The House Wins with Options
You're probably better off with cash.
When discussing the compensation package of a startup, it’s become second-nature to value the stock or option component as practically worthless.
This evaluation, while tired, is unfortunately often true. And it’s by design.
In the early stages of a startup, equity is cheap, since the company can freely allocate options or shares, while cash remains at a premium (either the startup isn’t bringing in significant revenue yet, is operating on limited venture funding, or both).
But startups need great individual contributors to build their product, compete, become sustainable. And often, they need experienced and versatile (read: expensive) ones at that. In the Bay Area, even new-grad contributors can easily command over $150k/year in cash: a price startups are either unable to afford or unwilling to pay.
Startups often get around this by offering option packages. What they can’t (or won’t) pay in cash, they’ll try to make up for in equity. The employee takes a short-term cash hit, for the potential of a much larger, long-term upside. Or so the thinking goes.
The philosophy is great: giving ownership to employees can align incentives, create belonging, and importantly, allow the company to afford an employee in the first place. But when it comes to equity, the devil is in the details, and companies choose pretty rough details.
For an early-stage, non-founding engineer or designer at a startup with fewer than 20 people, this might look like 1% equity. As the company grows to the 50-100 range, these equity amounts can easily drop to the negligible 0.1%. And that’s over four years.
It’s worth noting that companies often regard employee equity as second-class (literally and legally). Employees don’t get information rights (regarding valuations, roadmaps, outstanding shares, etc.). Their stock is the first to get diluted, and will likely be non-preferred and non-voting.
Compare this to institutional investors. They get regular, proactive updates around fundraising, revenues, exit strategies, and cap-tables. They almost certainly receive preferred, voting stock, have built-in anti-dilution clauses, and have priority liquidation preferences.
But the deal still gets worse. It’s common for startups that provide option grants to choose an aggressive exercise window (i.e. the period of time that you’re able to buy your vested options). Carta explains:
The vast majority of startups use the same 90-day PTE window—it’s basically become the de facto option. For all terminated option grants on Carta’s platform, 91.4% have PTE windows of 90 days or less.
In other words, if you leave the company, even after years of service, you have just the exercise period to scrounge together the money to purchase your options and pay any applicable taxes on it, too. If you can’t afford the options, you forfeit them back to the company. For good measure, these options will be re-packaged to the next new-hire.
But let’s say you’re able to fully exercise your options (i.e. buy them). Congratulations – you’re still the owner of a negligible amount of Monopoly money in the form of private stock. You are on the cap-table as a formal shareholder (again, as a second-class one), but you have no way of selling the stock in exchange for cash [1]. This is often only possible during a liquidity event, which is a fancy way of saying the startup gets acquired (taking between 7 and infinity years), or IPOs (same timeline).
The changing venture capital and private equity landscape has contributed to these exit timelines extending further and further out. Why? One of the primary reasons a company goes public is to raise an amount of money (through the IPO) that it couldn’t or would rather not raise privately (through a venture capital, private equity, or debt deal).
But nowadays, the startup world is flush with private equity money (see SoftBank’s Vision Fund, a thin wrapper around Saudi Arabia’s oil wealth), which has made the public market less attractive and necessary for founders. Why deal with the headaches, costs, regulations, and transparency of being public, when you can just raise a Series E privately?
And if the company is so successful that they get to consider a public offering, they certainly have had the option to be acquired, too. But why settle for that?
We’re left in an environment in which startups raise more and more capital, and take longer and longer to exit, which diminishes the chances of early-stage employees to actually cash-out on the stock they’ve vested and paid for.
We’re left with startups offering the best engineers and designers a materially lower salary, in exchange for the option to buy a trivial amount of private, second-class stock over four years, that maybe, someday, between seven years and never, can be sold to make up for the cash originally left on the table.
That, or the startup goes under and the stock’s worthless anyway.
Where do we go from here?
If you’re considering joining a startup, value your options package at $0. If they happen to be worth something in the future, consider it a small bonus for taking on the risks of joining an early-stage startup – not as part of your regular payroll. Push for a higher base salary instead, and give less weight to a largely symbolic options grant.
For founders and employees: you have a lot of tools to make your equity packages actually meaningful and valuable. You can award stock over options, increase exercise windows, pay the associated purchase tax, even create buyback programs that trigger on the next fundraising round or valuation.
But seasons come and go, and changes take time – especially when changes cost companies money. So next time you negotiate an offer, remember: the house wins with options.
Footnotes:
[1] With the trend of private, multi-billion dollar startups comes the secondary options market, too. Based on the details of an employee’s grant, it may be possible to sell options to a third-party, or even, an existing investor, at some discount.
[2] Thanks to Kevin Chen for reviewing and editing this post.