This is the ultimate nightmare of every employee in the tech industry: being left with nothing when the company you’ve slaved for reaches an exit.
Much as in Tolstoy’s saying, so is the case with exit sob stories, every unhappy story is unhappy in its own way.
One employee worked in the company for 7 years, without realizing how much her equity had been diluted over the years. Another was employee number 3, but didn’t realize his options expire 90 days from termination. Either way, they were both left with nothing, as the company was sold for millions of dollars.
Don’t let this happen to you.
Don’t let the legal lingo and the pressure that the company will put on you at the final stages of signing your contract (and they will) prevent you from getting what’s rightfully yours.
Read this carefully to know your rights and to negotiate the best equity terms for yourself. So that you will go home with the financial fruits of your work and not with zero money and a bitter taste in your mouth.
Types of employee stock options
There are two types of employee stock options:
- Statutory stock options (a.k.a. incentive stock options (ISOs)) these options qualify for preferential tax treatment. The Internal Revenue Code, and IRS Publication 525 (Employee Compensation) contain detailed information on what constitutes a statutory stock option.
- Non-statutory stock options (a.k.a. non-qualified stock options (NSOs)). NSOs are any stock options that do not qualify as a statutory stock option. If a company specifically grants an ESO as a non-qualified stock option or if the company grants an ISO that fails to meet the qualifying criteria for preferential tax treatment.
The main components of an equity agreement
To understand what you should ask for and to be able to assess if what you are being offered is good or not, let’s examine the main components of an equity agreement.
Grant price/exercise price/strike price
- What it means – options are the right to buy a specified number of shares at a specified price. The grant or strike price is the specified price at which you can purchase the company’s stock.
- Common terms – Due to IRS rules, the strike price will always be set at FMV (fair market value) via a process named a 409A valuation.
- What should you ask for – If the potential employer sets the strike price substantially higher than the current fair market value valuation, it’s a red flag, as it results in a direct transfer of wealth from workers to the founders and investors. You should ask for the company’s most recent 409A valuation. Do not let the company drag their feet on issuing an options grant, as your vesting schedule does not start until it does, and your options may be covered by a substantially higher 409A valuation.
- What it means – Instead of providing the options all at once, companies spread-out the options over time. This period of time, until you can exercise your options according to the terms of your employee stock option plan, is called a vesting period.
- Common terms
- “Standard options grant” is the total vesting period, usually 4 years
- “Straight-line” 25% get vested per year
- “1 year cliff” It’s common for none of your options to be vested if you leave the company during the first year.
- What should you ask for – the standard terms, described above are absolutely fine. But, watch out for companies that fire employees at the end of the first year (right before the cliff).
- What it means – The date by which you must exercise your options (convert them into stock) or they will expire.
- Common terms – Usually the written expiry is 10 years. However, in most cases there is a “90-day rule”, which states that the options expire 90-days from the termination of employment. This is the most challenging aspect of employee options, because during these 90 days you will either have to pay both the strike price and the taxes or forfeit the options and leave with nothing. This means that you will have to assess your risk, if the company will succeed in the future, your investment will be worth it, or if it doesn’t it may not be worth it.
- What should you ask for – Try to avoid the “90-day rule” and extend it as much as possible after termination.
- Issue Date – the date the option is given to you.
- Exercise date – the date you do exercise your options
If you are considering joining a startup with great potential, understanding these terms is important to avoid “exit misery”. To ensure you are well rewarded, You should know the percentage of the company your options represent after dilution.
You should also ask about the terms of preferred stock, and the size of options pool versus investors and versus founder’s common. Ideally, the company would only have a single share class. If separate share classes exist, most probably the employee options (and their eventual stock) will be of the lowest class.
Remember that companies, even the smallest and the nicest, are inclined to offer their employees unfair equity agreements. Use this information to select a company that you believe in and that you can enjoy the fruits of its success.