We've written before how founders should issue share options, so check out that article for a fuller explanation. This piece is focused more on employee expectations, and what aspects of a share options scheme are particularly important to the people you hire.
Earlier in my startup career I made a rookie error.
Believe it or not, I was offered and accepted a salary of around one-third market rate, expecting the difference to be made up in share options.
In my defence, this was as much about desperation as anything else. Having shut down my own company, I was a recovering founder, and people weren’t exactly throwing opportunities my way. Time was against me too - I had rent to pay and my work visa was about to expire.
OK, enough excuses...
My wife and I quickly worked out that our family could just about live on the salary, and the promise of "generous" share options sounded like it would more than make up for the lack of income. The company appeared to be on a great trajectory too. Having just surpassed $1 billion GMV, they had raised capital from one of the more respected VCs, and seemed destined for the big time. To me, an eternal optimist, it felt like I needed to get on the rocketship while I still could.
This time next year, we'll be millionaires!
Something felt wrong.
This wasn't my first startup, so when I received the offer, I asked for detail on the share options. Obviously I wanted to calculate the total value of the offer.
This is where things got uncomfortable.
While I was told how many options I was getting, the founder refused to tell me the strike price. I thought that seemed weird. Worse, he refused to tell me how many shares the company had issued, on a fully diluted basis.
"I’m sorry, that's confidential."
I should have run for the door there and then, but stupidly I didn’t.
The founder assured me that I was getting a great deal. Now they had funding the company had plenty of runway, and I was getting more options than anyone in the company, other than the CFO.
I pushed back but got nowhere.
This was a tough spot. I'd now pushed as much as I dared. I felt the information I was requesting was pretty standard. Nevertheless, soon I reached a point where I felt I couldn’t push harder without losing the offer. Worse still, I was out of time and had no other options.
Of course, when I later found out how many options I had, the number was (you’ve already guessed it) 5-10 times lower than I was expecting. What an idiot.
Who was at fault here?
Well, firstly, I believe it's every startup founder's responsibility to have a fair and transparent approach to options. I also think that the value of options-plus-salary should be noticeably higher than each employee's market value, because there's a real chance the company will fail.
But the real fault lay with me.
It's up to the employee to understand what they're walking into and, in this instance, I didn't.
What can be learned?
The lesson for founders and employees is to aim for an options arrangement that is fair on everyone.
- There should be transparency about the number of options on offer and the current number of issued shares, on a fully diluted basis.
- The strike price should be no higher than the share price at the last round of funding (not the next one). As am employee, it will be partially your responsibility to help the company secure its next round of funding, so you should be a beneficiary from the increase in valuation. (NOTE: I believe in some places it's possible to price the options much lower than the last recorded share price, but in that case the recipient will have to pay income tax on the difference, which may not be the outcome you're looking for. Best to check with an accountant on this one.)
- Your share options should have "accelerated vesting". Most options come with a 4-year vesting schedule, which deters people from leaving (if you leave, you only have the right to buy the options that have already vested). Without an acceleration clause, if the company sells before your options vest, they're effectively no longer yours, so you miss out. Accelerated vesting prevents this because your options vest automatically in the event of a sale or IPO.
- Hirers should explain to their new hires how much runway they have. If people knew you only had three months of cash remaining, they may choose to defer their decision and join you once you've raised some more capital. It's only fair to give them that option.
- In my view, share options should not have a limited exercise period. Often, when you leave a company, you're only given a limited amount of time to "exercise" your options. Exercising is not something to treat lightly because it will cost you. Not only may you have to pay for the options (number of options held multiplied by the strike price) but also you'll need to pay tax on them, because they are treated as a benefit. This is a big risk, because once you've bought those shares, there's no obvious way for you to sell them. If the company fails, you'll be out of pocket for both the price you paid, and the tax (although it may be possible to reclaim that, depending on jurisdiction). By removing the exercise period, founders enable option holders to hang onto their options until the shares can be sold. That effectively enables the holder to pay the premium and the tax from the gain.
What else to be aware of when you're offered options.
The truth is that very few people make money from their options. For example, estimates suggest that only 2-400 Uber employees made >$1m from their share options. $1m may sound pretty good, but remember that Uber employed ~27,000 people when it IPO’d in 2019 and is one of the great success stories of our time. That company you're interviewing with? It’s no Uber.
Yes, a handful of companies starting now may become worth billions, but the majority will fail or at best achieve moderate success. In most cases employees’ options will be worth ~zero.
Even if the company succeeds...
- You may be fired and lose your options.
- Your company may accept bad investment terms to stay afloat, meaning employees and even founders get nothing (look up FanDuel. Its founders and staff received $zero when the company sold for $465m).
- A deal may be structured in which founders do well but employees don’t (remember Adam Neumann?).
- You may get fed up and leave. If your options agreement contains a fixed exercise period (often 90 days), you’ll have to buy your options or lose them. Can you afford (to raise) a 5 or 6-figure payment for options (and the associated tax!) that may STILL end up being worthless?
- You may even make $1m, but then realise it took >10 years. What did you sacrifice in the meantime?
Whatever you do, don't accept a job purely based on the riches that your options will bring you, and chances are they won't!
Know someone who's been offered options?
Share this with them - it may help them avoid a costly mistake:
If you have suggestions for how I can improve this article, please drop me a line on LinkedIn. I'd love to keep it current. Thanks.