
An Engineer’s guide to Stock Options - olivercameron
http://blog.alexmaccaw.com/an-engineers-guide-to-stock-options
======
grellas
Really nice write-up explaining stock options. A few added thoughts sparked by
some of the comments already made in this thread and otherwise:

1\. The value of options is inextricably linked to tax and you need to
understand the tax basics in evaluating the economic risks and benefits of
holding and exercising any kind of option. With NQOs, you are taxed on the
spread as ordinary income on the date of exercise (meaning, on the difference
between what the stock is worth and what you pay to exercise). With ISOs, the
value of the spread becomes subject to AMT and you can wind up paying large
taxes that way in spite of the supposed tax benefits of ISOs. The way to avoid
having a large spread subjecting you to such tax risks is to exercise as early
as possible before the company value goes up much but you then need to take
the economic risk associated with having to pay hard cash for stock whose
long-term value is highly uncertain. Moreover, early exercise is not possible
if your options haven't vested unless you specifically get an early exercise
privilege as part of your grant. With an early exercise privilege, and
particularly if the grant is made for a bargain price, you can early-exercise,
file an 83(b), and (as long as you hold the stock for at least 2 years) get
the equivalent of a restricted stock grant by which you pay no further tax
until you eventually sell the stock at a liquidation event. In that case, you
are also taxed at the lower long-term capital gains rates. Of course, in the
early-exercise scenario, you do not get to bypass vesting and your shares
remain subject to their original vesting requirements and can thus be
forfeited in whole or in part if those requirements are not met. But early
exercise does provide an elegant solution to most of the tax risks associated
with options provided you are willing to assume the economic risks of paying
for the stock up front.

2\. Other than the early-exercise scenario, 83(b) elections are not required
for option grants. Under 83(a) of the Internal Revenue Code, any service
provider who gets property in exchange for services is taxed at ordinary
income rates on the value of the property received. For example, if you do
work for a startup and are paid in stock when you complete the deliverable,
you are taxed on the value of the stock received. You are taxed on the value
of that stock as it exists as of the date you receive it in payment for such
services. So, if you do development work tied to a milestone, and you meet
that milestone, and you get 100,000 shares for the work, you would be taxed
on, say, the $1.00/sh that the stock is worth on the day six months or a year
(or whatever) out when the milestone is met, and not on the $.01/sh that it
was worth when the contract terms began. In contrast to this performance-based
form of incentive, let us say that you get a time-based incentive by which you
buy the stock up front for a nominal price but you must earn it out over time.
With such a time-based performance incentive, which is what is called
"restricted stock", you own the stock up front and you pay no tax at the time
of purchase in the normal case where the amount you pay for it equals its fair
value on the date of the grant. Because the stock must be earned out as part
of a continuing service relationship, and is hence subject to a "substantial
risk of forfeiture", there is a very important technical question under
section 83(a) on what the date is on which you are deemed to have received the
stock in exchange for your services. Well, the default rule under 83(a) is
that you receive it on the date it is no longer subject to a substantial risk
of forfeiture and that then becomes the relevant date on which the value of
the stock is measured for purpose of computing the taxable service income on
which you must pay tax. So, if you get your 100,000 share grant at $.01/sh,
and you pay $.01 share, you pay no tax at inception. But, as that grant vests
at, say, a monthly ratable rate over four years, the IRS treats you as having
received 48 separate grants (one each month) over the four-year period. Thus,
at each vesting point, you are treated as having received property in exchange
for services under 83(a) and you pay tax on the difference between the value
of the property received and what you paid for it. If you paid $.01 per share,
and if the stock is worth $1.00 at a given vesting point, you realize $.99
worth of taxable income per share. In a venture whose value is rising quickly,
in the absence of any saving mechanism, you might have as many as 48 separate
tax hits (basically, having to pay tax on the difference between what you paid
for your grant and the 409A valuation price placed on the common) just for the
privilege of holding a piece of paper that may or may not ever have an
ultimate cash value of any type. It is in this type of scenario, and only
here, that 83(b) comes into play by providing that, in lieu of having to
suffer under the default rule of 83(a), you can elect to pay all taxes up
front on the grant and not be subjected to the often onerous workings of the
default rule. This means that, for an 83(b) election even to be relevant, you
must first _own_ your stock (or other property) and that stock or property
must be subject to a substantial risk of forfeiture. If you hold only an
unexercised option, you do not yet own the stock and it is not subject to
forfeiture (hence, 83(b) is not relevant). If you do an early exercise,
though, and get stock under terms where it must still vest out and can be
forfeited, then 83(b) does apply. But that is the only case normally where it
becomes relevant at all to options.

3\. Options really shine when they wind up on a level playing field with the
preferred stock and they tend to dim commensurately to the extent they do not.
Optimum case is IPO when all stock is (typically) forced to convert to common
prior to the public offering and, thus, all shares participate equally in the
benefits. This can happen too in big-scale M&A exits but a drop-off occurs on
lesser ones in at least two ways: (a) where the total acquisition price is
largely gobbled up by the liquidation preferences and/or management incentive
plans; (b) where an acqui-hire occurs in which a few founders get a
disproportionate share of the total value through employment arrangements made
on the other side of the deal.

4\. Given all of the above, and given that IPOs remain at far below the old
bubble levels in frequency, it can be risky to lay out any excessive cash to
exercise at any time before a liquidity event. Too many things can happen by
which a seeming "sure thing" winds up evaporating before your very eyes,
leaving you with no more than a pretty lousy capital loss that you get the
privilege of deducting at the rate of no more than $3,000 per year unless you
can find other capital gains to offset it against.

5\. The 90-day tail for exercise upon termination of a service relationship
applies only to ISOs and not to NQOs but, of course, ISOs have other
advantages and they are what is typically offered in VC-backed ventures. In
other types of ventures, where the company value is already somewhat high at
the time of grant, I have seen executives bargain for and get NQOs with long
exercise periods following termination just to have the flexibility to leave
the venture if needed without being forced to forfeit the options.

6\. In light of all of the above, having to pay an angel backer 25 or 30% of
your gains to provide you with a risk-free exercise in an otherwise high-risk
situation may be worth it even though the cost seems high on its face. It is a
matter of preserving some decent part of your potential upside while giving up
the rest to make the upside potential even a possibility for you given the tax
risks involved. If IPOs come back strong some day, then you may be giving up
too much at such a cost because they are the great leveler when it comes to
weighing the value of options against other forms of equity holdings. Until
that day comes, however, options remain a valuable but relatively high-risk
way of deriving value from a startup if you need to part with any significant
cash (either for the purchase or for the associate tax) for the privilege of
hoping to profit from a startup. Again, for those who need to weigh their
choices, this piece provides great insights and stands head and shoulders
above the typical discussion of such issues. Great work by the author in
making an otherwise dry and even formidable subject pretty accessible.

~~~
philjr
This is great information and I too would consider long and hard before laying
out significant sums of cash early on. You're completely subject to market
risk and you've just handed over some of your own money. Everyone's appetite
for risk here is different...

That being said, my own personal opinion is, if you're in early enough that
options are on the table, you've basically taken a bet on the company anyway
and you're probably already sacrificing salary for equity. I wouldn't go
mortgaging the house to purchase your options, but it's unlikely that's
necessary and if you're seeing strike prices of under a couple of dollars per
share, then you're probably talking about very affordable options.

In Ireland, the main tax differential is income tax (effective rate of 52%) or
CGT (@30%). I didn't pay enough attention to this, so word to the wise of
anyone going through this. Go talk to someone now, not when your company is
IPO'ing.

Some interesting tidbits here from an Irish perspective which probably applies
to lots of other non-US countries on options in US companies:

* Pre-IPO, the fair market value of the share is calculated and reported to the revenue commissioner along with an FX (USD -> EUR) rate set by the ECB. Talk to your finance/accounts dept. who are obliged to report this periodically. This fair market value determines the amount of tax you pay.

* The difference between the fair market value of the share and the strike price is essentially counted as income (not BIK, not CGI) when you exercise. In a lot of cases (Facebook, Twitter, Google, LinkedIn, Workday) the fair market value of the share was substantially less pre-IPO (12 months, 24 months) than post-IPO. That means exercising early in most of these situations would have been to your advantage if you were at these companies. Be aware you're completely subject to market risk here.

* Once you exercise the options and own the stock, then increases are subject to capital gains. An example here might be if the strike price on your options is $1, the fair market value is $2 & your company IPOs at some point in the future at $10. If you purchased options at the earlier milestone with a fair market value of $2 and sold at IPO, you'd pay 52% tax on $1 ($2 - $1) and CGT (30%) on $8 ($10 - $2). If you purchased at IPO and sold immediately, you'd pay income tax on $9 ($10 - $1). However, you need to actually hand over cash to exercise options and pay the tax, so be very aware that this is essentially now an investment.

* FX (USD/EUR) fluctuations can be just as important as stock fluctuations. Make sure you take that in to account. Right now, for example, this isn't quite in your favour, with the USD to EUR rate at high 1.35's/1.37's lately. Look at the currency history. You have options to sell and hold your money in USD (banks in Europe will typically open you a USD account) in which case you can hold until you believe the FX rate comes in line with what you expect. Again, you are subject to market risk here (your investments may go up as well as down!). In Ireland, gains via FX like this are also subject to CGT.

I'm not a tax advisor, but what I hope I'm convincing most people here is that
if you do think you just hopped on a rocket ship (a Twitter, Google, Facebook)
and you're a non-US resident with a reasonably significant amount of options
(1,000+), I'd go talk with a tax consultant immediately and consider at least
purchasing some of your options up-front if you've got cash that you're
willing to bet with.

We've had a number of high profile IPO's here in Dublin recently (LinkedIn,
Facebook, Workday & Twitter) so hopefully this convinces someone who jumps on
the next one to go talk to a tax advisor.

~~~
Kudos
Thanks for this, didn't expect to get advice for someone working in Ireland
with options in a US company in the comments.

~~~
philjr
Just be aware I completely oversimplified the tax calculations here :-)

Happy to pass on details in Dublin for some folks I got advice from. I'll
stick my email in my profile

------
JshWright

      I like thinking about shares as a virtual currency.
      Shareholders are speculating on that currency, and
      the company is trying to increase its value. Companies
      can inflate or deflate this currency depending on
      their performance, perceived potential or by issuing
      new shares.
    

I consider myself a fairly smart person, who had a reasonable grasp on the
basics of financial markets, currencies, etc. That simple paragraph just
triggered a huge light bulb moment for me. It's suddenly a lot easier to
reason about stocks, etc, than it was 5 minutes ago...

~~~
AsymetricCom
We should start a thread about how ignorant you were before this awesome
guide. I'm sure we can talk about all sorts of stupid things people believe
while managing to learn nothing beyond the scope of the very basic article.

~~~
JshWright
Apparently I've triggered some deep seated angst... Let me try to clarify what
I meant, and maybe you'll feel better?

This post didn't present any new 'facts' for me. I was already aware of all
the details he explained (and most, but not all, of the implications of those
details). My point was simply that by framing shares as currency presented
them in a way that I had never considered before, and that comparison caused a
number of other things to 'click.'

My apologies if my learning offended you...

~~~
AsymetricCom
Not at all, now that I've learned about your learning, we can all discuss how
happy that makes us feel. It's a win-win.

Wait, maybe if there was a higher context to share our approval of the article
without distracting away from its content? Like some kind of high-level rating
system that was enforced through a framework of some sort and presented as a
low-friction indicator of the quality of the article? We could even improve it
by presenting the highest quality articles above the fold.

Of course then content that appealed to the lowest common denominator would
become the most approved, and people could congregate around shared
understanding and beliefs, further cementing those ideas as the "right ideas".

Only if there were some social rules that would prevent this "circle jerking"
behavior that causes forums to devolve into roaming bands of up-vote brigades.
We could start by not "circle jerking" about the quality of the article, we
could probably go a long way toward reducing congratulatory posts that
celebrate elementary-level understanding of economic systems, and in turn,
encourage feel good comments that are up-voted because people agree with them
instead of them actually contributing anything.

~~~
JshWright
It seems I'm woefully ignorant in the ways of online forum posting...

I had assumed that excerpting a specific portion of TFA and highlighting why I
found it particularly insightful would have been germane to the conversation
thread.

If only there was a way you could have expressed your opinion that my comment
didn't add anything to the conversation without resorting to sarcasm and
obtuse rhetoric... (Unless you haven't crossed the 'able to down-vote
threshold yet... in which case, no worries).

------
nwatson
I've "pre-exercised" before, with a meaning different from what's depicted
here in the article.

In the "pre-exercise", I was able to exercise the stock before I'd vested in
it, with the understanding, of course, that the company would buy back my
unvested shares at the exercise price if I left the company before vesting all
the options.

The disadvantage, of course, is that you pay for your stock up front, and will
lose all or most of the money if the company doesn't pan out.

There are several advantages ...

Advantage: the price you exercise at is near the fair-market value of the
Common Shares you purchase (and haven't yet vested in), so there's no
immediate gain and so no immediate short-term gain tax consequences. You need
to make sure to file an 83(b) form so you're telling the IRS you're paying
your $0 tax up front, rather than monthly as your stock vests. (The
disadvantage with the latter is that the difference between what you paid and
what your stock is worth as it vests could be huge, and there's no way to
liquidate your stock to pay that tax.) (There's also something about AMT in
here, I'm kind of fuzzy, but I think consequences can be the same.)

Advantage: your long-term capital gains clock starts ticking the day you buy
the stock, even though you bought before any of it vested. When, three years
down the road, you can liquidate your stock in that acquisition or IPO or
secondary-market sale, you already purchased your stock three years ago, and
pay only long-term gains. Otherwise, you'd buy the stock and sell on the same
day, with the gains considered as short-term-gains/income rather than long-
term gains.

My personal outcome with pre-exercised stock: worked out OK twice, lost all my
pre-exercise once, but overall I came out ahead on taxes even with the loss.
YMMV.

What the article says is "pre-exercise" is just an "exercise" \-- you vested
the stock, you have every right to purchase it even though the company's stock
isn't yet liquid. The problem, of course, is that you may have a huge gain and
no way to pay for taxes on that gain.

(Edit: note about AMT, clarification.)

~~~
kevinpet
What you're talking about is usually called early exercise.

I don't see any reference to "pre-exercise" in the article.

------
7Figures2Commas
There's some valuable information here, but a lot of detail is lacking. For
instance, the post does not distinguish between incentive stock options (ISOs)
and non-qualified stock options. The tax treatment is quite different.

More importantly, technical details aside, I think it's important for a
prospective employee to make some strategic decisions about equity up front.

The author writes:

> If the company seems reluctant to answer these questions, keep pressing and
> don’t take ‘no’ for an answer. If you’re going to factor in your options
> into any compensation considerations, you deserve to know what percentage of
> the company you’re getting, and its value.

And in the next paragraph he writes:

> I’d be wary of compromising on salary for shares, unless you’re one of the
> first few employees or founders. It’s often a red flag if the founders are
> willing to give up a large percentage of their company when they could
> otherwise afford to pay you. Sometimes you can negotiate a tiered offer, and
> decide what ratio of salary to equity is right for you.

You can't have it both ways. If you focus on equity (by demanding that the
company divulge detailed information about its share structure), you are
sending the signal that equity is just as important or more important than
salary, and thus opening the door to a negotiation that contemplates a trade
of equity for salary. Precisely the thing that you want to avoid!

Unless equity is expected to be liquid in the near future (i.e. you're at a
company expected to go public in the near future), an equity-focused
negotiation is more likely to benefit the prospective employer than employee.

~~~
tptacek
I think you make a valid point but may have picked the wrong hill to fight for
here, because there is no way to evaluate an equity grant without knowing the
percentage associated with the grant. Even if you don't care much about
equity, if you care about it at all you should be able to get that
information.

~~~
7Figures2Commas
> ...because there is no way to evaluate an equity grant without knowing the
> percentage associated with the grant. Even if you don't care much about
> equity, if you care about it at all you should be able to get that
> information.

1\. Calculating a true percentage associated with a grant can be difficult.
You can identify the number of shares of stock outstanding across all classes,
the number of currently authorized shares, and the size of the option pool.
But you don't know how much of the option pool will actually be used, how many
options will vest, etc.

2\. Unless you're an executive hire or unicorn, most companies will not give
you all of the data necessary to meaningfully evaluate the equity grant. You
can ask for it, as so many suggest, but asking for something that a) you
almost certainly won't receive and b) that you're not trying to focus on (for
the reasons I originally gave) is not very strategic.

3\. At an early-stage, venture-backed startup (my comments are not intended to
address late-stage, liquidity-all-but-certain scenarios), the equity structure
of the company is likely to change considerably and perhaps unpredictably,
rendering your initial evaluation all but useless.

4\. If an early-stage startup is capable of offering you a satisfactory salary
(at market or, these days, above market), you are far better off trying to
ascertain what the company's runway is. Your biggest risk at a startup is not
that you're going to join the next Facebook as an early employee and walk away
with next to nothing but rather that the company is going to run out of cash.

~~~
tptacek
These all seem like really good points. I'm going to keep my part of this
conversation very narrow and just re-assert that if you ask for the percentage
corresponding to your grant, you should get it, without much trouble. Not
getting it is a very bad sign. I'd say the same thing about current
liquidation preferences.

You're absolutely right that nothing your employer tells you at the time
you're hired is going to be controlling once a new round of funding is taken.
If the company is going gangbusters when it takes a new round, the new round
probably won't hurt you at all. If it's a slog when you go for more money, it
could totally ruin your returns.

------
vikas5678
Is it odd that almost every startup I or my friends have interviewed with
refuse to answer the "number of outstanding shares" question? Have others had
similar experiences?

~~~
patio11
Without some notion of how much your equity grant represents of the company
(by current dilution), the actual number of options you get cannot be sensibly
valued. The total number of shares at a company is _totally arbitrary_.
Seriously, when you register one, the state just asks you to _pick a number_.

If a company won't tell you enough to calculate the percentage, that's like
you asking "What's your offer for salary?", "Dollars. Definitely dollars.",
"Can you be more specific?", "No. We consider exact salary offers to be
competitively sensitive."

~~~
gabemart
Please forgive my ignorance, but if you know the number and price of the
options, is the problem that you don't know the current valuation? Because it
seems like if you know the price of the option, how many options you're being
offered, and the current valuation, it's trivial to work out the number of
outstanding shares. I guess the current valuation is privileged? Or that there
is no current-valuation if it's been a while since the last round?

~~~
jplewicke
It's still necessary to consider the total number of shares. Let's say you've
been issued 500,000 options with a $0.10 strike price, and the company is
currently valued at $4 million. The approximate pretax value of exercising
your options immediately would be:

~ $2,000,000 if they've only issued 500,000 shares ~ $100,000 if they've
issued 13,000,000 shares ~ $2,000 if they've issued 40,000,000 shares.

And your returns would be negative for any greater number of shares.

The real problem is that you don't know the price per share from the current
valuation.

~~~
gabemart
I must have misunderstood. I thought that the strike price always reflected
the current price of the shares at the time the option was issued, but it
seems that this is not the case. Thanks for clarifying.

~~~
loumf
I'm pretty sure the strike has to be greater than or equal (out-of-the-money)
or there are tax implications. So, they would need to tell you (I AM NOT AN
ACCOUNTANT)

Not that an at-the-money option has no value -- but I think for tax purposes,
it's not treated as such.

------
bsirkia
Can you talk a bit more about the dilution an employee should expect if the
company completes more funding? That could have a serious impact on your
shares. Who usually gets diluted first? Founders? Previous investors?
Employees?

If you're an employee that received options and the company is doing another
round of funding, should you be worried or on the front foot about finding out
what will happen to your options?

~~~
arram
Everyone gets diluted when a company raises more money: founders, employees,
and previous investors. Investors usually have ‘prorata rights’ which mean
they are allowed to invest additional money at the new valuation to maintain
their given percentage ownership of the company.

Founders generally have the same class of stock as employees (common stock),
and so are in the same boat.

Investors have preferred shares. Preferred shares have a few special
properties, but the most important is ‘liquidation preference’, meaning
they’re first in line to get their money out if things go wrong. Sometimes
investors have a right to a multiple on their money back: twice their money
would be a 2x liquidation preference.

One thing to ask about in the case of a company that has raised money on
convertible notes. Since they haven’t actually sold equity, but only debt
which will later convert equity, it’s worth asking if a given stake is before
or after those notes convert.

Generally, if things are going well, dilution isn’t worth worrying about. In
any case, the founder will be just as diluted as any employees, so their
interests are aligned.

~~~
bri3d
> Founders generally have the same class of stock as employees (common stock),
> and so are in the same boat.

Not quite - Another extremely important point is ensuring that there isn't a
hidden type of equity/option ("Series FF" or alike) sitting above you as an
employee. In this situation founders are less aligned with you as an employee
as they get the option to cash out rather than being diluted in follow-on
rounds. This is a mechanism designed to align founders with investors by
causing founders to shoot for the moon even through appealing exit offers, but
has the side effect of allowing them to stop caring and not exit until it's
too late (they've got theirs, after all).

~~~
arram
That's why I said 'generally'. Either way, AFAIK, series FF doesn't change
liquidation preferences or the effects of dilution.

------
throwawayy123
If I decide to leave a company in which I have partially vested stock options,
would it be okay to ask my employer (or anyone else in my company) if they
would be interested in buying the options off of me at the current valuation
(EG, last amount of money raised)? Is something like this common, or would I
get laughed out of the room?

Similarly, how liquid are markets like Second Market in terms of liquidating
option value at a startup that's raised multiple rounds of funding but has yet
to exit or IPO? Are there angels (or networks of angels) that buy small
amounts of pre-exit equity?

~~~
balls187
If you don't exercise your vested options, they will automatically expire
after a certain date.

The company doesn't really have any incentive to purchase your options from
you, however they will likely have a clause that gives the company first right
of refusal--that is, if you plan on selling any shares prior to a liquidity
event, you have to first offer them to the company for FMV.

As to pre-IPO, post fund raise, your stock is typically Restricted stock
units, which have clauses that prevent you from selling stock.

It's possible, with board approval to issue a special class of common stock,
that can be sold to outside investors. This is usually done to allow long-term
founders to get some liquidity outside a liquidity event. This typically
doesn't happen for most employee's though.

In an IPO scenario, all outstanding shares convert to a single class of stock,
which can be freely sold (after a lock-up period).

------
snorkel
Here's the short version. Sell. Sell it all. As soon as you are legally
allowed to, sell. Sell all of it. Taxes and maxes blah blah blah just sell it,
take the cash, and be thankful.

~~~
e1ven
This is talking about Stock Options, not pure stock grants. This means that
"Sell it all" isn't quite as simple as you might suggest - First you need to
"Buy it all". But there is often vesting, which means you can't buy it all
yet.

------
arielweisberg
I thought 83(b) only helps with RSU grants? For ISO grants I thought you can't
do an 83(b) election?

Can anyone clarify?

~~~
ChuckMcM
That is correct. The 83(b) declaration is only valid for 'restricted stock'
which is stock that is granted to you rather than as an option to buy.

In those situations you acquire the 'right' to the stock over time (this is
called vesting). And when you vest stock the IRS treats it like income and it
gets added to your W2 as such.

The 83(b) election allows you to take the entire tax hit immediately even
though you don't have the ownership rights on the stock yet. You need to come
up with the tax payment but since you "own" the stock even when it vests you
won't pay additional taxes, and your ownership starts the clock on long term
gains (vs short term gains).

If the stock is going up an 83b can save you some money, if it is going down
it makes it more complicated (you can write off up to $3,000 of "loss" per
year of stock which is worth less than the 83b election price. I got to do
that for just over 10 years on my dot com era 83b stock election.

Generally places like Facebook or Google will sell some of your RSUs as they
vest to cover the tax hit so its pretty invisible to you.

~~~
DanielRibeiro
Note that there are a few alternatives to this. Fred Wilson, from Union Square
Ventures (who pg wrote about it here[1]), gave a 1 hour class on the
subject[2]. He covered tax and mechanisms to avoid taking unecessary invetment
gains tax.

Another great post on this subject (which may be a bit dated nowadays) was
this one[3]. Hacker News startup lawyer had also some great comments on its
corresponding HN thread[4]. Note that it embeds the _Introduction to Stock
Options_ [5] that also had an amazing discussion on HN a few years ago[6]

[1]
[http://www.paulgraham.com/airbnb.html](http://www.paulgraham.com/airbnb.html)

[2] [http://www.avc.com/a_vc/2012/04/mba-mondays-live-employee-
eq...](http://www.avc.com/a_vc/2012/04/mba-mondays-live-employee-equity-
archive-and-feedback.html)

[3] [http://gigaom.com/2011/06/05/5-mistakes-you-cant-afford-
to-m...](http://gigaom.com/2011/06/05/5-mistakes-you-cant-afford-to-make-with-
stock-options/)

[4]
[https://news.ycombinator.com/item?id=2623182](https://news.ycombinator.com/item?id=2623182)

[5] [http://www.scribd.com/doc/55945011/An-Introduction-to-
Stock-...](http://www.scribd.com/doc/55945011/An-Introduction-to-Stock-
Options-for-the-Tech-Entrepreneur-or-Startup-Employee)

[6]
[https://news.ycombinator.com/item?id=3252290](https://news.ycombinator.com/item?id=3252290)

------
joosters
Quick question: Why should a company give share options to employees, and not
plain old shares? Is this just because it's better tax-wise for the company?

~~~
doki_pen
If they gave you shares you'd have to pay income taxes on those shares for
something that may never make you any money. Most people wouldn't choose to do
that.

~~~
joosters
But (assuming a startup or young company), the shares would have little value
and so the tax would be small. Plus, if the shares became worthless you could
offset that loss against future income (I guess?)

View it like the company giving you a cash bonus - not many people would turn
down the bonus, even if it meant there would be tax due on it.

If you think the shares have future value, then paying the tax on their
current price would seem a good deal. If you don't think the shares are value,
then share options would be even worse.

Admittedly you've still got to pay the tax up-front...

~~~
Peaker
If the shares are given after an investment of $1 million, then 0.5% of the
company is $5000, just by a conservative evaluation that takes only the
investment value into account.

If you think the shares have a _guaranteed_ future value, then the shares are
better than the options.

If you think the shares have a _guaranteed_ lack of future value, then the
options are free, whereas the shares will cost you.

If you think there is substantial _risk_ that the shares will have no value,
then getting options rather than shares mitigates that risk. You only pay for
that mitigation if you actually exercise the options, in which case the cost
comes off of a big payoff, rather than an upfront payment out of pocket.

------
xerophtye
This was truly a great article and i have bookmarked it for later reading (i
haven't read all of it yet). But perhaps i can expand on this explaining what
"options" are in the first place.

Ok imagine a situation where stock X costs $100 today. Alice thinks that the
price will go considerably up, bob thinks it'll go down. So they make a deal,
one year from now, Alice will buy shares of stock X from Bob at $104
dollars[1]. Now if Alice's prediction is right, she'll make a profit by buying
low ($104) and selling high (at the then market price). If bob's prediction is
right, he'll profit by buying low (market price) and selling high($104). This
is called a Forward Contract.

Problem with Forward Contracts are that they put you in an obligation to make
that transaction, no matter how much loss. What if the price falls and Alice
doesn't wanna buy from bob? So then instead of a Forward Contract, she'd get
an option (a "Call" option to be specific). This will give her the option to
either buy the shares at the agreed upon price (called "strike price") if it
is favorable, else do nothing. Well what about Bob? He can get into a "put"
option (with someone else) that gives him the option to sell stock X if it is
favorable.

Pretty neat huh? but the difference here is, Forwards are free (except for tax
etc) and options cost a "premium" to get into. But since options COST
something, that means you can SELL them as well and make money off of that.
And their prices vary just like the price of stock varies.

Hope this helps

------
mseebach
What is the exact mechanism for "golden handcuffs"? Can the company prevent a
vested option holder from exercising and then selling the shares to a
secondary market investor immediately (offering them to the company for first
refusal, obviously)? In that case, can't I just line up a secondary market
investor, borrow the cash to exercise, sell, repay the loan and thus get out
of the handcuffs?

~~~
spacehome
No. The golden handcuffs arise from the fact that the employee doesn't have
the cash on hand to exercise the options and pay the taxes since there is no
liquid market from the shares. If the employee quits, then they forfeit the
upside of the options since the options expire 90 days after terminating
employment. So, if the employee wants to participate in the options' upside,
he or she is forced to stay with the company until a liquidity event --
textbook golden handcuffs.

It should be noted that Alex MacCaw and friends are offering a way out of this
dilemma for 25-30% of the upside by supplying the cash required to exercise so
that the employee can leave. This advertising is probably the whole reason
Alex wrote the article.

~~~
mseebach
So, just to make sure, the thing I can't do is line up a secondary market
investor, because there probably aren't any? And being that secondary market
investor is what you're saying Alex MacCaw and his friends are?

~~~
spacehome
A secondary market investor is someone who will buy the shares from you after
you've exercised. These people may or may not exist, depending on how
attractive the company is. The shares you purchase from the company will
likely be restricted, and you won't be able to transfer them for a year. After
that year is up, you can sell it to whomever you wish. The company will have
right of first refusal, but if it comes to that, you don't really care who
buys the shares off of you (company or secondary market investor) because you
get paid the same either way.

This is technically different that what Alex is proposing, but the end result
is fairly similar. He's offering to loan you money to exercise. You keep
ownership of the shares, and the loan comes due if and when there is a liquid
market for the shares. He's allowing you to move on from the company before
any other investor is interested in the shares, but still provide upside to
you if and when the shares are actually worth something. And he takes some cut
because he's assuming the (very significant) risk that no other investor is
ever willing to pay for the shares.

------
gesman
Red flags (from personal experience):

\- "We will give you a big share of our (of-course-soon-to-be-facebook-or-
google) company (15%+ in stock options) if you'll agree to work for us for
close-to-nothing".

\- Senior officers starting leaving the company one by one.

\- Senior officers giving small promises that have tendency not to
materialize.

\- Senior officers do not have any/good exit track record. Opposite would be a
green flag.

~~~
kika
I'm not getting #1. Essentially, they're offering you a "founder grade" share
of the company. Why not?

~~~
gesman
If you jointly owns IP - that's fine. But if you're only an employee albeit a
proud owner of large chunk of options, it's possible that real founders are
just testing the market at your expense.

~~~
kika
With 15% you can have a seat in the board or at least some voting rights.
Having that it would be more difficult to just dissolve the company without
any real reason. But generally speaking you're right, thanks.

~~~
gesman
Solid cubicle quite often is a better financial investment than a shaky board
:)

------
mfkp
Very interesting - I was unaware of the financing options until I read this
article. Seems like it could be a good idea if you're unsure if the company
will be successful long-term, a way of hedging your bet. Though I would hate
to give up 20-25% of the potential upside, I'd consider this if I was on the
fence about exercising my options.

------
dlevine
You didn't mention the difference between nonqualified (NQSO) and incentive
(ISO) stock options. The difference is key.

------
willvarfar
And here's a nice guide from way back in 2004:
[http://www.ftpress.com/articles/article.aspx?p=170920](http://www.ftpress.com/articles/article.aspx?p=170920)

What's interesting is that this chap Ivan Goddard is doing the Mill processor,
and that has an interesting company structure; OotB has an agreement to
incorporate, and they keep renegotiating it. He explains this in this talk:
[http://www.youtube.com/watch?v=Bxga49vukQ8](http://www.youtube.com/watch?v=Bxga49vukQ8)

------
dmourati
Read Venture Deals by Brad Feld. It will make you more knowledgeable then
99.9% of all the people in venture funded companies and put you on the level
playing field with the VC's.

------
brosco45
They are like lotto tickets, mostly worthless, some are worth a lot.

~~~
erbo
Exactly. These days, I'm inclined to say, "Put not your faith in stock
options."

------
sarah2079
This is very helpful, thanks. I was very surprised when I first learned that
AMT will cause you to owe tax on your gains when exercising options, even if
they are only on paper. (If the company is public or there is a private
market, fine, but it is incredibly inconvenient to be taxed on something for
which there is currently no market). This is an area where it can really pay
to plan ahead.

~~~
maxerickson
On the other hand, an expiring option for a non-liquid asset is not a good
form of compensation.

------
egometry
Pretty god. I've been recommending David Weekly's short e-book on this matter
for years... specifically as mandatory reading for engineers taking their
first or second job.

Learn from our mistaaaaakes!

[http://www.amazon.com/Introduction-Stock-Options-David-
Weekl...](http://www.amazon.com/Introduction-Stock-Options-David-Weekly-
ebook/dp/B0055PQ4H8)

------
anon_nsotax
Can someone comment on determining fair market value of a private company?

I exercised NSO stock options of a private company after being vested for a
year. Everything I read indicates I need to declare the spread of current FMV
with the value of the option grant date. How do I determine the current FMV if
their is no market though?

~~~
philjr
Some good commentary by Fred Wilson about 409a's...

[http://www.avc.com/a_vc/2010/11/employee-equity-the-
option-s...](http://www.avc.com/a_vc/2010/11/employee-equity-the-option-
strike-price.html)

------
dsri
>> You can think of a stock option as a Future.

You probably shouldn't, as they are distinct terms. A futures contract obliges
you to make the transaction on the specified transaction date, whereas an
option gives you the option to do so.

------
tejay
What about profit-sharing instead of options/warrants/shares?

We've found that it dampens the 'build-to-flip' mentality and lets us all
enjoy the fruits of our labor while we're building the company, not afterwards
=).

------
nraynaud
I have a related question: I have some non-privileged stock in a private
company, and I want to sell it (I want the money and I don't care about the
future of a company I don't work for anymore).

Who could be an interested buyer?

~~~
prostoalex
[http://www.sharespost.com](http://www.sharespost.com)
[http://secondmarket.com](http://secondmarket.com)

------
djm_
Does anyone have any UK specific advice considering stock options? ..and how
does it affect things if these are offered to a contractor and not a FT
employee, is that even possible?

~~~
arethuza
From what I recall, the company needs to have an HMRC Approved Company Share
Option Scheme [1] to allow the recipients of options to avoid income tax at
the time they are granted. IANAL. These schemes are open to employees and
executive directors - although it looks like there is a time requirement for
directors [2] there doesn't appear to be one for employees.

Maybe you could work as an employee one day a week and as a contractor for the
remaining five and get the options as an employee? :-)

[1]
[http://www.hmrc.gov.uk/manuals/essum/essum40105.htm](http://www.hmrc.gov.uk/manuals/essum/essum40105.htm)

[2] [http://www.out-law.com/en/topics/tax/share-plans/hmrc-
approv...](http://www.out-law.com/en/topics/tax/share-plans/hmrc-approved-
company-share-option-plans-csop/)

My main advice - if you think there potentially a chunk of money involved I
would go and see an accountant or lawyer that knows the details of the current
legislation and can give you detailed advice on what to do - I've done this in
the past around options and the advice was worth every penny.

~~~
walshemj
mm I think that Revenue might see that as disguised employment and go after
you under ir35 rules.

------
kylelibra
Is there a good formula for figuring out taking a lower salary in exchange for
options? For example:

.

Current Salary On Open Market = X

Startup Salary = Y

Option Value Today = Z

.

4(X) = 4(Y)+Z(2 _)

_ this is obviously the big IF, if people are saying think of it as windfall,
maybe 1.5??

~~~
svachalek
If you were going to do it from a pure accounting perspective, you'd take the
expected value of the options + salary and compare directly. You should
probably also figure in high value benefits like 401(k) match.

The problem there is, the expected value is more or less the current market
value of the options (if you believe in anything approaching an efficient
market), which is more or less the strike price times the number of shares.
So, often these are in the neighborhood of $10k over 4 years or $2500/yr.

In other words, don't try to talk yourself into it from an accounting
perspective.

~~~
spacehome
Maybe.

But just looking at expected value ignores risk. Most people are risk averse,
especially at the amounts of money we're talking about here.

~~~
svachalek
Expected value is not $millions. Expected value is a few hundred $k (usually,
if you are realistic about the potential of the business and your tiny share
as an employee) MULTIPLIED by the relatively small chance of hitting that
exit, say 1%. In short, a few thousand dollars, which is approximately what
you get by multiplying out the strike price.

IMHO it takes risk into account in a very sobering way.

~~~
spacehome
> Expected value is not $millions.

Speak for yourself.

------
yogin
Thank you for this, I have to admit I've been quite confused about this for
some time. Great explanation, it finally makes a lot more sense to me!

------
unreal37
I'm waiting for the day in the near future when an article on stocks begins
with "Stocks are a lot like Bitcoin..."

------
hafichuk
Any advice if the company is already public and they are offering stock
options as part of the compensation package?

~~~
amackera
Look at the share price on the market. If they option strike price is less
than the market share price (and the market price seems like it will be steady
or go up), might be a smart idea.

IANAFinancialAnalyst.

------
jisaacks
So what happens when the company exits before you are vested?

~~~
prostoalex
Most stock plans have triggered vesting.

So it's possible to start a job on Monday, have the company acquired on
Tuesday and immediately vest for all 4 years going forward.

------
elwell
What if you're too lazy to exercise your share?

~~~
balls187
Usually the Employee Share agreement has a clause that states that when you
leave the company (or even in change of control scenarios) any vested stock
options must be exercised by 90 days, otherwise their forfeit back to the
company.

~~~
joshuapayne
This is important. The 90 day time period is a typical clause in your options
agreement. It is not universal. You should check for this and other "standard"
clauses in your options agreement to ensure that your company isn't sneaking
something past you when you're signing on.

------
puppetmaster3
lol, none of this matters. the terms are, what the terms are, you can just try
to get more shares and more $.

------
michaelochurch
Two corrections:

1\. OP says: _Once you’ve cliffed, you have the right to buy shares in the
company._

"Cliffing", when used as a verb, refers to firing someone just before the
cliff-- not an employee achieving it. It's something you'd rather avoid.

2\. If the company isn't publicly traded, you should ask to see the cap table.
If you're employee #30 and your share is 0.05%, that might be fair if it's a
biotech that has already taken a $100M infusion from the venture capitalists
(who'll typically take 90%, in that case). For a web startup, it's terrible.
You need to know how much equity the investors, executives, and employees at
various levels have, so you can evaluate your likelihood of getting an
improvement if you perform well. Without the cap table, you don't know enough
about the startup to decide whether to take a job there.

~~~
tptacek
Exactly what does the cap table have to do with your expected outcome,
presuming you know the percentage of your allocation, the liquidation
preferences and valuation, and the company's runway?

~~~
gatehouse
If you don't know who owns the company you don't even know who you work for.
It might not matter to most people as long as the cheques don't bounce, but if
you want to even hallucinate having a meaningful role in the direction of the
company it starts to matter. I really don't know what people are willing to
disclose to employees but the SEC rule for public companies is a 5% stake or
more is disclosed.

~~~
tptacek
This is not true. It matters who your company directors are. It does not
matter how much of a stake some random angel investor ended up with, or how
much the VP of Product Marketing got. I have _founded_ a company where I
didn't know what the cap table was (obviously, I could have) and I assure you
I had all the influence I wanted on it's direction.

The cap table is, to this whole conversation, a MacGuffin.

~~~
gatehouse
I agree that the directors are who really matters. It matters which groups of
people can make 50% + 1 of votes, because they can select the directors.

------
antimora
Taxes can be tricky depending what type of stock options you have. This
recently found document tries to point out several strategies:

THE STOCK OPTION TAX DILEMMA FACED BY PRE-IPO COMPANY EMPLOYEES BY BRUCE
BRUMBERG, ESQ., MYSTOCKOPTIONS.COM EDITOR-IN-CHIEF AND CO-FOUNDER

[https://welcome.sharespost.com/system/resources/BAhbBlsHOgZm...](https://welcome.sharespost.com/system/resources/BAhbBlsHOgZmSSI3MjAxMi8xMi8yMS8yMS8zNS8wOC85MjUvU1BfV1BfT3B0aW9uVGF4XzEyMTExMi5wZGYGOgZFVA/SP-
WP-OptionTax-121112.pdf)

