I would also recommend the book Consider Your Options at http://www.fairmark.com/books/consider.htm . It costs <$25 and will take a few hours to read, but can save you from making very expensive mistakes.
I bought this book back in the early days of Google to make sure I was doing everything right. It's boring but clear and helpful, which is about as much as you can expect from a book about stock options.
I'm going to check this book out. But I've always had one nagging question about vesting I haven't found a good answer for.
Say you have a bunch of shares vesting over 2-4 years.
Is it possible (or realistic) to make an arrangement that in the event of an acquisition or liquidity event that your stock becomes full vested? Even if its been less than the full vesting period?
Post-Enron, the government suddenly felt it was really important to have all options be priced by third parties, even tiny three-person private companies, so it’s now a legal requirement that if the Board wants safe harbor from lawsuits, it must get a 409(a) valuation done every 12 months. These usually cost around $8000 and are done by the most unimaginably braindead accountants you can possibly imagine. Their job is to tell you a high price (say, 1/4 of Preferred) and your job, amusingly, is to explain to them why your company is Really On The Brink Of Absolute Annihilation so as to coax them into a 1/6 or so valuation, which then the Board will accept. This process is time and money you cannot afford, but the government mandates it. (source: page 12 under "Pricing")
At the core of this issue was (and still is) how "deferred compensation" can be exploited by executives as golden parachutes. When execs can spread out their compensation over time, the tax treatment of the compensation can be minimized for the execs and maximized for the companies. Before 409a, the reverse was true. Whenever corporate profits are earned they're either re-invested or distributed -- only two ways to handle the money.
Before 409a, golden-parachute-type arrangements taxed execs when amounts were actually (or "constructively") received as income. This tax treatment made it favorable for employers to give deferred compensation as incentive -- lots of it. Makes sense: amass huge liability for work that was never actually done on profits that have not yet been earned. If you're an executive of General Motors, or on the board of any large company, this pre-Enron way was good for the manager getting deferred compensation, but bad for the company. Any future profits go to the executives FIRST (whether or not those execs are even at the company still!), and the short-term performance of the company and manager is what they want to focus on.
There has always been a huge battle between corporate profits and executive compensation. One of the best professors I had in grad school had done his doctoral on golden parachutes, and this is a pretty interesting area. Complicated, but interesting.
Unfortunately, we don't have any laws creating incentives for corps to give profits to the common shareholders (in this case, employees receiving vanilla stock options), just the laws that encourage companies and their (current and former) executives to engage in tug-of-war over the distribution of future profits. When this happens, very little of the value tends to trickle down to Joe Shareholder .
Does anyone have a link to a document that would detail the ways that you could get screwed over by a startup? Or by VCs? I know there are tricks that can be made via dilution, or something, but all I've heard are horror stories, but no actual mechanics of how it was done, and what you should look out for when looking at joining a startup.
> Does anyone have a link to a document that would detail the ways that you could get screwed over by a startup? Or by VCs?
There's really no need, because it all falls under this category: You work really hard, and then they use one of the many powers of the board to screw you out of a payoff. I've seen punitive dilution, reverse splits plus new issuance, firing before vesting events.
If you haven't looked up variable-reward experiments, it's worth a gander because it bears a strong resemblence to startups.
This (extremely well-written) document has made the HN front page at least once before. I think this is a testament to how useful this information is for entrepreneurs. I didn't have time to read it in full last time, glad it's back again.
Hey there's something I'm a bit confused about. The text talks about how when you receive stock as an employee you pay income (gains) tax over them for which they might not have the cash. Does this also hold for other stock holders like the founders?
When the FMV has increased, do founders also have to pay taxes for their shares?
To avoid this, vesting founders would presumably file an 83b election within 30 days of receiving the shares (mentioned in the PDF.) Then, they only have to pay tax when they sell the shares. And if they held on to those shares for over one year, this would be a smaller, capital gains tax.
Great guide overall – a couple of clarifications, though. The first sentence of the Ownership section seems to confuse ‘authorized’ with ‘issued and outstanding’ shares. The amount of shares authorized must be in your corporate charter and requires shareholder approval to change. From that pool of authorized, the board can then issue shares which then become the ‘issued and outstanding’ shares. If you add in the amount of shares that could be issued if all securities convertible into that class of stock were converted (e.g. convertible debt, options, warrants) then you have fully diluted issued and outstanding. Also, as someone pointed out, ISO vs. NSO has nothing to do with employee vs. advisor: ISO’s are incentive plans/options that are designed to meet certain requirements in order to allow favorable tax treatment.
A book that I also find interesting, and give great insights in venture capital, is the book wrote by Chris Dixon, http://amzn.to/uQSXnb.
It's only 2,99 and give good and insightful advices for startups and venture capital.
one question - the doc has a very standard "I'm not a lawyer so go get a lawyer" which is understandable and appreciated. Could someone who is a lawyer read the document over and give a thumbs up/down or give their notes on it?
obviously their notes wouldn't be legally binding either, but it would be a step which would improve this already awesome guide.
No bank in their right mind would give millions of dollars to a "coder" with a "great" idea.
A bank (or any rational debt holder) has little interest in upside. Their interest is capital protection and repayment.
Debt is typically divided between "asset lends" and "cash-flow lends". You can get serious leverage with an asset lend, maybe 80% of equity, but that assumes you have assets (less debt) as colateral. So if you want $3m, you need at least $3m in equity.
As for cash flow lends, rational debt providers won't go anywhere near even 5 times for an unstable/unproven company. 5 times what? Usually some proprietary measure of earnings (EBIT, EBITDA, EBITDA-C, NPAT, cash flow, etc, adjusted for whatever the bank decides). So for $3m, you usually need $1m in cash-flow already. Even then, you have to deal with monthly or quarterly debt covenant reporting.
Most businesses who qualify for cash flow lends are relatively solid. That's because the covenants are restrictive (and especially frightening for an inconsistent business). A 5% drop in revenue can filter down to a serious drop in the proprietary cash-flow calculation and have the bank calling its capital the next day.
Compare that to a VC scenario. Imagine you've burnt through $3m, sales have dropped, then the bank calls the entire $3m loan. Maybe in the US that stuff flies, but in most responsible financial markets, that means you're toast for 5-7 years. You won't even get a mobile phone contract in some countries.
Of course there are business suited to traditional debt, but I can't imagine the typical HN reader would look for serious capital from credit institutions, unless of course they made serious money and they couldn't get VC for market size reasons.
This has a lot of really valuable information - thank you for sharing. I only entered the working world a few years ago and I wish I had read something like this before I had a job offering options so I wouldn't have been so clueless about how to look after my long term interests.
If you're receiving NQSOs (non-qualified stock options) instead of ISOs, note that the document is entirely confused about them. They have nothing to do with advisors vs employees.
Shameless plug: I work at truequity (http://www.truequity.com) where we provide a subscription based product, for start-ups, to manage stocks & options. I think it really helps founders understand what happens to their company when investors come in.
[+] [-] Matt_Cutts|14 years ago|reply
I bought this book back in the early days of Google to make sure I was doing everything right. It's boring but clear and helpful, which is about as much as you can expect from a book about stock options.
[+] [-] dmix|14 years ago|reply
Say you have a bunch of shares vesting over 2-4 years.
Is it possible (or realistic) to make an arrangement that in the event of an acquisition or liquidity event that your stock becomes full vested? Even if its been less than the full vesting period?
[+] [-] shawnee_|14 years ago|reply
At the core of this issue was (and still is) how "deferred compensation" can be exploited by executives as golden parachutes. When execs can spread out their compensation over time, the tax treatment of the compensation can be minimized for the execs and maximized for the companies. Before 409a, the reverse was true. Whenever corporate profits are earned they're either re-invested or distributed -- only two ways to handle the money.
Before 409a, golden-parachute-type arrangements taxed execs when amounts were actually (or "constructively") received as income. This tax treatment made it favorable for employers to give deferred compensation as incentive -- lots of it. Makes sense: amass huge liability for work that was never actually done on profits that have not yet been earned. If you're an executive of General Motors, or on the board of any large company, this pre-Enron way was good for the manager getting deferred compensation, but bad for the company. Any future profits go to the executives FIRST (whether or not those execs are even at the company still!), and the short-term performance of the company and manager is what they want to focus on.
There has always been a huge battle between corporate profits and executive compensation. One of the best professors I had in grad school had done his doctoral on golden parachutes, and this is a pretty interesting area. Complicated, but interesting.
Unfortunately, we don't have any laws creating incentives for corps to give profits to the common shareholders (in this case, employees receiving vanilla stock options), just the laws that encourage companies and their (current and former) executives to engage in tug-of-war over the distribution of future profits. When this happens, very little of the value tends to trickle down to Joe Shareholder .
[+] [-] steve8918|14 years ago|reply
Does anyone have a link to a document that would detail the ways that you could get screwed over by a startup? Or by VCs? I know there are tricks that can be made via dilution, or something, but all I've heard are horror stories, but no actual mechanics of how it was done, and what you should look out for when looking at joining a startup.
[+] [-] jpdoctor|14 years ago|reply
There's really no need, because it all falls under this category: You work really hard, and then they use one of the many powers of the board to screw you out of a payoff. I've seen punitive dilution, reverse splits plus new issuance, firing before vesting events.
If you haven't looked up variable-reward experiments, it's worth a gander because it bears a strong resemblence to startups.
[+] [-] tibbon|14 years ago|reply
[+] [-] DanielRibeiro|14 years ago|reply
[+] [-] eykanal|14 years ago|reply
[+] [-] wyclif|14 years ago|reply
[+] [-] tinco|14 years ago|reply
When the FMV has increased, do founders also have to pay taxes for their shares?
[+] [-] d_r|14 years ago|reply
Described in more detail here: http://www.grellas.com/faq_business_startup_004.html
[+] [-] caffeine5150|14 years ago|reply
[+] [-] dudurocha|14 years ago|reply
[+] [-] drewda|14 years ago|reply
[+] [-] tomhallett|14 years ago|reply
obviously their notes wouldn't be legally binding either, but it would be a step which would improve this already awesome guide.
[+] [-] dweekly|14 years ago|reply
[+] [-] captainaj|14 years ago|reply
[+] [-] rokhayakebe|14 years ago|reply
[+] [-] todsul|14 years ago|reply
No bank in their right mind would give millions of dollars to a "coder" with a "great" idea.
A bank (or any rational debt holder) has little interest in upside. Their interest is capital protection and repayment.
Debt is typically divided between "asset lends" and "cash-flow lends". You can get serious leverage with an asset lend, maybe 80% of equity, but that assumes you have assets (less debt) as colateral. So if you want $3m, you need at least $3m in equity.
As for cash flow lends, rational debt providers won't go anywhere near even 5 times for an unstable/unproven company. 5 times what? Usually some proprietary measure of earnings (EBIT, EBITDA, EBITDA-C, NPAT, cash flow, etc, adjusted for whatever the bank decides). So for $3m, you usually need $1m in cash-flow already. Even then, you have to deal with monthly or quarterly debt covenant reporting.
Most businesses who qualify for cash flow lends are relatively solid. That's because the covenants are restrictive (and especially frightening for an inconsistent business). A 5% drop in revenue can filter down to a serious drop in the proprietary cash-flow calculation and have the bank calling its capital the next day.
Compare that to a VC scenario. Imagine you've burnt through $3m, sales have dropped, then the bank calls the entire $3m loan. Maybe in the US that stuff flies, but in most responsible financial markets, that means you're toast for 5-7 years. You won't even get a mobile phone contract in some countries.
Of course there are business suited to traditional debt, but I can't imagine the typical HN reader would look for serious capital from credit institutions, unless of course they made serious money and they couldn't get VC for market size reasons.
[+] [-] jpdoctor|14 years ago|reply
[+] [-] Perceptes|14 years ago|reply
[+] [-] kens|14 years ago|reply
[+] [-] dweekly|14 years ago|reply
[+] [-] pagehub|14 years ago|reply
[+] [-] dladowitz|14 years ago|reply
[+] [-] yoramv|14 years ago|reply
[+] [-] fernandose|14 years ago|reply