federal capital gains tax and state tax in many states (though not in CA). This is interesting, but it seems like people rarely take advantage of this when eligible, and many startups aren’t eligible.
The IRS says:
Most nonstatutory options don't have a readily determinable fair market value. For nonstatutory options without a readily determinable fair market value, there's no taxable event when the option is granted but you must include in income the fair market value of the stock received on exercise, less the amount paid, when you exercise the option. You have taxable income or deductible loss when you sell the stock you received by exercising the option. You generally treat this amount as a capital gain or loss.
One quirk of stock options is that, to qualify as ISOs, the strike price must be at least the fair market value. That’s easy to determine for public companies, but the fair market value of a share in a private company is somewhat arbitrary. For ISOs, my reading of the requirement is that companies must make “an attempt, made in good faith” to determine the fair market value. For other types of options, there’s other regulation which which determines the definition of fair market value. Either way, startups usually go to an outside firm between 1 and N times a year to get an estimate of the fair market value for their common stock. This results in at least two possible gaps between a hypothetical “real” valuation and the fair market value for options purposes.
First, the valuation is updated relatively infrequently. A common pitch I’ve heard is that the company hasn’t had its valuation updated for ages, and the company is worth twice as much now, so you’re basically getting a 2x discount.
Second, the firms doing the valuations are poorly incentivized to produce “correct” valuations. The firms are paid by startups, which gain something when the legal valuation is as low as possible.
I don’t really believe that these things make options amazing, because I hear these exact things from startups and founders, which means that their offers take these into account and are priced accordingly. However, if there’s a large gap between the legal valuation and the “true” valuation and this allows companies to effectively give out higher compensation, the way stock option backdating did, I could see how this would tilt companies towards favoring options.
Even if employees got the same class of stock that VCs get, founders would retain less control if they transferred the equity from employees to VCs because employee-owned equity is spread between a relatively large number of people.
This answer was commonly given to me as a non-cynical reason. The idea is that, if you offer employees options and have a clause that prevents them from selling options on a secondary market, many employees won’t be able to leave without walking away from the majority of their compensation. Personally, this strikes me as a cynical reason, but that’s not how everyone sees it. For example, Andreessen Horowitz managing partner Scott Kupor recently proposed a scheme under which employees would lose their options under all circumstances if they leave before a liquidity event, supposedly in order to help employees.
Whether or not you view employers being able to lock in employees for indeterminate lengths of time as good or bad, options lock-in appears to be a poor retention mechanism -- companies that pay cash seem to have better retention. Just for example, Netflix pays salaries that are comparable to the total compensation in the senior band at places like Google and, anecdotally, they seem to have less attrition than trendy Bay Area startups. In fact, even though Netflix makes a lot of noise about showing people the door if they’re not a good fit, they don’t appear to have a higher involuntary attrition rate than trendy Bay Area startups -- they just seem more honest about it, something which they can do because their recruiting pitch doesn’t involve you walking away with below-market compensation if you leave. If you think this comparison is unfair because Netflix hasn’t been a startup in recent memory, you can compare to finance startups, e.g. Headlands, which was founded in the same era as Uber, Airbnb, and Stripe. They (and some other finance startups) pay out hefty sums of cash and this does not appear to result in higher attrition than similarly aged startups which give out illiquid option grants.
In the cases where this results in the employee staying longer than they otherwise would, options lock-in is often a bad deal for all parties involved. The situation is obviously bad for employees and, on average, companies don’t want unhappy people who are just waiting for a vesting cliff or liquidity event.
Another commonly stated reason is that, if you give people options, they’ll work harder because they’ll do well when the company does well. This was the reason that was given most vehemently (“you shouldn’t trust someone who’s only interested in a paycheck”, etc.)
However, as far as I can tell, paying people in options almost totally decouples job performance and compensation. If you look at companies that have made a lot of people rich, like Microsoft, Google, Apple, and Facebook, almost none of the employees who became rich had an instrumental role in the company’s success. Google and Microsoft each made thousands of people rich, but the vast majority of those folks just happened to be in the right place at the right time and could have just as easily taken a different job where they didn't get rich. Conversely, the vast majority of startup option packages end up being worth little to nothing, but nearly none of the employees whose options end up being worthless were instrumental in causing their options to become worthless.
If options are a large fraction of compensation, choosing a company that’s going to be successful is much more important than working hard. For reference, Microsoft is estimated to have created roughly
10^3 millionaires by 1992 (adjusted for inflation, that's $1.75M). The stock then went up by more than 20x. Microsoft was legendary for making people who didn't particularly do much rich; all told, it's been estimated that they made
10^4 people rich by the late 90s. The vast majority of those people were no different from people in similar roles at Microsoft's competitors. They just happened to pick a winning lottery ticket. This is the opposite of what founders claim they get out of giving options. As above, companies that pay cash, like Netflix, don’t seem to have a problem with employee productivity.
By the way, a large fraction of the people who were made rich by working at Microsoft joined after their IPO, which was in 1986. The same is true of Google, and while Facebook is too young for us to have a good idea what the long-term post-IPO story is, the folks who joined a year or two after the IPO (5 years ago, in 2012) have done quite well for themselves. People who joined pre-IPO have done better, but as mentioned above, most people have diminishing returns to individual wealth. The same power-law-like distribution that makes VC work also means that it's entirely plausible that Microsoft alone made more post-IPO people rich from 1986-1999 than all pre-IPO tech companies combined during that period. Something similar is plausibly true for Google from 2004 until FB's IPO in 2012, even including the people who got rich from FB's IPO as people who were made rich by a pre-IPO company, and you can do a similar calculation for Apple.
There are several potential counter-arguments to the statement that VC returns (and therefore startup equity) don’t beat the market.
One argument is, when people say that, they typically mean that after VCs take their fees, returns to VC funds don’t beat the market. As an employee who gets startup options, you don’t (directly) pay VC fees, which means you can beat the market by keeping the VC fees for yourself.
Another argument is that, some investors (like YC) seem to consistently do pretty well. If you join a startup that’s funded by a savvy investors, you too can do pretty well. For this to make sense, you have to realize that the company is worth more than “expected” while the company doesn’t have the same realization because you need the company to give you an option package without properly accounting for its value. For you to have that expectation and get a good deal, this requires the founders to not only not be overconfident in the company’s probability of success, but actually requires that the founders are underconfident. While this isn’t impossible, the majority of startup offers I hear about have the opposite problem.
This section is an update written in 2020. This post was originally written when I didn't realize that it was possible for people who aren't extremely wealthy to invest in startups. But once I moved to SF, I found that it's actually very easy to invest in startups and that you don't have to be particularly wealthy (for a programmer) to do so -- people will often take small checks (as small as $5k or sometimes even less) in seed rounds. If you can invest directly in a seed round, this is a strictly better deal than joining as an early employee.
As of this writing, it's quite common for companies to raise a seed round at a $10M valuation. This meeans you'd have to invest $100k to get 1%, or about as much equity as you'd expect to get as a very early employee. However, if you were to join the company, your equity would vest over four years, you'd get a worse class of equity, and you'd (typically) get much less information about the share structure of the company. As an investor, you only need to invest $25k to get 1 year's worth of early employee equity. Morever, you can invest in multiple companies, which gives you better risk adjusted return. At rates big companies are paying today (mid-band of perhaps $380k/yr for senior engineer, $600k/yr for staff engineer), working at a big company and spending $25k/yr investing in startups is strictly superior to working at a startup from the standpoint of financial return.
There are a number of factors that can make options more or less valuable than they seem. From an employee standpoint, the factors that make options more valuable than they seem can cause equity to be worth tens of percent more than a naive calculation. The factors that make options less valuable than they seem do so in ways that mostly aren’t easy to quantify.
Whether or not the factors that make options relatively more valuable dominate or the factors that make options relatively less valuable dominate is an empirical question. My intuition is that the factors that make options relatively less valuable are stronger, but that’s just a guess. A way to get an idea about this from public data would be to go through through successful startup S-1 filing. Since this post is already ~5k words, I’ll leave that for another post, but I’ll note that in my preliminary skim of a handful of 99%-ile exits (> $1B), the median employee seems to do worse than someone who’s on the standard Facebook/Google/Amazon career trajectory.
From a company standpoint, there are a couple factors that allow companies to retain more leverage/control by giving relatively more options to employees and relatively less equity to investors.
All of this sounds fine for founders and investors, but I don’t see what’s in it for employees. If you have additional reasons that I’m missing, I’d love to hear them.
_If you liked this post, you may also like this other post on the tradeoff between working at a big company and working at a startup.
Many startups don’t claim that their offers are financially competitive. As time goes on, I hear less “If you wanted to get rich, how would you do it? I think your best bet would be to start or join a startup. That's been a reliable way to get rich for hundreds of years.” (that’s an actual Paul Graham quote) and more “we’re not financially competitive with Facebook, but…”. I’ve heard from multiple founders that joining as an early employee is an incredibly bad deal when you compare early-employee equity and workload vs. founder equity and workload.
Some startups are giving out offers that are actually competitive with large company offers. Something I’ve seen from startups that are trying to give out compelling offers is that, for “senior” folks, they’re willing to pay substantially higher salaries than public companies because it’s understood that options aren’t great for employees because of their timeline, risk profile, and expected value.
There’s a huge amount of variation in offers, much of which is effectively random. I know of cases where an individual got a more lucrative offer from a startup (that doesn’t tend to give particular strong offers) than from Google, and if you ask around you’ll hear about a lot of cases like that. It’s not always true that startup offers are lower than Google/Facebook/Amazon offers, even at startups that don’t pay competitively (on average).
Anything in this post that’s related to taxes is U.S. specific. For example, I’m told that in Canada, “you can defer the payment of taxes when exercising options whose strike price is way below fair market valuation until disposition, as long as the company is Canadian-controlled and operated in Canada”.
You might object that the same line of reasoning we looked at for options can be applied to RSUs, even RSUs for public companies. That’s true, although the largest downsides of startup options are mitigated or non-existent, cash still has significant advantages to employees over RSUs. Unfortunately, the only non-finance company I know of that uses this to their advantage in recruiting is Netflix; please let me know if you can think of other tech companies that use the same compensation model.
Some startups have a sliding scale that lets you choose different amounts of option/salary compensation. I haven't seen an offer that will let you put the slider to 100% cash and 0% options (or 100% options and 0% cash), but someone out there will probably be willing to give you an all-cash offer.
In the current environment, looking at public exits may bias the data towards less sucessful companies. The most sucessful startups from the last couple generations of startups that haven't exited by acquisition have so far chosen not to IPO. It's possible that, once all the data are in, the average returns to joining a startup will look quite different (although I doubt the median return will change much).
BTW, I don't have anything against taking a startup offer, even if it's low. When I graduated from college, I took the lowest offer I had, and my partner recently took the lowest offer she got (nearly a 2x difference over the highest offer). There are plenty of reasons you might want to take an offer that isn't the best possible financial offer. However, I think you should know what you're getting into and not take an offer that you think is financially great when it's merely mediocre or even bad.
The most common objection I’ve heard to this is that most startups don’t have enough money to pay equivalent cash and couldn’t raise that much money by selling off what would “normally” be their employee option pool. Maybe so, but that’s not a counter-argument -- it’s an argument that the most startups don’t have options that are valuable enough to be exchanged for the equivalent sum of money, i.e., that the options simply aren’t as valuable as claimed. This argument can be phrased in a variety of ways (e.g., paying salary instead of options increases burn rate, reduces runway, makes the startup default dead, etc.), but arguments of this form are fundamentally equivalent to admitting that startup options aren’t worth much because they wouldn't hold up if the options were worth enough that a typical compensation package was worth as much as a typical "senior" offer at Google or Facebook.
If you don't buy this, imagine a startup with a typical valuation that's at a stage where they're giving out 0.1% equity in options to new hires. Now imagine that some irrational bystander is willing to make a deal where they take 0.1% of the company for $1B. Is it worth it to take the money and pay people out of the $1B cash pool instead of paying people with 0.1% slices of the option pool? Your answer should be yes, unless you believe that the ratio between the value of cash on hand and equity is nearly infinite. Absolute statements like "options are preferred to cash because paying cash increases burn rate, making the startup default dead" at any valuation are equivalent to stating that the correct ratio is infinity. That's clearly nonsensical; there's some correct ratio, and we might disagree over what the correct ratio is, but for typical startups it should not be the case that the correct ratio is infinite. Since this was such a common objection, if you have this objection, my question to you is, why don't you argue that startups should pay even less cash and even more options? Is the argument that the current ratio is exactly optimal, and if so, why? Also, why does the ratio vary so much between different companies at the same stage which have raised roughly the same amount of money? Are all of those companies giving out optimal deals?
The second most common objection is that startup options are actually worth a lot, if you pick the right startup and use a proper model to value the options. Perhaps, but if that’s true, why couldn’t they have raised a bit more money by giving away more equity to VCs at its true value, and then pay cash?
Another common objection is something like "I know lots of people who've made $1m from startups". Me too, but I also know lots of people who've made much more than that working at public companies. This post is about the relative value of compensation packages, not the absolute value.
Thanks to Leah Hanson, Ben Kuhn, Tim Abbott, David Turner, Nick Bergson-Shilcock, Peter Fraenkel, Joe Ardent, Chris Ball, Anton Dubrau, Sean Talts, Danielle Sucher, Dan McKinley, Bert Muthalaly, Dan Puttick, Indradhanush Gupta, and Gaxun for comments and corrections.