
Fixing the Inequity of Startup Equity - Harj
https://data.triplebyte.com/fixing-the-inequity-of-startup-equity-469793baad1e
======
abalone
Hold on, if we get this wrong we may be lowering the value of everyone's
options and hurting startups. Are there any added protections here against
high turnover in infancy-stage startups?

For 30(?) years since the invention of stock options there has also been a de
facto added protection against high turnover in infancy-stage startups, where
having to rehire and retrain employees is extremely costly. Pre-IPO you
basically had to pick a team and take it to that level of maturity before you
could leave. You couldn't hop around seed-level startups without giving up
your options, usually.

What's changed now is startups are staying private longer, leading to unfair
scenarios. E.g. you're at a >$1B company with >100 employees for 6 years and
you still lose your options. Traditionally a company would have gone public by
that time, but now it's not, so we need a fix.

But if you overcorrect and now eliminate that added protections for younger
startups, you risk creating an incentive to leave companies just for the sake
of options portfolio diversification. Why bet on one team when you can bet on
three, since even 1/3rd of a unicorn that makes it is worth more than 100% of
the one that doesn't. And that individual decision leads to higher turnover
which can kill infant startups.

Bottom line this fix should be more carefully targeted at what has _changed_
to exacerbate unfair situations, namely startups that have reached "should be
public" levels of maturity, yet are still staying private.

~~~
mahyarm
The internet has made it more clear that being an early startup employee will
be worse in almost all possible cases compared to working at google even when
you get to the $1 billion 'unicorn' status.

For example, I was a jr. engineer at a stage A $5 million startup with ~%0.4
of the company in stock options. When it reached its $1 billion valuation 4
years later, my options with dilution were worth x25. But $500k/4 years is
$125k/yr, which is pretty close to the stock compensation working at google.
But these options were not cash equivalent like google's stock, and I had to
drop it all on the floor because of the 90 day window. I lost $500k in
compensation because I decided to work at the startup vs. google.

Imagine if your employees had a good amount of savings and could easily afford
the $10-20k it costs to pre-exercise their options in your infant stage
startup. Then these rules are pretty moot. It takes advantage of people who
don't have the money to pre-exercise options, who tend to be younger people.

Also it's unfair, investors can diversify their income sources, while
employees cannot.

~~~
abalone
That's rough. $1B sure feels like a point where a company has graduated from
infancy/childhood to being able to handle some turnover. Having said that,
valuations a year ago were pretty crazy so maybe they really weren't.

I have to say that's a heck of a lot of dilution, too. 200x growth in
valuation vs. only 25x in your stake? What's that, over 85% dilution?? Sounds
like that juicy unicorn valuation was only achieved by a lot of fundraising
rounds under presumably not awesome terms. Not that that makes you feel any
better.

I'm thinking there should be some kind of extra incentive for early stage
teams to stick together, but with a more explicit maturity point. It used to
be IPO/acquisition. Now that IPO is often farther off there should probably be
some other metrics. What are they? Valuation? Number of employees? Length of
employment? Revenues? Some combination?

~~~
mahyarm
You give them stock straight out with a 'reverse vesting' buyback schedule and
you cover the tax. If that starts becoming 'too expensive' because of taxation
/ valuation reasons for the company, then you've reached the size where you
give 10 year options or RSUs.

US startup stock options push the tax externality to their employees. In
somewhere like canada, your tax bill is due at liquidation, not at the
purchase of options. It makes a lot more of this problem go away. For most
early stage employees that do well in a tax scheme like canada's then paying
$20k for stock in a large valuation company isn't nearly as painful as paying
$20k + $100k in AMT tax.

I think that would probably be reasonable for most angel investment and stage
A teams. It isn't a stretch for the company to pay an extra $10-30k for a
stock transaction where %60 of it cycles back to them anyway for a total of
$4k-12k of a tax bill.

Also another way to value the stock to give to early employees is to treat
them as investors investing the $500k+ or whatever equivalent they are giving
up for 4 years and giving them that as their stock where you foot the tax
bill. Also giving them the same visibility and protections that those
equivalent angel investors would get.

The percentage points you start giving up for that although starts becoming
too large for most founder's tastes, and thus we get the current situation we
have today. Many engineers tell themselves, why should I join an early stage
startup when I can do so much better as a founder with a similar risk profile?

edit:

I realized you want a way to keep the golden handcuffs that are unique with
the US tax law and current equity structure to incentivize poor-ish early
employees to stick around without creating an incentive to fire them with back
loaded options.

You could create a second stock option reward for the early employees with a
company performance + time condition vesting condition and pay the tax bills
by giving them the stock right away.

Pinterest's long term stock option expiry date is contingent on being with the
company 2-3 years, otherwise it goes back to the same 90 expiry window I
think.

You could try many structures, and the market will respond to it compared to
their other offers. A good way to start is to explicitly state what you
actually want, and then engineers could state what their price is for that ask
in comparison with what they can get.

~~~
abalone
Pinterest also didn't enact that until they reached a multi-billion $
valuation and hundreds of employees. They did it when they already knew they
could handle turnover. Earlier stage companies might need longer.

But then it's hard to set a definite timeframe. What you want is to
incentivize sticking together as an effective team to reach a point of
maturity, to maximize the chances of getting there and thus the options being
worth anything. It's probably more about size and valuation. That's what was
nice about effectively tying it to IPOs (when IPOs happened earlier). Going
public was a decision that the board made when they company was "ready".

~~~
st3v3r
Why should I care more about the company and "turnover" than the people whom
the current system gives an incentive to fire so they get screwed under
current equity regulations?

~~~
abalone
You should care about both, but if the company fails then your options won't
be worth anything.

~~~
st3v3r
But you're saying that I should care more about the company. I'm asking why.

------
Harj
We're excited to make 10 years the new standard option exercise window for
startup employees. Each of us have personally experienced someone close to us
dealing with the stress of trying to exercise their options within 90 days and
it sucks.

We'd like to see more companies making this change, we'll be keeping the
public list of YC companies who have either implemented or pledged to
implement an extended window, updated here:
[https://triplebyte.com/ycombinator-startups/extended-
options](https://triplebyte.com/ycombinator-startups/extended-options)

~~~
tn13
I dont understand these things much but I think encouraging employees to
exercise their options as early as possible is better thing to do when the
value of those stocks is dirt cheap.

~~~
Harj
Sure that works early on but we wanted to get momentum behind a solution that
would work for any size/stage of company.

------
gregrata
While this would be great, I'd personally like to see the tax code change -
being taxed on the "value" of something you can't realize, and my NEVER
realize, is crazy.

Most of the time I've been at a startup as a founder/early employee, the
strike price was low enough that I'd be willing to take a roll of the dice and
just exercise, if I was going to leave. It's usually 10's of thousands of
dollars.

By the time I started vesting a fair amount, the _TAX_ on that was non-trivial
- 100's of thousands if not more. Something I personally can't really do.

------
AndrewKemendo
Sorry but this doesn't fix it, it just delays the inevitable.

The main problem is that startups are offering options instead of restricted
commmon stock. That means the new hire is paying for stock as an _investment_.
That's not a benefit at all.

I have talked at length elsewhere on HN [1] about the system we use to give
employees actual common shares, at current strike price, and delay any taxes
until exercise so they have zero out of pocket expenses until they have to pay
taxes (usually only capital gains).

[1]
[https://news.ycombinator.com/item?id=10818573](https://news.ycombinator.com/item?id=10818573)

------
ant6n
Does anybody know of a startup where common stock is issued right away (or
let's say after a probation period), and then the employee issues options back
to the startup, which expire at fixed intervals corresponding to the vesting
schedule?

For an early startup, this would mean when there is a liquidity event, almost
all of the gain would be capital gains.

In Canada, it would be even better: people can defer taxes on stock and option
grants until disposition (sale/bankruptcy). And the stock could be placed in a
registered (i.e. tax-sheltered) account.

~~~
keithba
Many early stage startups will use early exercise options with a clawback
mechanism.

After the 409a valuation of the startup gets too high, this option becomes
much harder for employees, which is why you don't generally see it outside of
the earliest stages.

~~~
chimeracoder
> After the 409a valuation of the startup gets too high, this option becomes
> much harder for employees

(Disclaimer: I am not a lawyer, not your lawyer, this is not legal/tax advice,
etc.)

As I understand it, it's not just the valuation, but also the tax
implications. If the options (as _granted_ ) are worth more than a certain
threshold (~$100K), you can't early-exercise them without losing ISO tax
treatment on the value in excess of the $100K threshold. This threshold is on
an annual basis, so not exercising them early means that you quadruple[0] the
amount that will be eligible AMT (which is preferable to ordinary income tax).

[0] Assuming the standard vesting schedule, in which 1/4 of the shares are
made available each year

------
birken
Great stuff.

I've personally had to deal with these decisions and know many friends who
struggled with figuring out how they could possibly pay for exercising their
vested shares, in some cases after they were laid off and had no choice in the
timing.

If I were getting a job, I'd only consider offers with extended exercise
windows. If they combined it with a more back-loaded vesting schedule [1], I
wouldn't mind and would evaluate that. But dealing with the 90 day exercise
window is black and white: it isn't worth all the potential trouble and risk
you can be forced to take on.

1: 20%/20%/30%/30% instead of 25%/25%/25%/25%, or 6 years instead of 4 years

~~~
JonFish85
Does it really matter that much? If you're a first-50 employee, then maybe
your shares will be worth a decent amount of money, but your exercise price
will be very low (most likely). If you're not a first-50, your options
probably won't be worth all that much anyways--is it really worth discarding
working for a company based entirely on your exit strategy?

~~~
birken
Yes, it does matter.

If the stock has appreciated in value, your exercise price may be low but your
AMT bill may be high even if you have no liquidity at all. In my case I paid
more in AMT than I did to exercise all my shares, though both individually
were large and incredibly risky investments.

I could afford the risk and it did eventually work out for me, but some people
can't afford the risk or frankly don't want to deal with the incredible
complication of doing it. Just trying to figure out what your AMT bill might
be involves doing your entire tax return based on projections, which depending
on what time of year you are leaving could introduce quite a bit of inaccuracy
and guesswork.

If you have an extended exercise window you just don't have to worry about it.
If you want to take the risk of early exercise to get better tax treatment, do
it. But if you don't (which I suspect will be the majority of people), all of
the complication goes away completely... just sit on your options and
exercise-and-sell when/if you get a chance at liquidity.

~~~
timr
On the other hand, converting your options to NQSO means that you pay income
tax on the spread at the time of conversion. This sucks equally badly in the
situation you've described: you're stuck with a big tax bill, at your income
tax rates, based on fictional income.

The only good option (pardon the pun) here is to allow your employees to early
exercise.

------
JonFish85
As much noise as I hear about this, it's not really that simple. In my
estimation, lengthening the exercise window just ensures that dilution will
happen faster. If you have 5% of a company locked up by people who no longer
work there, you have to find a way to reward current employees. Sure, cash is
one way, but it might be easier to issue more stock, most likely of a
different class. It might sound good on paper, but ultimately I really don't
think this (edited: "this" = extending the window) will have any real positive
impact for employees leaving the company.

~~~
holman
> If you have 5% of a company locked up by people who no longer work there,
> you have to find a way to reward current employees

We need to get past this line of thinking. Why do companies not say the same
thing for the salaries they've paid former employees? "Boy, I wish we could
get back the $30,000 we paid Bob between July 2011 and October 2011."

We don't say that because the employee _earned_ that and once they've earned
it, it's out of your account and into theirs. Stock, though a different
mechanism, needs to be thought of the same way. If someone has worked there
long enough to vest that stock, _they should have the option available to own
that stock_. Just because they made the company successful enough to not be
able to afford to exercise their options in time doesn't mean we should take
that possibility away from them.

Whether or not it was intended years ago when it became a norm, the 90 day
exercise window, at this point, is a surrogate mechanism for companies to
steal compensation from employees after the fact. That's horrible.

~~~
khuey
People think that way because you can't claw back the salary but you can
dilute the entries on the cap table.

------
hkmurakami
Next up (and the harder problem imo) is for companies to feel like they have
enough leverage vs investors (mainly institutional VC) that they can be
"nonstandard" in their option contracts (particularly during seed and A
rounds). It's no coincidence that the companies that have taken the lead on
this front are the startup darlings and/or repeat founders who have
considerable leverage against funders (including YC companies, since their
cred boost makes being nonstandard much easier than those without the brand).

We've made huge progress in that direction over the last 5 years as ZIRP made
money cheap (and since the main leverage investors have against companies is
the scarcity of funding, their leverage has decreased dramatically since the
80's). But as the funding mania crescendo of 2015 has passed, ZIRP is being
wound down, and as private and public market valuations of small young tech
companies plummet, I am not sure if that trend will continue into the future.

If there is one cohort that can band together to change the status quo, right
now, that would be the YC companies. I am hopeful that enough momentum can be
built over the next small handful of years by these companies so that "what is
normal" can change permanently.

~~~
bretpiatt
I understand the Fed moved the overnight rate up to 25 basis points. It isn't
going to last. Rates are going to stay low for the foreseeable future for a
laundry list of macro economic reasons -- the easiest to cover is the USA
cannot afford to raise rates as it will increase the global consolidation of
capital in the US causing severe issues for EU and AP regional (bond
primarily) markets. The yield of the 10 year Treasury should show that money
is still flooding in and it is still hard to find quality returns:
[https://ycharts.com/indicators/10_year_treasury_rate](https://ycharts.com/indicators/10_year_treasury_rate)

------
throwaway6497
This is great! I hope this becomes the new norm for all new startups. If a
start-up doesn't want to follow this then it really shows the values founders
believe in and the kind of company they want to build.

Is this kind of plan unpopular with VCs; shark and Gordon Gekko ilk?

------
boulos
Slightly off-topic: The title made me wonder if it was going to be about the
vast difference in equity grants between founders and employees (oh well).

But back on topic, harj et al. what's your opinion of Restricted Stock for
early employees? I believe the issue is just that granting Restricted Stock
once the company / share valuation is high enough is a _definite_ tax impact.
But it seems like nearly every pre-Series-A company could give the early
employees 100% Restricked Stock. Is there some reason I'm missing that this
never seems to happen?

Edit: s/RSUs/Restricted Stock/ since that's what I actually mean (the
weirdness of RSUs remains funny).

~~~
harryh
If you are starting at a pre-Series-A company you are probably much better off
getting options (that you early exercise) instead of RSUs to get cap gains tax
treatment.

~~~
boulos
Oops, I should have said _Restricted Stock_ (not RSUs). Founders get
restricted stock (with vesting), so why not the first several employees?

~~~
harryh
Ya. That's prolly a good idea in many cases. You just have to be careful that
the FMV doesn't climb too high, and employees correctly handle their 83b
paperwork or there will be tax problems.

Honestly I suspect this is why it isn't more standard. It's kind of a pain in
the ass to get right. Options are just easier.

------
andreasklinger
@Harjeet thanks for writing this up and putting the work into.

Imo our industry needs this. Atm there is very little incentive for
experienced people to join early stage start-ups as non-founders vs starting
their own thing. Tikhon summarized this quite well:
[https://medium.com/@tikhon/founders-it-s-not-1990-stop-
treat...](https://medium.com/@tikhon/founders-it-s-not-1990-stop-treating-
your-employees-like-it-is-523f48fe90cb)

Making options more employee friendly by default in our industry is an
important & good first step!

------
Animats
OK, that's the option exercise period. The next step is better antidilution
terms. Employees should have the same antidilution protection as founders.

------
jtfairbank
@harj - How do you feel about granting cash bonuses to employees at pre-
determined intervals to cover the tax cost of exercising their options? It
seems like that would solve a lot of these issues, but also give the employee
the flexibility to keep a small amount of cash if they'd prefer that over the
risk of owning stock.

An example: I join a $5,000,000 Series A startup with a 1% equity grant that
vests evenly over four years. At the end of each year, I get a $5000 bonus for
the purpose of paying taxes on exercised options. It's a bit more than the tax
cost for the first year, and likely a bit less in the later years, but after 4
years I've been given $20,000 which should be enough to cover most of the tax
burden. If I leave at the end, I still have a 90 day window to exercise them
and the money in the bank to do so. I could just keep the cash, exercise them
at the end, or exercise them for a cheaper cost each year.

That doesn't seem too unreasonable for post Series-A startups cost wise. An
extra 5k a year is nothing compared to the cost of a developer overall.

------
oroup
How about this - the company agrees to purchase And give to the employee any
options that are vested and un-exercised for two years and agrees to cooperate
w a declared set of known secondary buyers. Employees are on their own for the
taxes and can always decline.

* It extends the retention effect of equity since it starts kicking in at year 3 and extends smoothly forward.

* It has no cash impact on the company since its buying the shares from itself.

* In the early years the tax impact should be minimal. In later years there should be secondary buyers who can give employees enough cash to cover the tax liability at the cost of offering a discount.

* It discourages the pure lottery players since it requires the employee to either cover the tax burden or engage a secondary firm and deal w the discount they require.

* The downside for the company (aside from increased dilution vs the status quo) is that it establishes a clear market price for common equity which can be disadvantageous.

------
cballard
It scares me that this could be used to justify stock options as having a
value other than $0, and could be used to drive down real actual cash money
salaries. I'm fine with the current situation because I have no plan to act on
the options anyways - I don't invest in lottery tickets either.

~~~
boling11
If you believe that the stock options of the startup you're at are worth $0,
you should just ask for a market salary with 0 equity. Many companies will
give you a sliding scale of cash / equity.

------
kriro
As I understand it the major problem is that engineers need a lot of cash to
get even more cash if they exit the company and need it in 90 days. Possibly
very naive question...couldn't you include a clause along the following line
in your funding round(s): "Investor X guarantees that they will offer to cover
the necessary cost to exercise all options in return for Y%". So basically if
engineer A leaves and could exercise options the investor must offer a "bridge
loan" with guaranteed ROI (either cash or just keep the equivalent options).

Good investors shouldn't mind this clause that much (I'd think) as it takes
away one major point of worry for engineers and lets them concentrate on their
job from day 0.

------
alva
"Many employees don’t have the money to exercise their options within such a
short window and lose them."

Sounds like an excellent opportunity for a business. Providing short term
loans, taking x% or the exercised options. Although I am not familiar with US
laws that cover this area.

~~~
JonFish85
I really doubt whether that would work. The loans aren't necessarily "short
term", as the term is pretty much not known, the shares are the lowest on the
totem pole when it comes to payout and you have absolutely no control over the
company. That's a lot of risk, and if the cost of exercising options is so
high as to be difficult, the shares probably don't have the upside that might
be required to make it work.

~~~
alva
My bad, misunderstood the nature of these type of options. I was making the
assumption that the options could be exercised and then sold straight away.
Eg, employee has option to buy during this window at a strike of 1.1, current
value 1.3. I presumed the issue was raising the initial (options x preferred
price) cash plus any taxes/fees involved.

~~~
JonFish85
I believe most companies whose stock is publicly traded provide this for their
employees. If you have stock in, say, Google, when your stock vests, you can
have it sold and take the difference directly--no loan needed. I've never done
such a thing, so it's only hearsay on my part, but that's how I've understood
it to be.

~~~
ropiku
It's called a cashless exercise. You exercise and sell the stock right away so
you don't need to have the money to buy.

However the problem is most startups in this case are not liquid so you cannot
sell your shares (with some exceptions). Google and other public companies
give you direct shares via RSUs since they can sell part of your shares to
cover the taxes.

------
spoonie
Does having a bunch of vested, 10-year-window options on the books of a
startup affect its valuation? Would a potential buyer look at that and think
"That's a liability!"?

