coined “phantom gains.”

So what is the key take-away from all this boring tax discussion?

1. Ask about and use the early exercise option if you can afford to take on the risk of owning stock in your startup
2. Do not exercise options and hold stock if it means taking on large tax liabilities. It isn’t worth the risk.
3. Hire a tax accountant before you exercise any options

Additional Reading

Brad Feld (VC out of Boulder) has some good posts on how to understand the share structure of a startup:

• Venture Capital Deal Algebra
• Liquidation Preferences
• To Participate or Not (Participating Preferences)

Tim Wolters talks about anti-dilution clauses (a topic I don’t cover):

• Beyond Dante: Term Sheet Terms: anti-dilution clauses

Ask the VC discusses equity terms:

• Equity Compensation Terms

Terms

acceleration - an increase in the rate of vesting, 100% or full acceleration means your entire option package vests all at once

cliff - option vesting often has an initial blackout period. The cliff is the end of this period.

double trigger - acceleration on acquisition and change of role/termination

early exercise option - a feature of some option plans which allow the employee to exercise options before they vest

exercising options - you pay your option strike price, they give you a share in return

fair market value - the current stock price (FMV)

Incentive Stock Option (ISO) - type of option where gains realized when exercising are charged against AMT tax

liquidity event - an acquisition, IPO, or other situation which allows an employee to sell stock

Non-Qualified Stock Options (NQSO, “Non-qual”) - type of option where gains realized when exercising are taxed under normal income tax

reverse vesting - equivalent to early exercise option (see above)
single trigger - acceleration on acquisition

strike price - how much you pay for a share

trigger - an event that causes acceleration

valuation - estimation of the value of a startup

vesting - the process and schedule by which options become yours

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[1] Much of the move away from options has to do with how they are expensed on the balance sheet of the granting company. I think Warren Buffet said it best in his book The Essays of Warren Buffett : Lessons for Corporate America,

“It seems to me that the realities of stock options can be summarized quite simply: If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where should they go?”

I have heard some companies argue that they can’t expense options because it would make their reporting look different in comparison to those who don’t. This is akin to arguing that you had to cheat on the math test because everybody else was cheating and your score would look bad in comparison if you didn’t.

[2] Founders typically vest common shares, not options. More on that in a later post.

[3] There are situations where the company will buy back shares from you. During the bust, this was not true.

[4] Very fancy spreadsheets are assembled to derive a valuation. These spreadsheets are waved around to prove the valuation was not just a guess, when in fact, it was exactly that. Anybody who tells you otherwise took business school way too seriously.