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What I Wish I'd Known About Equity Before Joining A Unicorn

What I Wish I'd Known About Equity Before Joining A Unicorn

Disclaimer: This piece is written anonymously. The names of a few particular companies are mentioned, but as common examples only.

This is a short write-up on things that I wish I'd known and considered before joining a private company (aka startup, aka unicorn in some cases). I'm not trying to make the case that you should never join a private company, but the power imbalance between founder and employee is extreme, and that potential candidates would do well to consider alternatives.

None of this information is new or novel, but this document aims to put the basics in one place.

The Rub

Lock In

  • After leaving a company, you generally have 90 days to exercise your options or they're gone. This seems to have originally developed around a historical rule from the IRS around the treatment of ISOs, but the exact reason doesn't really matter anymore. The only thing that does matter is that if you ever want to leave your company, all that equity that you spent years building could evaporate if you don't have the immediate cash reserves to buy into it.

  • Worse yet, by exercising options you owe tax immediately on money that you never made. Your options have a strike price and private companies generally have a 409A valuation to determine their fair market value. You owe tax on the difference between those two numbers multiplied by the number of options exercised, even if the illiquidity of the shares means that you never made a cent, and have no conceivable way of doing so for the forseeable future.

  • Even if you have the money to buy your options and pay the taxman, that cash is now locked in and could see little return on investment for a long and uncertain amount of time. Consider the opportunity cost of what you could otherwise have done with that liquid capital.

  • Due to tax law, there is a ten year limit on the exercise term of ISO options from the day they're granted. Even if the shares aren't liquid by then, you either lose them or exercise them, with exercising them coming with all the caveats around cost and taxation listed above.

    Does ten years sound like a long time? Consider the ages of these unicorns:

    • Palantir is now thirteen years old.
    • Dropbox will be ten years old this year (2017).
    • AirBnB, GitHub, and Uber are all within a year or two of their ten year birthdays.
  • Some companies now offer 10-year exercise window (after you quit) whereby your ISOs are automatically converted to NSOs after 90 days. This is strictly better for the employee than a 90-day window, but as previously mentioned, ten years still might not be enough.

  • Golden handcuffs kick in fast. The longer you stay with a company, the more equity you build, and a decision to leave becomes that much harder. This can culminate to the point where early employees have modest liquid assets but are "paper millionaires", and have to make the hard decision to throw all that away or stick around until their founders allow them some return.

Liquidity Events

  • No time horizon for any kind of liquidation guaranteed. In fact, no liquidation event is ever guaranteed, even if the company is highly successful. One could be at 1 year out, 5 years, 10 years, or never. We've seen a lot of evidence in this day and age that companies are staying private for longer (see the list above).

  • The incentive to IPO between employer and employee are not aligned. Employees want some kind of liquidation event so that they can extract some of the value they helped create, but employers know that allowing employees to extract that value might cost them some of their best people as they're finally allowed the opportunity to pursue other projects. One more reason to stay private for longer.

    • Although the above is one reason that founders don't want to IPO, it's not the only reason. Many of them do believe (rightly or wrongly) that there is another 10x/100x worth of growth left in the company, and that by pulling the trigger too early on an IPO all of that potential will be lost. For a normal founder, their company is their life's work, and they're willing to wait a few more years to see the canvas fully realized. This is a more noble reason not to liquidate, but from an employee's perspective, is still problematic.

Founder/Employee Power Imbalance

  • Founders (and favored lieutenants) can arrange take money off the table while raising rounds and thus become independently wealthy even before they make true "fuck you" money from a large scale liquidation event. Employees cannot. The situation is totally asymmetric, and most of us are on the wrong end of that.

  • Even if you came into a company with good understanding of its cap table, the ground can shift under your feet. New shares can be issued at any time to dilute your position. In fact, it's common for dilution to occur during any round of fundraising.

Private Markets

  • Private markets do exist that trade private stock and even help with the associated tax liabilities. However, it's important to consider that this sort of assistance will come at a very high cost, and you'll almost certainly lose a big chunk of your upside. Also, depending on the company you join, they may have restricted your ability to trade private shares without special approval from the board.

Valuations

  • Especially in early stage companies, equity is offered on the basis of a highly theoretical future valuation number. Sam Altman recommends offering the first ten employees 10% (~1% each), which could be a big number if the company sells for $10B, but consider how few companies actually make it to that level.

    If the company sells for a more modest $250M, between taxes and the dilution that inevitably will have occurred, your 1% won't net you as much as you'd intuitively think. It will probably be on the same order as what you might have made from RSUs at a large public company, but with far far more risk involved. Don't take my word for it though; it's pretty simple math to run the numbers for a spread of sale prices and dilution factors for yourself before joining, so do so.

Tender Offers

  • Some companies acknowledge the effect of drawn out phases of illiquidity on employees and engage in a tender offer to give employees some return (google around for some examples). I don't want to overstate this because receiving a tender offer is strictly better than the alternative, but keep in mind that one will probably be structured to minimize the amount of value you can extract. They're also very likely be infrequent events. Read the fine print, run the numbers, and consider how much your annual return to date will actually be (including all the time you've spent at the company, not just the year of the offer). It's probably less than what you could've gotten in RSU grants at a public company.

Working Environment

  • This isn't equity related, but it's worth considering that the environment at a big unicorn isn't going to be measurably different from a big public company. You're going to have little impact per employee, the same draconian IT security policies, lots of meetings, and fixed PTO. In the worst cases, you might even have to use JIRA.

I'm Doing It Anyway!

So you decided to join a private company anyway. Here's a few questions that I'd recommend knowing the answer to before accepting any offer (you'd be amazed at how infrequently this information is volunteered):

  • How long is my exercise window if I leave the company?

  • How many outstanding shares are there? (This will allow you to calculate your ownership in the company.)

  • Does the company's leaders want it to be sold or go public? If so, what is the rough time horizon for such an event? (Don't take "we don't know" for an answer.)

  • Have there been any secondary sales for shares by employees or founders? (Try it route out whether founders are taking money off the table when they raise money, and whether there has been a tender offer for employees.)

  • Assuming no liquidation, are my shares salable on a private market?

  • Has the company taken on debt or investment with a liquidation preference of more than 1x? (Investors may have been issued > 1x liquidation preference, which means they get paid out at that multiple before anyone else gets anything.)

  • Will you give me an extended exercise window? (After joining I realized that most people's window was the standard 90 days, but not everyone's. Unfortunately by then I'd lost my negotiating leverage to ask for an extended term.)

It's really tough to ask these without sounding obsessed with money, which feels unseemly, but you have to do it anyway. The "you" of today needs to protect the "you" of tomorrow.

Summary

Working at a startup can be fun, rewarding, interesting, and maybe even lucrative. The working conditions at Silicon Valley companies are often the best in the world; it's quite conceivable that you might want to stay there even if there was never a possibility of a payoff. But don't forget that as far as equity is concerned, every card in the deck is stacked against you.

The correct amount to value your options at is $0. Think of them more as a lottery ticket. If they pay off, great, but your employment deal should be good enough that you'd still join even if they weren't in your contract.

I don't say this just because of the possibility that your startup could fail, but also because even in the event of success, there are plenty of scenarios where getting a payout will be difficult. Say for example that five years in you want to try something new, or want to start a family and need a job that will pay you well enough to let you afford a starter home in the Bay Area (not easy). Your startup Monopoly money will put you in a precarious position.

If you're lucky enough to be in high enough demand that you can consider either a public company with good stock liquidity or a billion-dollar unicorn, give serious consideration to the former.

@samv
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samv commented Jan 24, 2017

I read all of this, and I definitely concur with your early statement that "None of this information is new or novel". But it's true that few people have a good grasp of this stuff, and it is passed around as secrets shared in 1:1's and other such venues. So 💯 for sharing it and bringing attention to these important issues.

First of all, you need to consider the Employee Stock Options fund. This group, based in Silicon Valley and founded in 2012, solve all or almost all of the problems in the section about "the rub". The way it works is that you first take your share options paperwork to ESO fund. If the fund likes the look of them (generally, due to lack of public information on private companies, this means "have they funded in the last 2 years?" plus some proprietary secret sauce decision making), then they'll make an offer to pay your expenses for them. They pay for the exercise money, and all payable AMT that accrues in the future for holding those shares. In return, they get a cut. Exactly how big depends on just how hot they think that start-up is. This involves the employee signing a contract granting ESO limited right of attorney to perform the transaction to transfer to ESO once the shares are liquid.

So you get the best of both worlds. Keep 80% of your imagination instead of 100% but don't worry about the cash outlay or tax implications. To make up the 20% you lost, just dream bigger.

As for the questions that you recommend asking in the interview, I'd say that this is largely bad advice. The last question about a negotiating position is definitely insightful, but the others could really come across as self-serving, especially if you ask someone who has no idea about such technicalities. For instance - the question about trading shares in a private market. The reason shares in a private company can't just be sold to anyone (without board approval of the company) is due to federal disclosure laws. Those laws state that as soon as there are more than 500 shareholders (IIRC) then the company must disclose detailed quarterly financial reports. At which point, generally they may as well IPO because their financials are public. So, the general practice is that you can't sell to people who don't already hold shares, or do anything that would increase the number of shareholders and tick them closer to that disclosure time bomb. So why would you ask about that?

I guess my main point is, those are good questions to be answering for yourself, somehow - but I really, really suggest that you should NOT ask those kind of questions in a job interview. Casually pry them out of someone during the obligatory lunch during that all-day engineering interview, perhaps - but most of the questions are kind of rude and improper and will just result in you getting a bad reputation.

One last thing - generally, you can exercise ISOs as soon as they vest. It's a good idea to do this regularly, eg quarterly. Save up some of that paycheck from when you first start in an earmarked account for exercising your options. Sometimes the problem isn't really that the shares are expensive, it's just that you didn't budget for them. A few hundred bucks a month can quickly add up especially if you stay put for 2-3 years, and then it seems like a massive chunk of cash. Plan for it. There's many peripheral benefits to exercising while still employed - you pay less tax if you sell after 2 years of share ownership, so start that clock ticking as soon as possible. And the other reason is to avoid the lock-in mentioned in the article. The risk-adjusted yield of ISOs at growth tech companies is second to none - these are good assets to own; especially if you are diversified.

@mrhashinclude
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mrhashinclude commented Jan 25, 2017

Also worth reading (and possibly linking to in the original post), is the Open Guide to Equity Compensation

@ummahusla
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ummahusla commented Jan 26, 2017

Thank you 👍

@adityar7
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adityar7 commented Jan 27, 2017

It is indeed true that founders typically have the power to benefit while screwing employees, and that should not be the case. However, the first few employees (until the company reaches Seed or Series A) are basically putting faith in the founder to not screw them. Unless these guys value equity substantially as part of compensation, companies won't get off the ground (if you've never run a company, you won't get "why"). And then we'll all be screwed.

@brandonsturgeon
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brandonsturgeon commented Jan 27, 2017

ok

@richardhaven
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richardhaven commented Feb 1, 2017

"The correct amount to value your options at is $0. Think of them more as a lottery ticket"
This is good. How much is a lottery ticket worth? How much is a lottery ticket worth when the odds are not only hidden, not fair or random, and can change by the founders ?

A magic phrase is "liquidation preferences". It is the stated way that a company buy-out would affect employee options. The number does not actually matter because the employees will get whatever the founders choose to give them from the buy-out money. The magic of the phrase is that the HR person you say it to will know that you know that hiring options in a startup are worthless, and they might give you more money.

As for the taxes: the only way to get a tax liability is to gain a profit. If one gets options and does not exercise them, then one is investing in the stock. If that stock them drops in value, one still owes for the receipt of the option. Choosing not to exercise an option immediately is foolish.

@gaia
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gaia commented Feb 9, 2017

salable = sellable.

great article!

@jt-gilkeson
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jt-gilkeson commented Feb 10, 2017

A few more things to be aware of:

  1. Early Exercise / Exercising in general - if your valuation falls significantly, the company may reprice stock options to the lower value, anyone who has already exercised does not get to participate - additionally if you leave, the company most likely won't purchase back your unvested shares since they are underwater.

  2. Acquisition - in some circumstances, the company may choose to sell off the products and employees and leave the old company as a shell - if this happens, your exercised stock will not generate a payout and the shell is most likely to go to 0.

  3. Someone said you don't pay taxes upon exercise of ISOs - this may not be correct - the spread at time of exercise for ISOs is taxable if you are subject to AMT (and exercising the stock may make you eligible for AMT).

@ChrisTichenor
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ChrisTichenor commented Jun 19, 2018

Some companies also have terms in their grant agreements that state that in the event of a sale, all your unvested options vest automatically. In that case, if you're thinking about leaving your company for whatever reason, if you have a good relationship with management it's in your best interest to speak with management about that first and to see if there's any possibility that might happen. I left my last company and they sold a couple weeks after my last day and closed the deal in less than a month, which ended up costing me a good chunk of money if I had pushed back my start date at my new job to a few weeks later.

@masongoodwin
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masongoodwin commented Dec 27, 2018

Thanks for sharing the informative post. Despite hitting a low in 2016, IPOs are retrieving strength these days. Though IPO is a complex, lengthy and expensive process, however, many Unicorns like Uber, Palantir, Snap etc. are entering the public market and looking to introduce initial share price for individual investors.

@LeafyLi
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LeafyLi commented Mar 13, 2020

"In fact, it's common for dilution to occur during any round of fundraising."

Think this means

"In fact, it's common for dilution to occur during every round of fundraising."

@chnsh
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chnsh commented Oct 26, 2020

I asked a potential company about "How many outstanding shares are there?" and they replied that this isn't readily available knowledge - even inside the company. Is this a red flag at all?
On the whole, the company looks great and I like other aspects of the role.

@mpokryva
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mpokryva commented Nov 22, 2020

I asked a potential company about "How many outstanding shares are there?" and they replied that this isn't readily available knowledge - even inside the company. Is this a red flag at all?
On the whole, the company looks great and I like other aspects of the role.

Uhh, yeah. That is definitely a red flag. If you got to the offer stage and they're not willing to tell you this, walk away. Knowing how many shares you're getting without knowing the fully diluted share count is like knowing how much something weighs but not knowing the units. Employees are investors in a company. They're investing their time, effort, and losing out on other opportunities. They have the right to know this kind of stuff.

@tamsky
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tamsky commented Nov 17, 2021

  1. What percentage of the company do the options offered represent?
  2. Are you including all shares in the "total shares outstanding"?

@RicardoGralhoz
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RicardoGralhoz commented Dec 28, 2021

@tamsky
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tamsky commented Dec 30, 2021

https://news.ycombinator.com/item?id=17717727 also contains discussion of the the holloway.com link:

  1. Typical Employee Equity Levels mostly restricted content

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