Post Category → Equity

Early Hires: Options or Stock?

Nutshell:  While the conventional equity path of a startup is to issue (i) common stock to founders and (ii) options to employees, early hires concerned about taxes will often insist on receiving stock as well. Voting power, along with other political factors, present a few tradeoffs for founders to consider in that scenario.

Vocabulary:

  • “Option Pool” – a portion of the company’s capitalization set aside (after founder stock is issued) for equity issuances to employees, consultants, advisors, etc., and subject to a special “plan” designed to comply with complex tax rules.  Even though it’s referred to as an “option” pool, properly designed equity plans will allow for direct stock issuances under the pool as well; not just options.
  • “ISO“ – Incentive Stock Option – a tax-favored type of option issuable only to employees, if certain requirements are met. The main benefit is that upon exercise, the difference between the exercise price and the fair market value on the stock at the time of exercise is not taxed as ordinary income. However, it is subject to the Alternative Minimum Tax (AMT), which can hit certain people depending on their tax situation.
  • “Restricted Stock” – For purposes of a private startup, just another way of saying Common Stock. The same security that founders get, except for non-founder employees it’s usually issued from the “pool” (under the Plan) using different form documents.
  • “Early Exercise Options” – Conventional options issued to employees are not exercisable until they vest; meaning until the recipient has worked long enough to “earn” the right to exercise them.  Early exercise options have modified vesting/exercise provisions so that they can be exercised from Day 1 – with the underlying shares becoming subject to the vesting schedule.  From the Company’s perspective, early exercise options are very similar to restricted stock issuances. The only real difference is that the recipient has the option to exercise and receive the Stock on Day 1, or sit on it and exercise later.

Convention.

The conventional path of a Company’s equity issuances goes something like this:

  • Founders receive direct issuances of Common Stock (not options)
  • Non-Founder employees receive ISOs (options)
  • Consultants, advisors, etc. receive NSOs (options)
  • Investors receive Preferred Stock, or SAFEs/Convertible Notes that convert into Preferred Stock

Backround:  

  •  The value of restricted stock is taxable as ordinary income on the date of issuance, unless its fair market value (FMV) is paid in cash.
  • Options, both ISOs and NSOs, however, are generally not taxable on the date of grant, as long as their exercise price is equal to the FMV.
  • So, you would normally expect employees to prefer receiving options over stock. No tax > Tax. And this is the case when the stock’s FMV is relatively high. That’s why later hires (usually after a Series A) almost always receive options, without question.
  • Stock gets to vote on stockholder approvals. Options do not (until they’re exercised for stock).

The Issues: Early employees want to minimize tax. Companies want to avoid giving away voting rights/complicating stockholder votes too early.

  • However, in the very early days of a startup’s life, avoiding tax on restricted stock is easy because of how low the FMV of the stock is (fractions of a penny): write a check for a few dollars (the full FMV), or just pay the tax on the few dollars of ordinary income.  You therefore get the “no tax on grant” benefit of options, without worrying about paying tax later on an exercise date.  Receiving stock also gets the clock running on long-term capital gains treatment.
  • Therefore, very early hires, when they do their homework, tend to insist on receiving restricted stock (or early exercise options) over conventional options. Better to deal with tax when the stock is worth (at least to the IRS) virtually nothing, instead of years later upon exercising the option when the tax bill could be much greater (ordinary income for NSOs, or AMT (for some people) for ISOs).
    • Sidenote: Conventional equity plans also have a 90-day post-termination exercise period, meaning, when an employees leaves a company (voluntarily or involuntarily) they have to exercise their options within 90 days, or they then get terminated – even if vested. Paying the exercise price isn’t an issue for an early hire in that scenario, because it’s very low (the fractions of a penny FMV), but if the AMT comes into play it can hit them with a tax bill.  This doesn’t come up in a Restricted Stock scenario.
  • The tradeoff from the Company’s perspective is that, just like founders, those hires that receive restricted stock will have full voting rights (including seeing whatever is submitted for stockholder votes) for all of their stock on Day 1, before they’ve vested in anything.  When only one or two people are in question, this may not be a big deal. It can be a way of making early employees feel like a part of the core team, because their equity is being treated just like founders.  When there are more than a handful of hires, however, it can get unwieldy fast. The number of people to consult for stockholder votes can go from 2-3 to 10, 15, 20. If there are consultants and advisors in the picture, they may start to ask why they aren’t getting the same tax benefits as early hires. And then at some point you have to draw a line and start granting options. Is the first optionee not as special as the restricted stock people? Politics. 

Generally speaking, the decision to give restricted stock v. options to very early hires is a practical/political one.  While the tax-favored nature of ISOs means that most early employees won’t see much of a tax difference between receiving ISOs v. restricted stock, the prospect of an AMT hit in the ISO scenario does make restricted stock, on net, better for recipients.  That needs to be balanced, on the company’s side, against the early voting power/information rights given away when an employee receives stock instead of options, and how it will play out with all of the company’s other hires.  

My general advice to founders is to be aware of the tradeoffs, and to consciously treat the early voting power and tax benefits associated with restricted stock as currency not to be wasted.  If there’s a very early superstar that you deliberately want to single out as a key player, use the currency.  If not, then make the decision based on all the other factors. Company culture will likely factor greatly into the calculus.  Many, many founders prefer to avoid the politics/complications and simply draw a line at the founder (stock)/non-founder (option) division.  Others are more selective. There’s no magic formula.

A few separate issues worth addressing:

  • The 90-day post-termination exercise period (after which unexercised options, vested or not, are terminated) often gets criticized as being unfair to employees, and there’s some justification for that criticism. The view is that the employee shouldn’t be forced to “use it or lose it” if they did their time (their option vested) and are now moving on to a new company.
    • The actual 90-day number comes from tax rules requiring that ISOs be exercisable only within 90 days of termination.  If an option is exercisable after that, it automatically becomes an NSO for tax purposes. But there’s nothing in the tax rules requiring that the option be terminated at 90 days. That’s largely meant (i) as a deterrent (frankly) to people quitting, and (ii) a way to clean up the cap table for people who didn’t want to pay their exercise price, allowing that portion of the pool to then be re-used for new hires.
    • While the 90-day period is still convention, key executives/hires will often either negotiate for an extended exercise period for their own grants, or the Company will as a gesture of good will, decide on its own to selectively extend the period when someone leaves on good terms.

Obligatory Disclaimer: This post contains a lot of fundamentals and generalizations on tax rules, but it’s obviously not intended to be an exhaustive statement of those rules. Circumstances vary, and you should absolutely not rely on this post without consulting your own attorney and/or tax advisors.  If you do, don’t blame me when it blows up in your face.  You’ve been warned.

How Founders Lose Control Of Their Startups, Apart from Ownership

Summary: There are many ways, apart from ownership %, that founders slowly lose control of their companies. Some of the more obvious ones get spelled out in term sheets, but professional players in startup ecosystems know how to use more subtle mechanisms to erode founder control.

Seasoned founders and startup lawyers know that there are really two things that matter most in negotiating a term sheet: economics and control.  In other words, from the perspective of a founder, (1) what % of the Company will I own after the deal closes (and, more specifically, what % of exit proceeds do I get), and (2) whose permission is needed to make key decisions? Of the “control” terms, there are explicit ones, like protective provisions,  that competent founders know to focus on.  But there are more subtle aspects, like the composition of the Company’s advisors, and even who the Company’s lawyers are, that when ignored can significantly erode the ability of founders to maintain influence over their companies; particularly in high-stakes situations when there’s significant internal disagreement.

As I’ve written before, being an entrepreneur raising capital means learning to give up control. That’s a given. However, I’m very much a believer in transparency and having your eyes wide open. By educating yourself, you ensure you give up control at the appropriate time, and with fair terms; instead of with subtle power plays that slowly hand control to other people without you even noticing it.

The More Obvious Forms of Control

  • Voting Thresholds and Protective Covenants – These are typically spelled out in stockholder agreements and organizational documents. There are 1,000 ways to draft them, but they basically boil down to: you can’t do X without getting approval from stockholders holding Y% of the Company’s overall capitalization, or a specific % of various classes of stock.
  • The Board of Directors – Who is on the Board, and who has the ability to elect/remove people on the Board? The Board is the core governing body of the Company, which means nothing serious happens without their approval. In a 5-person board, whether founders (common stockholders) elect 3 directors or 2 dramatically alters the power dynamics of a startup.

The Often Overlooked, But Important Control Mechanisms

While voting power and board composition are definitely the most important issues, I always advise founders that maintaining control/influence over the companies they started is much more nuanced than what gets spelled out in a term sheet.

How “Independent” is Your Independent Director?

It’s very common for VC-backed boards to have an “independent” director – usually an industry expert that gets elected by both the common stock (founders) and preferred stock (investors).  However, it’s also fairly common for VCs to suggest that the “independent” director come from their own network of executives.  In judging whether their VCs recommended “independent” is the right person, founders should absolutely include the loyalty of that director to the VCs in the calculus.  He’s in their network, and knows that keeping them happy will mean more influential board appointments in the future. If a founder CEO is well-informed and connected in her startup’s own market, she likely has her own ideas for more independent directors. Put them on the table for discussion.

Board Observers – Who is at the Board Meeting?

Investors often will ask, in addition to a Board seat, for one or two board “observer” positions; meaning, at a high-level, non-voting people who can nevertheless attend board meetings and (usually) engage in discussion with the board. The presence of board observers matters and absolutely will influence discussion on board-level issues, even if they ultimately can’t vote. Don’t hand them out without understanding how they alter a founder’s influence at meetings.

Whom do your lawyers work for?

I’ve touched on this issue before here: Don’t Use Your Lead Investor’s Lawyers. There are hundreds of scenarios in which, in the middle of high-stakes decisions and disagreement among decision-makers on the right (or legal) course of action, founders will turn (protected by attorney-client privilege) to company counsel for advice – what’s legal?, what are the consequences?, what are my options?, what’s “market?” etc. etc..  Many times the “right” decision for the Company is one that won’t sit well, and even piss off, certain groups on the cap table.  You don’t want lawyers who work for those people.

“Don’t just go with the lawyer that the VCs insist upon. These lawyers will work with the VC on a hundred financings and with you on only one. Where do you think their loyalties lie? Get your own lawyer, and don’t budge.“ – Naval Ravikant, Lawyers or Insurance Salesman?

Despite arguments from certain investors and lawyers who claim that the above is a non-issue (you can imagine why), most founders immediately recognize the problem when this reality is described to them.

Where do your advisors and executives come from?

The theme of “pay attention to loyalties” carries on into a Company’s advisors and outside executive hires.  Where did they come from? Who got them this job, or their last job? Are they all part of the same investor group or business network? The conversations they have with you (the founders) will not be the only ones they’ll be having. Pay attention. Careers are long, much longer than the life of a single startup.  Advisors and executives, even those with strong ethics, pay attention to who can get them their next position when their current one exits.

Nutshell: Voting control matters, but it isn’t everything. Loyalties, particularly long-term loyalties, drive human behavior. Don’t be lazy and let every influencer (director, executive, lawyer, advisor) in your company come from the network of a single investor group. Smart ecosystem players know that’s one of the best ways to gain influence over a company without putting anything on paper. Leverage peoples’ contacts, and of course contacts will overlap, but make sure you ultimately have real diversity of perspectives to turn to.  Otherwise, when it really matters, a dozen back-end conversations will end up with really only one voice whispering in your ear.  

It’s precisely when the stakes are highest that a founder needs brutal honesty from advisors and counselors. And nothing ensures honesty like transparency and true independence of viewpoints. Make sure you don’t lose it. 

 

Taking Non-Accredited Money – Survival.

Imagine you’re walking through a desert. You haven’t had water for days, it’s 100 degrees, and you know if you don’t get a drink soon your time here is done.  Then you come across a mucky pool of stagnant water that is almost certainly infested with some kind of bacteria. What do you do? Pass on it, for fear of getting sick? Sh** no. You get yourself a drink.  Rule #1: survive.  

This is the decision many startups face when questioning whether they should accept money from “non-accredited investors.”  It also highlights how ridiculous it is for startup lawyers to tell founders that non-accredited money is never worth taking.  They clearly haven’t stepped down from their mahogany pedestal and planted their feet on the same ground as their clients.  Being the product of low-income immigrants myself, and seeing how many successful startups rely on pre-angel funding (a lot), the “if you don’t have rich friends and family, don’t bother” mindset really rubs me the wrong way.

I’m not going to get into the background of what accredited v. non-accredited investors are, or why you shouldn’t take their money.  Most likely you’ve already heard it repeated in 5 different ways.  Professional investors don’t like them, there are onerous disclosure obligations, they can prevent you from raising larger amounts of money, etc. etc. Let’s just take it as a given. Taking non-accredited money is a bad idea. We all know it is. But you know what’s a worse idea? Shutting down when there’s life-giving capital on the table.

Texas is not California.

Unlike startups raised in the land of milk and honey (Silicon Valley), where many angels really will fund an idea, a true MVP, or something with no revenue, in Texas (including Austin) it generally takes a lot of work and some traction (with zeros) to get to a point where angels will even consider writing you a check.  And while it’s true that bootstrapping should definitely be considered, it simply isn’t feasible for a lot of business models; unless you’ve got some deep pockets.  For that reason, the “friends and family” round – $25K, $50K, $100K, whatever, just enough to build something angels actually find attractive – is often the difference between startups that scale, and those that never get off the ground. And statistically speaking, most people’s friends and family are non-accredited.

How do I safely take non-accredited money?

As a startup that knows professional venture capital will be essential to scaling, taking non-accredited money is not “safe” in an absolute sense.  No matter how you structure it, having non-accreds on your cap table/balance sheet will raise questions and diligence from future investors.  The real question should then be, given that whatever consequence is better than shutting down, how do I raise non-accredited money as safely as possible.  Here are some principles for taking non-accredited money, while minimizing the chances that it’ll prevent professional funding:

  • Get help.  Work with an experienced startup lawyer to ensure that you comply with relevant regulations as closely as possible, and within budget, for the financing.  A misstep from a legal standpoint could create an unfixable problem down the road.
  • Limit the group.  Take money only from people you consider true friends and family who can afford to lose all of the money they give you, and who understand that losing the money is a real possibility. This means people who care about you, want you to succeed, and absolutely do not view this money as a lottery ticket to becoming rich. This is not crowdfunding.
  • Lenders; Not Investors.  View the non-accredited friends and family as lenders, not investors.  Make it crystal clear to everyone that their money is a loan, not an investment.  It will not convert into stock, and hence if you hit it big, they will not get a piece of all the upside.  Post-IPO, you can offer free rides in your Bentley and shower them with benjamins. Just don’t offer them stock today. If the company succeeds, the money will be paid back. Offer them a very high interest rate, and work with your lawyer to structure a non-convertible promissory note.  Anyone who will write you a check for $5,000, knowing that it is extremely high risk, and that there’s no chance of a 100x upside, must truly be in it just to help you succeed.

Important sidenote: If you have people who are willing to back you in the above way, you are rich – in a way that many people aren’t. Other people leverage their affluence. Leverage yours.

  • Long Maturity; Subordinated.  Set the repayment terms of the non-convertible note so that the debt does not become “due” until the Company has raised a significant amount of money, maybe $2 million+, and that the debt will be subordinated to all future debt issued to professional angel (accredited) investors.
    • The goal here is to allay any fear from angel investors that their money will be used to repay your non-accreds, instead of funding growth.  The money is not payable until a true VC round, and their debt is always senior to the non-accred debt.

Does following the above principles mean that having non-accredited money in your company won’t blow up a possible financing? No, it doesn’t.  But, in my opinion, it will significantly de-risk things for you.  When VCs or angels ask about your non-accreds, you can make it clear to them that (i) everyone knows that they are being paid back, will never be equity holders, and are subordinated to all other investors, and (ii) they are a highly vetted group of true friends/family who will be cooperative with whatever helps the founders succeed. Once they are paid back, they are a non-issue.

To be clear, I am not promoting the funding of startups with non-accredited money in a broad sense.  I tell founders the exact same things other experienced startup lawyers do: it’s a bad idea, it creates more disclosure obligations, and some investors might not touch you.  If you can avoid it, do so. But being alive yet uncomfortable is always preferable to being dead.  And my observation is that, at least in Texas, a F&F round is often a prerequisite for progressing far enough to where angels find you investable. Drink the mucky water, and live to fight another day.