Everyone knows that stock options are awesome; what this blog post presupposes is, maybe they aren’t?
I have 3 main beefs with stock options:
1) They are hard to value for both the company and the employee
2) They are initially worth ~ nothing and probably will never be worth anything
3) They cost more than you think
1) Stock Options are hard to value for both the company and the employees
For pre-revenue startups that haven’t raised capital, this beef doesn’t really apply. It is generally accepted at that stage of the company that its stock and options are worth ~ nothing. As a result, founders and early employees often pay “par value” (often a tenth of a penny or less) for their stock and options. This is of course great if the underlying stock ends up being worth anything, and is what many people think of when they hear stock options. That however is not the reality for most option holders since most employees come on board AFTER the company has revenue or has raised capital. At that time, a company is required to issue options at “fair market value” which the IRS has made very complicated. Because it is complicated, a cottage industry has developed to value options for private companies (I recommend SVB), using one of a few methods. A heuristic is that options are often valued at 20% of the price of the last preferred stock round. There is typically a discount because of the liquidation preference of the preferred stock and uncertainty of the prospects of the company. When an employee joins a startup they do not get to negotiate the exercise price of their options but when they leave they must make their own determination whether the underlying stock is worth more than its exercise price. Employees, who are often not sophisticated or accredited investors, are typically given little to no information in which to make that valuation determination and are forced to come up with post-tax dollars to exercise their options (I’ll explain why this sucks later). It is a big gamble but often is not recognized as such.
2) Stock Options are initially worth ~ nothing and probably will never be worth anything
Because the option exercise price is the “fair market value” of the underlying stock, the option is worth ~ nothing at the time of grant. Let’s say the “fair market value” placed on the common stock is $1 and your exercise price is $1. That means you would be paying $1 to get $1 in value. Give a dollar; get a dollar. There is no value being transferred, and that is why options are not immediately taxable as income to the employee. (The gains are only taxed later if the option was exercised and if additional value was received for the underlying stock.) Therefore, generally-speaking employees should not assign much value to their options. If the underlying stock ends up being worth more than the exercise price, that’s great albeit highly unlikely; but trust me, you paid for them.
3) Stock Options cost more than you think
Often employees at startups are compensated at wages considerably less than what they could make at more established companies (e.g. IBM, Google, GE) or in service industries (e.g. consulting, law, investment banking, accounting). I previously explained that your stock option’s initial value is zero. That means any additional value created is somewhat dependent on you! It is important to understand opportunity cost. (Note: I am only talking dollars and cents and not other benefits of working at a startup.) If you could otherwise make $50,000 and are being paid $47,500 at a startup with $10,000 “worth” of options (vesting over four years), then you need to MORE THAN DOUBLE the value of the company to break even. Since the options have no initial value, that $10,000 “worth” of options is actually zero and thus, you need to turn that $10,000 into $20,000 to get to $50,000 per year. Not only that, but to come up with the $10,000 exercise price, you had to make $14,000 pre-tax. ($40,000 income is taxed at 25%). Furthermore, your $10,000 gain is taxed at 15-25% or MORE (many states have state capital gains tax). Let’s assume it is taxed at 20%, so you pay $2,000 of taxes on your $10,000 gain. In other words, you paid $10,000 ($14,000 of earnings) for $18,000 ($20,000 - $2,000) for a real return of $4,000! The option you thought was “worth” $10,000 was actually only worth $4,000 and it took four years and a successful outcome to get there.
I have other beefs with stock options that I will cover in another post, as well as a proposal for how to more adequately compensate startup employees, and more specifically, startup executives. I hope you found this helpful, and please comment if you agree or disagree with any of this!