My $20,000 Lesson: Stock Options are BS

It’s been a while since I covered the bullshittery of startup stock options on this blog, but today life had led me to needing to put out a distress signal to anyone who doesn’t quite understand how they work and why they are really a load of fancy horse manure, slightly more valuable than a handful of lottery tickets.

What’s worse is those lottery tickets come with a price. I’ve explained this on my blog before, but feel like it’s necessary to cover this topic one more time, just to make sure that the point is clear.

When you join a startup, part of your total pay package is in stock options. For the sake of simplicity, let’s say you are a new employee, relatively senior, and you are going to be given $100,000 in total compensation. That compensation will not be all cash. Say you get $70,000 in cash, $30,000 in options. The value of those options is really where the bullshit factor begins. Options are priced at what the investors think the company is worth. The earlier the company, the lower the “valuation” (i.e. price the investors think the company is worth), but also there’s a lot of guesswork involved as well. What is the company going to be worth when it sells? How can anyone know that before the product is tested and it’s clear that people actually want to buy that product for the long term?

The reality is, despite the math behind it, there’s plenty of guesswork involved. No one will tell you that because they want you to look at your stock options as this shiny golden egg. They are somehow even better than cash, as you can turn these goose eggs into solid 24k with the right amount of effort and passion and dedication. Bullshit. The founders want the valuation to be as high as possible because it enables them to maintain the most control of the company. So the founders have every reason to inflate the value of the company and weasel every last cent out of investors. Some downright lie. Some just white lie. Some don’t lie at all. Some have a great product and don’t have to. But for many, especially early on, there’s a lot of slight of hand going on, if you will. This isn’t necessarily terrible as companies do need to raise money to grow, but rarely is it in the best interest of employees, especially early employees who take massive paycuts to come to a startup both for the cultural aspects and the prospect of maybe their stock options helping them one day, oh, afford a downpayment on a house in the bay area.

Let’s pause here for a moment, because here’s where the story gets even better. Stock options are just that – options. They are not stock. So you are basically given the “option” to buy the stock at a strike price (which theoretically is low based on what the current valuation of the company. But remember all these numbers are bullshit until you actually have sustainable sales or a rapidly growing userbase.)

Why does this matter?

Taxes make stock options much less beneficial to the employee. This is how I lost nearly $20,000. Let me explain. If you’re granted NSO options, you’re allowed to file an 83(b) election. What this means is that you actually exercise (buy) your stock today for the strike price (woohoo, cheap stock)(wait, but isn’t that price bullshit anyway?) If you’re wondering why on earth you would buy the stock today for a price that may or may not be too high, this is why. Say your company is growing at a rapid rate. Two years go by and you have 100,000 options. Your strike price was .50 per share, so it will always cost you $50,000 to buy all of your shares. However, if you wait until the company raises more money, you have to pay tax on buying these shares. Basically as the price goes from complete bullshit to slightly less bullshit, you have to start paying a tax (fine) to exercise and buy the stock. You are theoretically making a profit here, even though you can’t sell the stock and even though the price is bullshit because in a private company there are a lot of bullshittery tactics and untruths that a founder and investment team can get away with that wouldn’t fly in a public company.

So why not just wait until an exit (i.e. when the company goes public or is acquired) to buy your stock and immediately sell it? That sounds like a great plan, and certainly the least risky, but here’s why that’s not such a good idea either:

– if you leave the company, you have 90 days to buy your options. otherwise, poof, they disappear in thin air.

– if you are leaving the company, you are either being forced out or quitting. often this is because the company is not doing as well as you thought it was going to do. your risk to exercise becomes larger as the true value of the company comes to light. but that true value is still hidden under a lot of falsehoods so as a common employee you will never be able to make an informed decision on your purchase (unless in the very rare case you have an honest CEO who is maniacal about transparency. Good luck finding one.)

– it takes a long time for a liquidity event. This is not a bad thing. Great companies, with rare exception, don’t go from nothing to something overnight. For instance, Salesforce.com, founded in 1999, went public in 2004. That is still an exception with a fast five-year growth. But if in our model above an employee had shares at the strike price of .50 and after four years left the company without previously exercising, we can guess that the stock cost more than $10 in taxable profits to exercise. It would have been a smart move, but it also would have been a much larger and more expensive risk than exercising earlier

Here is Where the Bullshittery Starts to Stink

If a startup employee exercises her stock without realizing that it’s a risk and an investment, then that’s the fault of that employee. But the fact of the matter is that just how big of a risk that the employee is taking is not clear. Still, that’s the employee’s responsibility to explore, understand, and make the best informed choices possible. Where it gets really funky is in the dirty details. The things that go on behind the scenes.

The great deceit used by executive teams (who stand to profit even if the company ends up selling for less than it raised, as long as it sells) in order to keep productivity high. The founders and executive team together must make everyone in the company believe their options are worth a lot of money, and this becomes even more necessary if the company isn’t performing well. If the company is performing well, it can always hand out cash bonuses and raises to its talented employees to stay. But if it isn’t, then all the executive team has to keep employees happy is stock options. Good news for them, they know those options are most likely worthless, but they can still hand them out like hyperlux candy.

Employees only make a profit on their stock if, and only if, the company is sold for more than the investors put in. Investors get preferred stock. This means that if the company raises $10M in preferred stock, it needs to sell for $10.00001M before the employees get anything. If the company is worth more than what it raised, theoretically all of the rest is divided by the total number of “common shares” in the pool. Say the company sells for $11M, then $1M would be split up amongst everyone depending what % of the company they own.

Of course, it’s not that simple. There are a lot of other factors that go into this. I don’t even pretend to understand all of them. Depending on what the founders and investors wanted to do when rounds of money were raised, other clauses could be written into the fine print of a thousand contracts.

But Wait, There’s More Bullshit You Say?

Plenty more. Let’s say the founders and investors decide it’s best to sell to a private company. The company may put into effect a variety of rules around how stock is purchased. Maybe it’s an all cash deal. Maybe it’s a mix of cash and stock. I was in a company once where I was given the option to either take $3 per share in cash or trade the shares in for shares of the new company, then valued at $8 per share. However, I was not actually given this choice as only accredited investors (networth $1M or more) could take advantage of this offer. I was stuck with the $3 per share price (which in that case still ended up being a small profit.) Most of my colleagues were able to trade in for shares of the new company.

Even those who were able to trade in for shares of the new company and other benefits were handcuffed to the new company for years to be able to have access to those benefits. This is why in some cases high-level employees quit before an acquisition, while they may not have control over the actual purchase terms, they might have more flexibility in deciding what to do with their earnings versus being locked in for another number of years. Even if you’re on the executive team with tons of stock options in your pocket, you can still get fucked over. Only the investors are safe. The founder(s) can do some weaselly things to cash out early as well. Employees are most likely to get screwed.

Not all employees deserve to be millionaires, but it’s the employees that build the company, not just the founder and the executive team. At least founders have to build something from nothing – which, even if they are in it with bad intentions, takes talent, perseverance, and perhaps takes years off their life. So, you can say that a founder, even if he chooses to build a fake company with the plan to tank the company, pull out millions of dollars for himself, and let the company and its employees suffer the consequences, still earned some of that cash because he was the mastermind who manipulated otherwise intelligent engineers and business types into believing that what he was building was real. That takes a lot of hutzpa. If one can maintain this for years and actually convince people to buy a product and paint the picture of a successful company to the market to raise more and more capital with great terms for them, then god bless the talented sociopath. If there were a grand judge at the end of life, surely the court would rule against their favor, but life instead favors those who bend the rules, thus I have a mild admiration for those who can get away walking the fine line between corruption and complete legality.

What gets under my skin is how the executive team, which is put in place in order to be the polish on top of a rusty car that isn’t starting, is who ends up benefiting even upon a failure of the company due to management decisions, not the employees who are working hours upon hours per week to build and refine a product. In fact, when the company is past the point of no return into the pit of despair, the employees have no upside to stay, while the executive team still has the opportunity to walk away with a sizable bonus, as long as it can keep the company together long enough to sell it. The investors just want some of their money back, and they’re willing to part with a few million dollars if the management team can sell the company. So basically the real estate agents get paid if they can sell the house, the people who built the house, who were told they owned a piece of that investment, see nothing unless it’s sold for more than the investors put in.

Even worse is that company management can change over time, and management objectives change. When you have sociopaths at the helm, anything goes as long as they profit in the end. The key is understanding their motive. Perhaps a founding CEO wants to build a company to a point where he can raise lots of money, leave the company, and sell shares back to the company. A new CEO may be put in to replace him, but the new CEOs objectives are not as easily understood. This CEO is often appointed by the board. They are then, supposedly, acting in the best interest of the board. If the company is tanking, which it likely is if the board is replacing the CEO, they have to give some incentive to the new CEO to come in and figure out how to sell it for as much as they can get back, all while making it look like everything is fine and dandy. What happens is that if the company sells for anything, 15% of that is carved out for the management team, 10% goes to the new CEO, 5% goes to the management team, 0% goes to the employees. The new CEO really then has no incentive to grow the company. It serves him best to sell the company as quickly as possible for the fastest time-to-profit ratio. The investors surely don’t mind that either because they want to recoop their as much of their money as possible as fast as possible to invest in another startup. It’s not worth anything sitting in a company that is losing value year over year.

There is other craziness that may go on behind the scenes. For example, an executive may offer another company “first right of refusal” on purchasing them. This may be done to help seal a partnership deal, and the executive may, using his better judgement, think that the agreement is best for the company (or at least best for his position in the company.) The problem here is that when the company actually tries to sell, you have one company that possibly doesn’t want to buy you at all, and another company that, even if they’re interested, will be angry about basically being legally bid matched by this other company within 30 days, and still lose the deal. Unless the startup is highly desired (and it takes a management team with a goal to build a great product for that to happen, not one who wants to tank the company) then there is no reason for either potential acquirer to pay top dollar for the startup. It just encourages a race to the bottom.

The new CEO may also, if he’s a really clever sociopath, trick the investors into thinking this is what he doing while instead setting things up to be even more in his favor. The founder likely still owns a bunch of stock in the company, even if he sold out a bit to get liquidity during a funding round (employees cannot do this but founders get to do a lot of things that screw over employees.) The new CEO, rightfully so (if he were to actually do the company right) wants to gain access to as much of the remaining equity as possible. He wants to dilute the founder (and with that dilute the early employees) so his percentage of the pie gets larger. To do this, he can take what’s called a “down round” where the actual value of the company that investors buy at is less than what it was once valued at. This shrinks the percentage of the pie that early employees (and the founder) have and makes it possible to give new employees more options at a lower valuation (and the CEO also gets a large chunk of these new options as well.)

While that could be the ideal situation for a company that’s failing due to poor early management, early employees who were given all of these shares at such a good strike price are basically SOL, especially if they left the company by choice or force. In fact, new management has every reason to want to get rid of early employees because they are hogging many shares at a low valuation to begin with. Here’s where things get into deep bullshit.

When you join a company and get a heap of stock options, you don’t actually get them. You get them over a period of four years. Usually this requires you stay at the company one year to have access to 25% of them, and then the rest vest monthly until that four year period is up. So, say, a management team sees you got a lot of shares early on and they want those shares back they can decide to fire you at month 11, and you get nothing. If they think the shares aren’t going to be worth anything anyway they have less incentive to fire you, but then your shares are worthless. If they are going to be worth something, while you were a valuable hire for the first 11 months of the company to help grow it from nothing to something, by the time it’s something they might want to hire someone more experienced or in their minds better than you, and out the door you go.

This is not to say that people can’t make money on stock options. Some do strike it rich. People argue that you shouldn’t work in startups to get wealthy. It should be for the experience. The culture. The opportunity. Yes, this is true, but if this was the only reason to work at a startup why would stock options even be part of the total package? Clearly, the lottery tickets are a part of why people chose to work at startups vs large companies. And the shiny $19B acquisitions of one company out of thousands upon thousands make otherwise intelligent people’s eyes glaze over. It could be them. It could have been me.

The one piece of good news is that if you early exercise (buy your shares) and leave before your vesting is over, you get the remaining money back. Sure, it was locked up for 0-3 years earning no interest, but you do get it back in the form of a check. Any stock you early exercised and purchased is locked in and a done deal. Here’s the kicker. You cannot sell any of this stock. You have stock, but it isn’t liquid until an exit. At this point, it’s probably clear that at exit it will be worth even less than it’s worth today, unless some great miracle happens. So you’re stuck with a pile of worthless stock. And as a former employee the management team has no reason not to do everything in its power to fuck you over. They don’t care that you actually paid money to invest in the company, because you bought cheap common stock. Wouldn’t it just be better to take that $20,000 and instead buy preferred stock in a startup? Except, oh right, you can’t do that because the government says unless you have $1M in networth you’re not an accredited investor and that would be too big of a risk for you to take. Somehow buying stock options in your own company with less control is a smaller risk. Someone explain that to me.

Ultimately, I’ve learned that stock options are most often worthless, and not worth exercising unless you really trust the management team, see a product with solid market traction and customers willing to buy more of that product, and know that there is a growing market opportunity for your product. If you have NSO shares (non-qualified stock options) which allow for early exercise, I would recommend that you wait to exercise these shares until you see serious traction and have proof the executive team (and especially the founders) are in it for the long haul, not just to build and flip a company or to tank it for their own profit. I’m now focusing more on cash comp, with fair stock options, versus being paid under market in exchange for a lot of stock options which I then have to buy. I soothe my soul with the thought that I “only” spent $5k per year on these options, plus interest lost, and I can tell myself that’s a tax-deductible educational expense (yes, one can deduct the loss like any other capital loss, but only when the company finally sells or goes under.) $5k per year for the lesson above maybe isn’t so terrible. I’m sure many others spend a lot more to learn the same lesson.

 

 

 

 

 

 

 

 

 

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2 comments

  1. kt says:

    Great and thorough write up on the risks of stock options. The flip side could have been true though as well… You exercised and the shared ended up worth a lot. In that case you may be kicking yourself for not negotiating for more stock and less cash. Or it could be worse in that your options are now way in the money and you can’t afford the tax bill of exercising your options, and are now truly stuck with a set of golden handcuffs until a potential liquidity event. $20k is a good bet on the company you decided to work for. If you weren’t willing to bet that then one should question if they should work for said company. With all that said congrats on your new role! Sounds like you were very ready 🙂

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