Startup Equity and Stock Options vs 5 22 13

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Startup equity basics on employee equity grants and stock option plans

Startup equity basics on employee equity grants and stock option plans

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  • 1. Startup Equity 201:Stock Optionsfor Founders and EmployeesMay 22, 2013by Jamie Lee@jieunjamiewith ZekeVermillionwww.adlervermillion.comThursday, May 23, 13
  • 2. DisclaimerHi! I’m not an accountant or a lawyer.The information contained herein and ensuing discussionshould NOT be considered tax or legal advice.The information is intended to help you get familiarized withgeneral concepts in startup finance, which may or may notapply to your situation.Thank you!Jamie Lee@jieunjamiejieunjamie.comThursday, May 23, 13
  • 3. Before joining a startup, ask•Do I trust this team? Is this the right company?•What is my percentage of ownership?•What is market rate salary and equity comp?•What is the estimated valuation at exit?•Do I need a lawyer or accountant (because devil’s in the details)?•How long is my vesting schedule?•What are tax implications?•Can I make 83b election for restricted stock grants?•Can I exercise my options early?Startup Equity: More ART than SCIENCEKey questions to ASK for Founders and EmployeesThursday, May 23, 13
  • 4. Startup Equity: More ART than SCIENCEbut still need to do the MATH1) Ownership = # Shares Granted toYouTotal CapitalizationFormulas Example1) 1% = 100K Shares Granted10M Total Shares Outstanding2) Dilution Factor =(#Your Future Shares + Future Investor Shares)Total Cap. + #Your Future + Future Investor Shares2) 0.17% = (50K + 2M)(10M + 50K + 2M)1% - 0.17% = 0.83% New Ownership3)Your Payday at Exit* =(Your Ownership X Company Exit Price)– (Total Exercise Price)3) $99K* =(0.83% X $30M) - ($150K)*Assuming $1 strike price and company acquisition price of $30MBEFORE taxes, very rough est.Thursday, May 23, 13
  • 5. Real Life Example: Tumblr Acquisition by Yahoo!How much does Founder David Karp take home?• David Karp, CEO of Tumblr, is said tohave owned about 25% of Tumblr attime ofYahoo! acquisition• Total acquisition price = $1.1 Billion• Total funds raised = about $125 Million• Quick math:$1.1 Billion total price- 0.1 Billion returned to investors(assuming 1x liquidation preference)$1.00 Billion for shareholdersx .25 owned by David Karp$250 Million payout approximatelyThursday, May 23, 13
  • 6. Real Life Example: Tumblr Acquisition by Yahoo!Words of co-founder and first hire, Marco ArmentLink to blog“As for me, while I wasn’t a “founder” financially, David was generous with my employeestock options back in the day. I won’t make yacht-and-helicopter money from theacquisition, and I won’t be switching to dedicated day and night iPhones. But as long as I manageinvestments properly and don’t spend recklessly, Tumblr has given my family a strongsafety net and given me the freedom to work on whatever I want.”Thursday, May 23, 13
  • 7. High(1)High ReturnLow Risk(2)High ReturnHigh RiskLow(3)Low ReturnLow Risk(4)Low ReturnHigh RiskLow HighriskreturnBack to Earth: Think like an investorConsider the risk profile of your investment.Your startup is like your baby.But let’s face it, most of us won’t workat the next Facebook or Google orTumblr.Brave souls featured inRead Write’s “8 Real-World Stories Of WhyStartups Fail”Failure is like a badge ofhonor, and a greatteacher. Financiallyspeaking, it means noreturn.Yup, that’sme.Thursday, May 23, 13
  • 8. High(1)High ReturnLow Risk(2)High ReturnHigh RiskLow(3)Low ReturnLow Risk(4)Low ReturnHigh RiskLow HighriskreturnBack to Earth: Think like an investorConsider the risk profile of your investment.Your startup is like your baby.But let’s face it, most of us won’t workat the next Facebook or Google orTumblr.Brave souls featured inRead Write’s “8 Real-World Stories Of WhyStartups Fail”Failure is like a badge ofhonor, and a greatteacher. Financiallyspeaking, it means noreturn.Yup, that’sme.Thursday, May 23, 13
  • 9. High(1)High ReturnLow Risk(2)High ReturnHigh RiskLow(3)Low ReturnLow Risk(4)Low ReturnHigh RiskLow HighriskreturnBack to Earth: Think like an investorConsider the risk profile of your investment.Your startup is like your baby.But let’s face it, most of us won’t workat the next Facebook or Google orTumblr.Brave souls featured inRead Write’s “8 Real-World Stories Of WhyStartups Fail”Failure is like a badge ofhonor, and a greatteacher. Financiallyspeaking, it means noreturn.Yup, that’sme.Thursday, May 23, 13
  • 10. Startup Equity Review:Owning a piece of the pieLet’s say your startup is likea pizza pie you and yourteam make from scratch.Individual slices are ownedby different people, but theteam’s goal is to grow thepie as a whole.As more people getinvolved and invest, yourslice may get skinnier, andthe pie bigger.This is calleddilution.Founders**55% Investors*25%Employee Pool20%*Hypothetical situation where investorshave bought a quarter of the pie.**If you own 51% and more of acompany, you own controlling interest.“Employee ownership issuch an important part ofstartup culture. It reinforcesthat everyone is on theteam, everyone is sharing inthe gains, and everyone is ashareholder.”- Fred Wilson,AVC.comThursday, May 23, 13
  • 11. Review: Employee Stock Ownershipat aVC-funded tech startupTypically, total non-founder employeeequity pool tends to fall between10% - 20%.TitleOfTotal SharesCEO 5.00 - 10.00%C-level Executives 1.00 - 3.00%VP, Directors 0.50 - 2.00%Managers 0.25 - 1.00%Board Directors 0.50%The details of who owns what kind ofownership is spelled out incapitalization table, or captable. It’s considered private andsensitive information.Thursday, May 23, 13
  • 12. 1. Founders and founding members receive commonstock. Special vesting schedule applies.➡ TIP: draw up and execute a partnership agreement as soon ashumanly possible.2. Restricted stocks are ownership interest issued toemployees at early stage companies while the value ofstock is low. Granted with certain restrictions, usuallyvesting, sometimes performance. Deemed taxableproperty.➡ TIP: Make an 83B election within 30 days of grant to limitfuture tax liability3. Stock options are the most common form ofemployee equity. Options grant the right to buy stockat a pre-determined price, and is deemed taxableproperty of grantee.Vesting restriction is standard.➡ TIP: Exercise early.Ask for cash bonus to cover the exercise costTypes of Employee EquityApple Computer, Inc.Incorporated on Jan 3,1977Stock value: $0Thursday, May 23, 13
  • 13. Review: Vesting Schedule4 year vesting with 1 year cliff is common.1 year cliff means you don’t vest duringthe 1st year. If you leave during this period,you leave with no equity.Unvested equity may be repurchased by thecompany and returned to the employeepool.Idea is to avoid a “hit and run” situation andto retain talented employees.Oops27.1%+1 mo.Day 1 1st year 2nd year 3rd year 4th year0% 25% 50% 75% 100%0 2,5002,7105,000 7,500 10,000VestedSharesGenerally, option strike price will not change throughout vesting schedule.Thursday, May 23, 13
  • 14. $0$25$50$75$1002013 2014 2015 2016Company XYZ Share PriceFMV Cost to EE100 shrs granted to EE at FMV of$1.00 with 4 year vest. EE files83B Election recognizing incomeof $1 (FMV) - $1 (shr price) = $0At end of 1 year anniversary,25 shares vested to EE.FMV rose to $5/shr.($5 - $1) x 25 shares = $100Don’t owe taxes until you sell.After 2 years, 50 shares vested to EE.FMV rose to $25/shr.($25 - $1) x 50 shares = $1,200 value.Don’t owe taxes until you sell.Restricted Stock Example: 83B ElectionThursday, May 23, 13
  • 15. Startup Equity Taxes 101• Ordinary income tax = 10% - 39.6%➡ Taken out of your paycheck• Short term capital gains tax = 10% - 39.6%➡ When you have owned equity for less than 1 year and sell it for profit• Long term capital gains tax = 0% - 20%➡ When you have owned equity for more than 1 year and sell it for profit• Alternative Minimum Tax (AMT)➡ Due on exercise of Incentive Stock Option. Complex adjustment required. CONSULT anaccountantlink to About.com pageSo complex, the IRS hasa special onlinecalculator for AMTAssistance.Thursday, May 23, 13
  • 16. Stock OptionsOptions give you the right to buy equity, not the equity out right.Exercising your option is when you buy the underlying stock at strike price.Consider:•Restrictions, such as vesting or performance•Strike price must equal Fair MarketValue at time of grant•Cost of exercising option•Tax liability at exercise•Tax liability at sale of underlying equity‣Earn or vest it‣Exercise it & pay taxes‣Hold stock‣Sell stock & pay taxesThursday, May 23, 13
  • 17. $0$15$30$45$60$75$902013 2014 2015 2016 2017 2018Company ABC Share Price and OptionsFMV SOP ISO100 options granted to EE at FMV of$10.00 with 4 year vest. Strike price isequal to FMV at time of grant, $10.This iscalled “At the Money”25 options vested to EE. She can buy 25shares at $10 and realizes gain: (FMV $25 -Strike price $10) X 25 shares = $375This spread between FMV and strike pricewill be taxed.If she sells the underlying stock, she will betaxed again for the profit.2 years in, management decide to incentivizethe EE with Incentive Stock Options. Similar 4year vest.At this time, FMV is $53, so strikeprice of ISO set to $53.“Spread”Thursday, May 23, 13
  • 18. ISO vs NSO SummaryCheck out this chart for full comparisonISO = only employees•Complex holding periods, annual limitations•Spread on exercise can incur Alternative MinimumTax (AMT), a complex minefield best navigated byexperienced accountants•Selling underlying stock at long-term capital gains taxrate ONLY if holding periods are met. If not, then amix of short-term and long-term capital gains taxrates.•Not tax deductible to employerNSO = employees and non-employees•More straight-forward and less complicated•Spread on exercise will be taxed at ordinary incometax rate•Selling underlying stock will incur either short-termor long-term capital gains tax depending on holdingperiod•Deductible to employerThursday, May 23, 13
  • 19. Equity Compensation: the NegotiablesBest if hire is C-level or executive-level, and company is pre-Series A fundraising.VC’s term sheet details can changewhat’s negotiable and what’s not.• Size of grant• Equity grant upfront (Founders stock, not options)• Early exercise of options• Partial vesting on the grant date• Borrow strike price against proceeds of liquidity event, in order to exercise without being“out-of-pocket”• Accelerated vesting if terminated without “cause”• Accelerated vesting if company is acquired and there is change-of-control• Single and double trigger• Other negotiables: base salary, title, benefits and other perksThursday, May 23, 13
  • 20. Startup Equity RECAP: More ART thanSCIENCE but still need to ASK and do theMATHBefore joining a startup, ask•Is this the right team and company for my success?•What is my percentage of ownership?➡ # shares you own / total shares issued•How long is my vesting schedule?➡ 4 years with 1 year cliff is standard•What are tax implications?➡Restricted stock: make 83B elections➡Option holders: liable for capital gains tax atexercise of NSO and when stock is sold forboth•What is total company capitalization?•What is the estimated valuation at exit?•What do I need to do when I leave?If you’re a founder or prospectiveemployee,•Research market rate salary and equity comp➡See appendices for references•Read the partnership and employment agreements•Negotiate like a business person•Consult a lawyer or tax accountantThursday, May 23, 13
  • 21. Sources- Andy Payne, Startup Equity for Employees: http://www.payne.org/index.php/Startup_Equity_For_Employees- Chris Dixon, The One Number You Should Know About Your Equity http://cdixon.org/2009/08/27/the-one-number-you-should-know-about-your-equity-grant/- Fred Wilson, MBA Monday Series on Equity: http://www.avc.com/a_vc/2010/09/employee-equity.htmlhttp://www.avc.com/a_vc/2008/11/restricted-stoc.html- How Stuff Works, Stock Options:http://money.howstuffworks.com/personal-finance/financial-planning/stock-options1.htm- Infochachkie, What The Heck Are My Startup Stock Options Worth?! Seven Questions You Should Ask Before JoiningA Startup: http://infochachkie.com/options/- Paul Graham, Equity Equation: http://paulgraham.com/equity.html- Startup Company Lawyer, What is an 83b Election?http://www.startupcompanylawyer.com/2008/02/15/what-is-an-83b-election/- Startup Law Blog, Incentive Stock Options vs Nonqualified Stock Options http://www.startuplawblog.com/2013/05/15/incentive-stock-options-vs-nonqualified-stock-options/#comment-899265747- Tax & Business Professionals, ISOs Versus Non-statutory Stock Options? http://www.unclefed.com/AuthorsRow/TaxBusProf/stockoptions.html- Wealthfront, Manage Your Tech Career: https://blog.wealthfront.com/startup-employee-equity-compensation/- Wealthfront, The 12 Crucial Questions About Stock Options: https://blog.wealthfront.com/stock-options-package-valuation/- Wikipedia, Restricted Stock: http://en.wikipedia.org/wiki/Restricted_stockThank you!Thursday, May 23, 13
  • 22. Appendix A: LLC v. C CorpThursday, May 23, 13
  • 23. Appendix A: LLC v. C CorpType ofEntityLimited Liability Company (LLC) C Corporation S CorporationOwnershipUnlimited members. Membersown “units.”500 shareholders if private. Nolimit on shareholders if public.Up to 35 shareholders, one classof stock allowed.LiabilityMembers not liable for companydebts.Shareholders not liable forcompany debts.Shareholders not liableTaxesNo entity tax; profits and lossesare passed on to members.“Double taxation” Company istaxed as an entity. Shareholdersare also taxed.“Double taxation” Company istaxed as an entity. Shareholdersare also taxed.ManagementDesignated in OperatingAgreement. May be managed byMember or Manager.Managed overall by Board ofDirectors. Officers manage day today.Managed overall by Board ofDirectors. Officers manage day today.Thursday, May 23, 13
  • 24. Appendix A: LLC v. C CorpType ofEntityLimited Liability Company (LLC) C Corporation S CorporationOwnershipUnlimited members. Membersown “units.”500 shareholders if private. Nolimit on shareholders if public.Up to 35 shareholders, one classof stock allowed.LiabilityMembers not liable for companydebts.Shareholders not liable forcompany debts.Shareholders not liableTaxesNo entity tax; profits and lossesare passed on to members.“Double taxation” Company istaxed as an entity. Shareholdersare also taxed.“Double taxation” Company istaxed as an entity. Shareholdersare also taxed.ManagementDesignated in OperatingAgreement. May be managed byMember or Manager.Managed overall by Board ofDirectors. Officers manage day today.Managed overall by Board ofDirectors. Officers manage day today.Thursday, May 23, 13
  • 25. Appendix A: LLC v. C CorpType ofEntityLimited Liability Company (LLC) C Corporation S CorporationOwnershipUnlimited members. Membersown “units.”500 shareholders if private. Nolimit on shareholders if public.Up to 35 shareholders, one classof stock allowed.LiabilityMembers not liable for companydebts.Shareholders not liable forcompany debts.Shareholders not liableTaxesNo entity tax; profits and lossesare passed on to members.“Double taxation” Company istaxed as an entity. Shareholdersare also taxed.“Double taxation” Company istaxed as an entity. Shareholdersare also taxed.ManagementDesignated in OperatingAgreement. May be managed byMember or Manager.Managed overall by Board ofDirectors. Officers manage day today.Managed overall by Board ofDirectors. Officers manage day today.Thursday, May 23, 13
  • 26. Appendix A: LLC v. C CorpType ofEntityLimited Liability Company (LLC) C Corporation S CorporationOwnershipUnlimited members. Membersown “units.”500 shareholders if private. Nolimit on shareholders if public.Up to 35 shareholders, one classof stock allowed.LiabilityMembers not liable for companydebts.Shareholders not liable forcompany debts.Shareholders not liableTaxesNo entity tax; profits and lossesare passed on to members.“Double taxation” Company istaxed as an entity. Shareholdersare also taxed.“Double taxation” Company istaxed as an entity. Shareholdersare also taxed.ManagementDesignated in OperatingAgreement. May be managed byMember or Manager.Managed overall by Board ofDirectors. Officers manage day today.Managed overall by Board ofDirectors. Officers manage day today.Thursday, May 23, 13
  • 27. ACME, LLCAnnual net profit: $100MNo corp taxAppendix B: LLC Tax Passthrough•Members taxed for ACME’s profit (or loss) proportionately•Members receive K1 tax form (and tax assistance from entity,depending on terms of agreement)A:10%$10MB:10%$10MC:80%$80MTax Liability Tax LiabilityThursday, May 23, 13
  • 28. ACME, Inc.Annual profit: $100MCorp tax: $35MNet profit: $65Mdividends paid out to shareholders(taxed on individual level)Appendix C: C Corp “Double Taxation”•Both ACME, Inc. and shareholders taxed•No tax assistance from entity to shareholdersdividends dividendsThursday, May 23, 13
  • 29. Appendix D: Recommended Online Resources• Check out Anonymous Startup Salaries, Stock Options and Equity on Ackwire.com• Check out Fred Wilson’s Cap Table Template on Google DocsThursday, May 23, 13
  • 30. Appendix E: Recommended Online Resources• Check out Patrick McKenzie’s Salary Negotiation: Make More Money, Be More• Check out David Weekly’s An Intro to Stock OptionsThursday, May 23, 13