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A founder’s guide to effectively managing your options pool
There’s an old startup adage that goes: Cash is king. I’m not sure that is true anymore.
In today’s cash rich environment, options are more valuable than cash. Founders have many guides on how to raise money, but not enough has been written about how to protect your startup’s option pool. As a founder, recruiting talent is the most important factor for success. In turn, managing your option pool may be the most effective action you can take to ensure you can recruit and retain talent.
That said, managing your option pool is no easy task. However, with some foresight and planning, it’s possible to take advantage of certain tools at your disposal and avoid common pitfalls.
In this piece, I’ll cover:
- The mechanics of the option pool over multiple funding rounds.
- Common pitfalls that trip up founders along the way.
- What you can do to protect your option pool or to correct course if you made mistakes early on.
A minicase study on option pool mechanics
Let’s run through a quick case study that sets the stage before we dive deeper. In this example, there are three equal co-founders who decide to quit their jobs to become startup founders.
Since they know they need to hire talent, the trio gets going with a 10% option pool at inception. They then cobble together enough money across angel, pre-seed and seed rounds (with 25% cumulative dilution across those rounds) to achieve product-market fit (PMF). With PMF in the bag, they raise a Series A, which results in a further 25% dilution.
The easiest way to ensure you don’t run out of options too quickly is simply to start with a bigger pool.
After hiring a few C-suite executives, they are now running low on options. So at the Series B, the company does a 5% option pool top-up pre-money — in addition to giving up 20% in equity related to the new cash injection. When the Series C and D rounds come by with dilutions of 15% and 10%, the company has hit its stride and has an imminent IPO in the works. Success!
For simplicity, I will assume a few things that don’t normally happen but will make illustrating the math here a bit easier:
- No investor participates in their pro-rata after their initial investment.
- Half the available pool is issued to new hires and/or used for refreshes every round.
Obviously, every situation is unique and your mileage may vary. But this is a close enough proxy to what happens to a lot of startups in practice. Here is what the available option pool will look like over time across rounds:
Image Credits: Allen Miller
Note how quickly the pool thins out — especially early on. In the beginning, 10% sounds like a lot, but it’s hard to make the first few hires when you have nothing to show the world and no cash to pay salaries. In addition, early rounds don’t just dilute your equity as a founder, they dilute everyone’s — including your option pool (both allocated and unallocated). By the time the company raises its Series B, the available pool is already less than 1.5%.
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You can’t afford to make poor decisions about incentive stock options
One of the big reasons you’re giving 110% of your talent and effort to your private company is because you’re hoping to eventually cash in on all those vested incentive stock options (ISOs) that have been sitting in some account, waiting for the day your company goes public.
There’s nothing wrong with that. Who doesn’t dream of reaping an options windfall and using it to retire early, buy a house, pay off their college loans, travel around the world or become a full-time philanthropist?
Unfortunately, when it comes to figuring out how to cash in their stock awards, most employees are on their own.
Their employers can’t always provide the answers they need — especially when the questions relate to personal finances. Most companies admit they need to be better at explaining how ISOs work in general, but they can’t legally work one-on-one with employees to help them exercise and sell shares the right way.
Most companies admit they need to be better at explaining how ISOs work in general, but they can’t legally work one-on-one with employees to help them exercise and sell shares the right way.
That’s why, when the time is right, many employees actively look for help from a qualified fiduciary financial adviser who can walk these could-be “options millionaires” through various cash-in scenarios.
Here’s a real-life example (using a pseudonym).
Kurt is a 50-year-old VP of product management at a healthcare startup that just went public. Over his three years with the company, Kurt had amassed 350,000 ISOs worth approximately $6 million. Unlike many options millionaires, he didn’t intend to cash in everything and retire early. He planned to stay with the firm but wanted to liquidate enough ISOs to pay for a vacation home and add greater diversification to his investment portfolio. This presented significant tax risks that Kurt wasn’t aware of.
If Kurt exercised his ISOs and sold the shares before a year had passed, his profits would be characterized as short-term capital gains, which are taxed as ordinary income.
To illustrate the potential tax implications of this action, we created a hypothetical scenario that showed if Kurt exercised all of his ISOs and sold the shares immediately, he would incur approximately $6 million in ordinary income, which would push him into the top tax bracket and put him on the hook for almost $3 million in combined federal and state taxes.
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Here are 3 things you should do with your stock options
There’s a reason startup compensation packages usually include equity, or stock options. For one, it’s a way for startups to remain competitive in the job market and attract top talent. But it’s also a way to reward those employees who join early and give them a tangible reason to stay incentivized to grow the company.
The problem is that while many employees do understand that their equity compensation could mean a big payday in the future — and, in 2021, that’s more likely than ever — they don’t often understand the inevitable complexities of their stock options. That puts employees at risk of not getting the most value after an IPO or, worse, losing them.
If you’ve ever been confused about your equity, or haven’t thought much about it, you’re not alone. That’s why I’m going to share three things all employees joining a startup should do with their equity:
Understand how to value your equity — and when it can change
While many startups are getting better at proactively communicating the value of your equity package upfront, some are still figuring out the best way to do it. That’s because, unlike the more straightforward number of a salary, stock options are more nuanced — they’re a living, breathing type of compensation.
The most important pieces of information to pay attention to are your 409A valuation, your strike price, the type of options you were granted and the preferred share price.
The 409A valuation is based on your company’s valuation. This is also referred to as the fair market value (FMV). The 409A valuation can, and does, often change — they have to be updated at least once a year by a third-party valuator in order to meet tax rules. The 409A also changes during a fundraising event. Investors involved in the funding round determine how they value the company and are given options, at that valuation, in exchange for cash.
The most important pieces of information to pay attention to are your 409A valuation, your strike price, the type of options you were granted and the preferred share price.
Since the company has now been valued higher, the 409A changes for everyone. It’s also possible for the 409A to go down if, for any reason, the company is now valued at a lower amount. This is known as a “down round.” Airbnb had a notable down round during the pandemic, though it eventually recovered and went public.
Your strike price is the price at which you can buy your stock options (also known as exercising). Yes, buy. You are given the option to buy them, which is why they are called stock options. But know that your strike price will likely never change. However, if you’re ever given more stock options (perhaps as a future bonus), this would be a separate grant and the strike price could be different. Companies are legally required to issue stock options at the most recent 409A price (or higher).
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How to protect your equity if you’ve been furloughed or laid off
Wouter Witvoet is founder and CEO of Secfi, a pre-wealth management equity planning platform for startup employees.
If you’ve been lucky enough to keep your job or business, you almost certainly know someone who wasn’t so fortunate.
Thousands have lost their jobs as companies significantly reduce workforces to adjust to uncertainties and economic challenges created by COVID-19. Many of these people in tech are now faced with a number of questions, from how they’ll pay next month’s rent to whether they’re eligible for unemployment. One area that is particularly confusing is what to do if your compensation package was tied to equity.
Here are some ways I suggest approaching the issue.
Safeguard your equity
Layoffs have become part and parcel of the current economic crisis with unemployment figures skyrocketing to record highs as a result of COVID-19. From multinational conglomerates to mom-and-pop stores, everyone is feeling the impact, and the startup sector is no different.
Despite difficult circumstances, the silver lining for employees is that we have seen many management teams go the extra mile to help their teams, especially when it comes to equity. Compared to traditional layoff situations, companies in the COVID-19 era are offering generous extensions and accelerated vesting on their options, which is undeniably good news for employees with equity.
Typically, equity plans come with a 90-day exercise window after employment termination. That means that if you leave the company, you will have to exercise your options within 90 days or they go back to the company. However, lots of management teams have decided to extend these deadlines many years out given the circumstances.
While layoffs are not easy, it’s been great to see management teams doing the right thing when it comes to equity for their employees who have been laid off. Offering extensions is a benefit that employers should be offering their employees who have helped build the company.
If your company is not offering this, consider negotiating and asking for an extension. This is the right thing to do for employees who are now out of work and a paycheck for the foreseeable future. Both options do not require the company to pay cash at the moment, so there are few reasons a company should deny this request in this environment.
Consider exercising your options
Even if you are granted an extension to exercise your options, employees that hold incentive stock options (ISOs) should look into exercising their options now to maximize their equity’s value.
Many companies are offering extensions for option exercises. While this is great in that it gives employees more time to figure out their exercise situation, waiting past the 90-day window may have much bigger tax consequences that employees need to consider.
ISOs are much more tax advantageous compared to non-qualified stock options (NSOs). They are not taxed under standard income tax and if you sell the stock two years after grant date and one year after exercise date, you sell them as part of a qualifying disposition. In short, this allows you to effectively convert everything north of your strike price to preferential long-term capital gain rates.
As part of offering these tax advantages, the tax code has limitations on ISOs. Most relevant to us at this point is that the fact that you cannot have ISOs past 90 days after you are no longer an employee. This means that even if your company allows an extension on your stock options past the typical 90-day expiration window, your ISOs will convert to NSOs and lose their tax benefit.
This creates a potential planning opportunity that employees who have been laid off need to consider. If you feel good about the upside of the company, then you should consider exercising your ISOs today to capture the potential tax benefits rather than letting them convert to NSOs. Employees who wait risk putting themselves in the same difficult situation once the extension ends at typically less favorable conditions due to an increased 409A valuation.
Negotiate for equity during a pay cut or furlough
In light of the economic slowdown many companies have begun to cut costs. Reduced pay or furloughing employees has become the new norm as businesses of all sizes struggle to navigate these changing times.
It can obviously be concerning if you find yourself in this situation. But for startup employees, the COVID-19 crisis could provide an opportunity to negotiate your compensation package to make up for this decrease, and even set yourself up to prosper in the future.
Startups typically offer equity as a means of deferred compensation and as a way to incentivize employees to own a piece of the company they are building. The compensation is deferred as most startups are cash-strapped and cannot afford to pay you what a larger company may be able to.
If your company is now asking you to take a pay cut, or even take no pay during this time, you should consider asking for additional equity to make up for the lost compensation. While not all companies may be amenable to offering more equity, there is no cash outlay from the company’s standpoint, so it’s an efficient way for your company to compensate you for your sacrifice while preserving their cash.
In addition, offering more equity shows a commitment from management to their employees during this difficult time. It may be the win-win scenario for your company and yourself in the long-run so it’s worth having the conversation with management to discuss if this is available for you.
If your company does offer you more equity, make sure you ask whether the 409A (or fair market value) of the company is being updated. With revised forecasts given the COVID-19 situation, it may be possible for your company to issue your stock at a lower strike price if the company revalues its 409A.
Don’t be afraid to ask for help
I can sympathize with startup employees right now because I faced a similar situation when I left a startup that I had joined as employee number four and was forced to wave goodbye to the equity I had banked on.
If you want to take action on equity but don’t know where to start, now might be a good time to brush up on how your stock options work. As the economy begins to reopen, there’s a good chance we’ll see a rush for candidates in tech as companies compete to bring in some of the extremely talented folks who lost their jobs this week.
Those who have a good understanding of equity may be positioned for a big payday down the line.
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