In a previous post, I give what I hope is a crash course in terminology and basic concepts around startup stock options. Having read that (or having a decent understanding of options), you might well ask: what good are stock options? Why would I want them? If you listen to some recruiters, the answer is that they make you rich. Is that true?
How can they be worth money?
Remember that, at their simplest, stock options just entitle you to buy stock at a preset price. Stock options for startup stock are valuable if you can sell the shares of stock you get from exercising the options for more than it costs to exercise the options and obtain the stock.
As an example, suppose that you join a hypothetical startup early on. The board awards you a grant of 20,000 options at $.20 a share. Years go by, your options vest, the company gets bigger and more valuable. Let’s say that you could sell a share of the company stock for $50 a share somehow. If you exercised your options for $4000 (20,000 options, $.20 each to exercise), you could sell the 20,000 shares for $1,000,000, and net $996,000 in profit. 1
As discussed in the previous article, startup stock is typically illiquid. By definition, the scenario above presumes liquidity — you couldn’t just up and sell illiquid stock. So, how could you actually reap your riches? There are a few common liquidity events.
The easiest outcome to understand is when the company goes public or IPOs; that is, it lists its stock on a public stock exchange and offers it for sale to the general public. In this case, you can just sell the shares from a normal brokerage account for whatever the public market will bear. No board approval or other restrictive exercise conditions required. 2
Tech companies don’t always choose to go public. Listing on an exchange involves publicly sharing a lot of information for the first time, which can go poorly 3. Share price after IPO may slump or otherwise disappoint 4. Even if the actual offering is successful, being a publicly traded company involves regulatory overhead that many companies may not want. A company that is well capitalized from private investment and doesn’t have board pressure to go public may simply choose to remain private. In this case, employee-held stock will generally remain illiquid, though can still be sold in a few common ways.
A tender offer is a way to allow existing stockholders to sell their stock without the trouble of a public listing. A investor or a group of investors will offer to purchase existing shares for a certain price, typically with the approval of company leadership. This can be a current investor looking to increase the size of their stake, a new investor looking to buy out existing investors, or something else. Tender offers may allow employee stockholders to participate, though with some restrictions and with a single take it or leave it price per share. In other words, they’re out of your control as an employee for the most part, but can provide some money if and when they occur. 5
There are also firms that specialize in acquiring pre-IPO positions in late-stage VC companies directly from employees (typically on behalf of other investors who want a position in the firm). EquityZen is one prominent example. As mentioned, it’s difficult to just decide to sell pre-IPO stock that you received as an employee after exercising stock options; option agreements can have very restrictive terms that significantly limit your ability to sell. That said, in some situations it is possible to sell, and these firms have expertise in navigating option agreements. 6
Finally, the company might be acquired. This isn’t necessarily a win for employee stockholders. Some acquisitions of the “make the investors whole” variety might leave little or nothing for less senior shareholders (employees with options); this is an example of a case where the options are worthless due to liquidation preferences and other factors. Even in cases where the options aren’t worthless, what you get for them can be far less than you might have dreamed about. 7
Am I going to be rich?
“You’ll have 40,000 shares of ACME social taglet box of the month club, so if the company goes public for $30 a share you’ll be a millionaire!” / “We plan to make our employees equity millionaires!”
Big asterisk. This is at the very least deceptive, especially for early stage companies.
- The odds of a startup making it to any of the liquidity events described aren’t good, especially if you join early. 8
- If yours does make it to an IPO, no one, certainly no one telling you this, can tell you what it will trade for when it does.
I do think this can come from a good place. Most of the leadership I’ve worked for over the years genuinely want to do well by their employees. The problem is that it’s just not their call. The market for their product, the fundraising market, their board, and other factors all influence what happens to the company.
40,000 shares is a lot, right? It sounds like a lot.
Maybe. 40,000 out of 400,000 total shares is a lot. 40,000 out of tens of billions isn’t. And the number of outstanding shares might change while you work there, and some investor might have a liquidation preference that eats up most of the proceeds of a sale, etc. It’s a hard question to answer when you join a company (the information you need to answer it is often tightly held), and in any case the answer will usually not remain the same over your tenure at the company.
But people do get rich!
Sure, though it’s uncommon. Threads querying about payoff from stock options pop up up HN from time to time.
- https://news.ycombinator.com/item?id=3325304 (this one is my favorite and has a poll, but is from almost 10 years ago)
There are (if we believe the responses) some people who have been made seriously wealthy by their startup options, and a much greater number who made nothing. Also keep in mind survivorship bias, and how it might lead the people who have had outsize success to be overrepresented in those threads.
Why have options at all?
The argument in favor of stock options is something like:
- Employees are taking a cut in immediate/predictable total compensation by working here instead of at FAANG, and we need to give them potential upside to compensate them for that short term cut.
- We want everyone to feel like an owner/feel incentivized to make the company succeed.
- We want to attract people who aren’t just motivated by money.
I think some of that comes from a good place; I’m a definite fan of people who work hard to make a company succeed being rewarded for their efforts. But startup options have a lot of downsides.
- IPOs are (IMO) the one event most likely to result in an unqualified win for employee shareholders, but many companies will never IPO (either remaining private or exiting via private sale to another company, assuming that they don’t fail).
- Pre-IPO startup stock is illiquid. You can’t easily sell it to pay for your house, start a college fund for your children, etc. To the extent that you can sell it (tender offers, secondary marketplaces), you do so only with the permission of company leadership, for a price that they have at least some control over, and in an environment that does not promote fair price discovery in the same way as a public stock exchange does.
- Due to SEC requirements and limitations on how pre-IPO startup stock can be traded and who can buy it, the buyers in any pre-IPO trades are sophisticated investors. If an employee sells pre-IPO stock in a tender offer or secondary marketplace, they are likely to be on the losing side of information asymmetry.
- Short of IPO, liquidity events for a startup can leave employee shareholders with nothing, even if the company is successful or the deal is perceived as a win for investors. Information about fundraising structure that would help employees more accurately evaluate the risk of this outcome is typically not disclosed during hiring or during normal work at the company.
- Laws around ISOs force employees who want to leave before a liquidity event (to grow their careers, care for their families, go back to school, etc) to choose between exercising their options (potentially incurring a large tax bill for an uncertain future payoff) or forfeiting them without exercising (losing any upside from their hard work).
These downsides are non-obvious to people just starting out in the field, and can be used as a way to take advantage of more junior engineers. More senior engineers (at least most of the folks I know) typically just value options at $0 and, if they choose to work for a startup, choose to do so for other reasons. 9
Can we make them better?
It’s a complex topic. I think many of the downsides are variants on a few themes:
- Pre-IPO startup stock is illiquid.
- Pre-IPO startup stock is difficult to value if you’re a regular employee.
- Taxes around ISOs effectively make startup stock a use-it-or-lose-it thing if you leave or are forced to leave your employer.
It wouldn’t be too awfully hard to improve some aspects of this:
- ISO to NSO conversion on departure, practiced by some companies, could be made more common or standard across the industry. This bypasses some of the scarier tax consequences of exercising stock options.
- Secondary exchanges for pre-IPO stock already exist. Rather than deferring to scary exercise clauses in option agreements, companies could establish and communicate clear policies about the process for exercise using a secondary exchange, maybe even identifying one that they prefer to work with.
This won’t guard against all of the downsides, of course; the company could still go under, a private sale could leave employees with nothing, dilution could leave employees with nothing, etc. It is an improvement, at least. I’m hopeful that the first bullet point may at least happen, given the notable companies already doing ISO to NSO conversions.
I have some more radical ideas, but those are for a future post.
This is simplistic and notably omits taxes (which in this example would be substantial), but hopefully illustrates the concept. ↩︎
Again, simplifying a bit here. There’s typically a lock up period after an IPO during which company insiders and existing shareholders are prevented from selling their shares. This isn’t legally required, and is thought to avoid depressing the price of the stock immediately after IPO by flooding the market with insider-held shares. Lock up periods can vary between company, but are often 90 or 180 days. After a lock up period expires, employees and insiders can typically sell their holdings. ↩︎
WeWork is a prominent example of this. While other factors were at play, the information in the documents released in preparation of the IPO contained a lot of information that didn’t paint WeWork or its management in a particularly good light. ↩︎
For example, see Lyft, Uber, or Snap. Make sure to zoom the charts out to their maximum interval. This can be depressing when lock up periods are taken into account. Insiders can celebrate a big win on IPO day, only to see the stock price slowly sink throughout the lock up period. ↩︎
Restrictions on tender rounds I’ve read about include allowing employees to sell no more than 50% of their shares, requiring employees to be accredited investors, and excluding certain types of stock. ↩︎
It goes without saying that you pay for this expertise, in that the person buying the stock from the marketplace is probably paying a good deal more than you end up receiving. ↩︎
I talk more about liquidation preferences in a previous post. ↩︎
One of the common bits of tribal wisdom in software is that 90% of startups fail. I think the actual number depends on what you count as failure, which data you’re looking at, etc. If the various sources are consistent about anything, it’s that the number is pretty high. ↩︎
Selecting for senior employees who can financially afford to do this seems almost certain to result in a less diverse workforce. ↩︎