This Week in Startups - Stock option grants deep dive with Becki DeGraw | Wilson Sonsini Startup Legal Basics

Episode Date: March 18, 2021

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Hey, everybody, welcome back to Startup Basics. This is the show where we take very basic topics that are important to get right, and we outline for you the best practices. These legal issues are important to get right from the beginning because cleaning them up is incredibly costly both in terms of time, money, and it's costly because it can kill a deal. I've seen deals fall apart because people didn't have their accounting, their HR, or most commonly, they're legal tight.

And remember, in startups, in business, tight is right is what I always tell. My founder is with me today again. To talk about keeping it tight is Becky DeGroff from Wilson Sonsini, my law attorneys and my law firm. How are you, Becky? Good, good, good. How are you doing? Good.

You heard me say, tight is right, tight is right. I love it. Can you confirm as an attorney that tight is right? Confirmed over and over. Right. Lucy Goosey? Not good. Lucy Goosey when you're doing product discovery, totally fine.

Lucy Goosey when you're doing ideation or coming up with a name for your company, great. Lots of ideas, no wrong answers. But when it comes to legal, when it comes to accounting, when it comes to HR, there are actually wrong answers. There are a lot of wrong answers. And we're here to tell you about the right answers. Stock option grants are filled, filled with anxiety, controversy, pain, suffering, glory and riches. They are like the end of the rainbow, you find the pot of gold, but there's a long distance over that rainbow and there's sometimes storms and other distractions along the way.

Let's talk about stock option grants. Why do they exist in startups? Well, startups don't have a lot of cash, so they want to be able to use their equity as a form of compensation. And everybody wants to be in early on these startups, get equity really. cheap that's going to be worth millions of dollars one day. And that will encourage you to take a little bit less on a salary, allow startups to preserve some of their very, very, you know, needed cash in those early days. Okay. So they exist as an incentive as part of compensation. Most times they're worth zero dollars because most early state startups fail and never get bought. Let's say 70% of the time. But in the other 30% of the time, they could be somewhere between

nice, meaningful, or life-changing, and in some cases, generational wealth. And it's very weird for you and I to watch this, Becky. We watch teams. You know, we both watched hundreds of teams work tirelessly, and then one team, everybody becomes millionaires, billionaires, sent to millionaires, whatever it is. And then other teams, they all become word zero. And that is, in some way, part of why they're so popular is, my goodness, these can be life-changing.

So let's talk about what a standard option grant from a company, from what I think most people refer to as the ESOP employee stock option plan, what is the typical size of an employee stock option plan in terms of the percentage ownership of the company? And where do those shares come from? Are they issued out of the founder's shares? In other words, if there's two founders and they own, you know, 40% each in the investors zone 20, does that, do those shares come out of the founders 80% or do they come out, are they added afterwards and do they dilute everybody 10%? What's the size of the employee stock

option pool and who pays for it? Yeah. So when you're when you're forming a company, you know, I always kind of give the example of the pie, right? It's only so big. It's 100% and founders are definitely going to take a piece of pie and going to have a big chunk of the pie, you know, vast majority of the pie. They took the risk. Exactly. But, you got to reserve some of that pie for future service providers, you know, whether it's employees or consultants or advisors, whatever it is that you're going to be using in those early days, again, you don't want to pay them your cash, so you got to give them some equity. So we will often say, you know, reserve 10 to 20 percent of that pie for future issuances.

Now, when you don't issue it at, and let's say until you actually issue it, the founders own on a voting control basis, 100% of the company. And if you never issue those options, you don't get diluted. But you have it there. You have it available to issue when and if you need it. And it varies from startup to startup depending on what type of hiring you need to do. If you're a sole founder and you don't have anybody else, you're probably going to have to do more hiring. You may have to hire somebody at the C-suite level to help you to.

to get things up and running before you you bring on an investor or get to an investor, in which case maybe you have a bigger pool that you reserve. Or if you don't have a bigger pool, but you end up needing it to your point, where does that come from? Essentially it comes from all of the existing stockholders at the time. Anytime that you have to, again, cut into that pie and you have to give somebody else a slice, it has to dilute everybody else pro rata. And this is typically a discussion point for those first investors. They come in, there's a company

with two founders, you and I founded a company, a third party comes in, they want to invest, you and I own 50%, they want to buy 20%, and they might say, we want the team, the two founders, to take that, we want them to take 10% of the out of their 100% ownership at the time. Other times, that gets created after the money's put in. But most of the time, investors putting money in don't want it to come out of theirs, right? Vast majority of times. I mean, I would say the only time that you really, as a company that you can negotiate to have an option pool increase associated with the financing come in post money,

meaning the investors will also share in that dilution with you is if you are an extremely hot company, you've got multiple term sheets on the table, and you can pick and choose who you want. It's a competition to be an investor in your company. Got it. Outside of that one scenario. your option grant is going to come, or your option pool increase is going to come out of the pre-money, which means all of the existing stockholders, other than the new investors, is going to

take the dilution hit on a pro rata basis. Which kind of makes sense. If I'm buying shares in the company, it's kind of a bummer to put a million dollars in and then have somebody say, oh, by the way, your shares are now diluted 10%. You're down to 900,000 like the day after he did the investment would be a little bit of a bummer. What is the typical structure of an employee stock options? There's something called the cliff. There's the vesting period.

And then I guess there's how long if you leave the company, do you have to execute? Yeah. So tell us about what's the standard today in Silicon Valley or if there are things that are competing standards, maybe even. Yeah, definitely. And maybe even before we jump into that, like you're going to put together an offer letter when you are giving a potential employee a grant. One thing that I really, really, really encouraged to do in that offer letter is to use the number of shares, not a percentage.

If you use a percentage, it's like a percentage of what? A percentage of ownership, a percentage of fully diluted? Do you include the pool? Do you not include the available pool? Is it on the date of the offer letter? Is it on the date that the individual starts? There's so many different variables that that can be. It just creates a lot of ambiguity.

So unless you are extremely specific about what percentage, on what date, of what, use a number. It's much easier. So if I had 25 million shares and I wanted to offer somebody 1% of the company, I would be offering them 250,000 shares. But I wouldn't say 1%, because what if we add an employee pool to it? What if another investor comes in and we issue another 5 million shares? 1% would be 300,000 shares as opposed to 250. So you could say to the employee, we're going to give you $250,000. 50,000 shares. They could ask how many outstanding shares are they? And that's a good question for

somebody to ask, correct? Absolutely. They're within their right as an employee to say, can I get the denominator. How many current shares are there in the company, fully diluted, you know, including the option pool? Absolutely. It's great to have that conversation and to tell them the percentages verbally. Just stick with the number when you're actually in the legal document so that it's really clear. There's no ambiguity. They can't come back and say, oh, well, actually, I thought I was supposed to get this many more shares. Right. They say 1% at the time of the IPO.

Exactly, right? After five rounds of funding. You don't want it. You don't want those arguments. So just again, tight, really tight language. Tight. So then what are the actual terms of that option? For a standard employee, vast majority, it's going to be a four-year vesting schedule with a one-year cliff.

That one-year cliff basically means you don't vest anything for the first year. It's kind of like a test-pefossed. period, just to make sure it's going to work out. You know, these are private companies. Maybe you don't want somebody that works for the company for a couple of weeks or a couple of months to end up on your cap table, right? Like, if it doesn't work out, you part ways, no harm, no foul as far as your cap table is concerned.

If they work out, great. They vest 25% basically what they would have vested over the course of a year on the one-year anniversary. And then once they're past that trial period, if you will, then they can start vesting monthly for the remainder of their vesting period, which would be, you know, for the for the next three years. So for a total of a four-year vest. Other things to think about is what is the exercise price of these option grants? That's a key, key term, right, that everybody's going to want to know. It's like, how much I have to pay for these things? The exercise price has to be tied to the fair

market value on the date that the board approves the grant. So not on the date of the offer letter, not in the date of your first day of employment, but on the date that the board approves it. So again, back to that offer letter, there's a reason why we have the language in there that says subject to board approval and at the fair market value as determined by the board. It's very important to have that in there.

Don't put in your offer letter, your current fair market value price. It may not be by the time that the board approves it. So employees should have an expectation that they're going to get an offer, but it may not have the fair market value in it right at that point in time, but after the board meeting, when they officially get them, they can then ask what is the fair market value and they should know.

And typically fair market value, FMV, is based on something called a 409A valuation report, which seems to be included in a lot of the online services. Different CapTable software will include it. It typically costs $2,000, $4,000, or it's included in a $5,000 software pack, for cap table management. Am I ballpark correct here on the early stage?

Yep, yep. The 409A is typically less than what people paid for preferred shares. Why is that? Because your preferred shares have extra rights, and namely they have a liquidation preference, which means if the company is sold, the preferred gets all their money back first before the common gets anything. So in that scenario, the common should be worth less than that preferred stock, because it has that preference, has that seniority over the common.

And that's the whole reason why we sell preferred stock, really. Otherwise, we just sell common stock. But we don't want, you know, we want to keep the common stock price cheap for our service providers so that it can be an incentive to them from a compensation standpoint. Just coming up with a scenario, which I am apt to do in these situations to make it easier to understand. We have a $10 million company. It has 10 million shares in it.

each share was bought recently, or 20% of the shares were bought recently by a seed fund for $1 each. That is the price of the preferred, $1. I, as one of the early employees, owned 1% of the company, but they told me I had 100,000 shares, but they didn't tell me 1%. I have 100,000 shares. And the 409 valuation comes back, and they value the company not at $10 million. They valued it at $3 million. why is there so much of a lower valuation?

What would be the reasons in a 409A report that an accountant or an attorney, who does the 409A, and how do they determine what that price should be? What are some of the factors they take into account? Yeah, so it's an independent third-party valuation firm. So like financial services arena. So not an attorney, typically not an accountant who does it, although some of the accounting firms do also do valuations. but it's kind of a different team that does the valuation side of things.

So like financial modeling folks. And that's what goes into it as various financial models. And depending on the stage of the company, what they can look at in terms of other metrics to look at. Like if the company actually has revenue coming in and prospects and they'll weigh that as a consideration. If they don't have any revenue yet, you know, they look at, they'll look at what has been raised in terms of other investors coming in.

But it really kind of depends on where the company is at and what metrics they can look at in order to do the financial modeling. So my strike price, the exercise price for me as an employee of those 100,000 at $3 million valuation, would be 30 cents. And if the company got bought for $20 million, each share would be worth $2. I'm just giving ballpark numbers here. I would have to pay the 30 cents in order to buy the share in a sale and then I would get the difference the $170. Yep, that's right. And sometimes it's, it's, we actually just net it out so you don't have to actually write a check, but your net result will be the same. Yep. Got it. So you don't actually, in the part of a sale, give the $30,000 and then get the $200,000 back and do the math in your

head. They just say, here, after you paid for your shares, this is what's remaining, you get this $170,000. And the other reasons might be, hey, the company is three months away from running out cash. Oh, hey, the company, as you mentioned, does not have customers yet, does not have revenue. It is a straight slope down, and in six months, we will not be here because we're burning whatever it is, 100K a month, and we have 600 left. So they take all that into account with the fair market value of the company. If you don't get a fair market value done, what happens? So this is where the consequences can be really bad from a tax perspective. So if you get a 401A evaluation report, that's considered a safe harbor, which means the board.

board can rely on it as long as no other material events have happened since the date of the 401A evaluation report. And you're kind of like, okay, we're good. We can rely on that report. If you don't have that report, the board has to come up with what is the fair market value? And let's say they get it wrong. And it turns out that, you know, they said it's 30 cents, or let's say they said it was 20 cents per share. And it turns out it really was 30 cents per share. those option grants are going to be considered discount option grants. And the IRS hates discount option grants. So they came up with code section 409A, which is where the valuation report name comes from.

And under that section, it basically says that if it's a discount option grant, it's going to be taxed as ordinary income. So you've got ordinary income taxes on it, both at federal and state level. Plus, we really hate these things. is what the IRS says. We're going to throw a 25% penalty on top of your ordinary incomes. And then, you know, like here in California, well, oh, no, no, we're not done yet. And then here in California and most other states follow suit as well. And they don't want to be left out of this.

So they said, no, we're going to have a 5% penalty that we're going to add on top of ours. So you've got federal and state ordinary income. You've got 25% penalties on something that you can't sell. Wow. It's an option grant that is in a private company that you can't sell, but you owe tax on it. And it gets worse. So the way that they actually look at it is when the option vest. So each month, right, when we're talking about monthly vesting, on that date, you look at the delta between the exercise price and the fair market value on that date.

So each month, presumably, maybe not each month that the fair market value goes up, but certainly, certainly each year, maybe each six months there's a valuation uptick, your tax bill each month gets bigger and bigger because that delta is growing. It's a, it's a bad, bad, bad thing. And people would wind up just not taking their options at that point as opposed to taking the tax bill or something? No, I mean, you don't really have a choice. You don't have a choice. I mean, this is the IRS, right? They say, yeah, they're not playing games. Yeah, you can't really seriously. Can't really opt out of paying your taxes, despite what some people are doing on their islands, et cetera. So there was an options backdating scandal. And this is another example of where

tight is right and to not play games to never bend the rules because bending is just not worth it. There were people who went to jail at some point because they had backdated options, very bad thing to do. Yep. Yep. And that's and that's, and that's, trying to get your employees or service providers cheaper options at evaluation from some prior date because some material event probably happened. And you're like, oh, I forgot to. We had these option grants that were outstanding from these 10 new hires that we just didn't get around to granting.

I wish we would have done it back then. Well, too bad. You do it now. And you give them a gross up if you feel bad about it, right? A gross up being. You can either give them. more shares. You can give them a cash bonus. You can give them something to attempt to make them whole, but you can't go back in time. Yeah. So if I, if I told somebody, yeah, I'll give you this

many options and I forgot to do it or I didn't have a board meeting or I forgot to bring it up or whatever, forever reason, I screwed up. Then you just say the person, hey, listen, I was supposed to give you this $100,000 in options back then, but now the fair market value went from 30 cents to 60 cents. So the difference there would be $0.30,000, $30,000. I'll just give you $0,000. 30,000 more shares, or if the shares were $1.50, I'm going to give you $15,000 or 20,000 more shares, just on top of it, another grant, correct? You can, but kind of going back to that offer letter that we've been talking about a number of times where we say subject to board approval and at the fair market value as determined by the board, as long as you have the right language in your

offer letter, there's no obligation, there's no legal obligation to do that true up or gross up. that's purely a, hey, if I screwed up and I want to make you whole, here's some ways that I can do that. And it's not backdating. What it is is it's going to come out of the company one way or another, whether it's cash or it's dilution. But here's the way that you can fix it. People were more loose about this.

The government has been very serious about this. So it's tight is always the way to do it. Keep it super tight. When people leave a company, there used to be a 30-day exercise window. I remember when I was coming into the industry. So one of the dark secrets of this was people would come work for a company. Then they would be forced to pay that 30 cents. They'd have to come up with $30,000 when they left.

And these were called golden handcuffs. You know, people who were in Uber, the company's price accelerated so much that when they left, they would have to come up with, you know, a lot of money to buy their shares or face losing them if they didn't exercise within 30 days. Is 30 days still the exercise window for these service providers and employees? or are people taking a longer window now? Because I hear a lot of people debating this. Yeah, this is a hot topic.

The norm right now is three months. And it has been for a fair amount of time. But there is definitely a number of companies who are considering or who have pushed out their post-termination exercise period to the full term of the option grant, which is 10 years. And some companies take that position of saying, hey, you vested in your shares. we want you to be able to benefit from those shares if you're no longer with the company. Some, you know, I say kind of apply that discretionary, you know, so it's not to everybody. So I can make a decision, hey, you're leaving, but you left on good terms, you hired your

replacement. I'm going to give you this extension. So you can almost keep it as like some carrots over here on the side. If employees leave, hey, you know, I could extend it for you. you if you ask nicely and if we have an agreement that, you know, if we call you on the phone and ask you what do you think we should do here? Do you know the, the archaeology of this decision you made, you might actually pick up the phone. So it's a nice way to keep people insented to root for the company. Yep. And as long as you have a reasonable business decision for making those

determinations, you're fine. Right. Reasonable business decision sounds like one of these like terms of art. I would say, you know, don't do it to, I'm only going to give it to my, I'll make it really easy. I'm only going to give it to white males, right? You don't, you don't want that to be the policy. You want a, you want what you just went through, right? Your example was, hey, you, you helped hire your replacement.

You gave us lots of notice. You help with a transition period. You're on call, you know, for a period of time. Those are all great business reasons for wanting to provide an extra incentive, right? As I always tell founders, do you want the people who worked for you for two or three years to feel great about their experience after they leave? Or do you want them to be better about it? You kind of want them to feel great about it because you might get a boomerang employee.

They left. They went to some other hot startup. It imploded. They realized that working for you wasn't as bad as they thought because they worked for somebody who was so much worse if they come back. I've had that a number of times. people are like, you're too hard to work for, and then they go work for somebody else, they come back for them. It's the worst, yeah.

No, you weren't that hard to work for. I kind of enjoyed working for you more than this other person who was incompetent. And so you just want people out there to be cheerleaders, right? And if they're vested, man, they have a literal financial stake in your outcome. It's better for you. It's better for you as the founder. That's certainly one argument, right? I mean, the other argument is that that is taking up space on your cap table, right?

and the more people that you have out there that are no longer contributing to the company, that's just setting there on your cap. Remember, we only got 100% in that pie. And you've got it, you've got to hire new people to come in. Yeah. But it also is dangerous for the employee to execute them. I remember I had some employees execute in a company and they're like, they spent $4,000. And like, should I spend this $4,000 to execute my shares?

I'm like, most startups fail. So. And they usually take 10 years. So is that $4,000 better for you in the stock market? doubling every seven years and it'll be, you know, 8,000 or in 10 years, it might be, whatever, 10,000. Or is it better for you to buy these shares and have the off chance they could be worth 10 times that?

You have to make that decision. I don't know how much cash you have in your bank account, but there have been many startup employees who left, wrote a $4,000 check to the company. And you literally are writing that $4,000 check. You literally are. Yes. Like you're literally sending $4,000 from the employee's bank account to the company's bank account. So now you're just like a venture capitalist or a seed investor buying their shares,

except your shares are common and behind the preferred. So you just paid for the privilege of being behind all that overhang of the preferred. And it could be, you know, in my job, seven out of ten, I expect to go to zero. So you're taking on risk. Absolutely. And, you know, I mean, in our example, we've been using 30 cents as the exercise price, the company could sell and there could be money that go to common. But what if it's only 20 cents a share? Right? Now you're under water. Yeah. So, you know, it's hard. It's hard to, hard to make that decision. There's definitely a lot of risk associated with it. And that's why you still have a salary. These are the icing on the cake of Silicon Valley. If you come to tech startups, you get this incredible lottery ticket. Some people might argue it's more of a coin toss. Some people might argue it's a lottery ticket. It's certainly not one in millions of chances they'll become worth something. It's probably, I would say, one in five or one in ten. would be just my back of the envelope based upon my own track record, that they could become worth something.

So you have to think it through. You know, maybe one in ten is a good way to think about it, which means if you go work for five startups, he still might not. Still might not, yeah, I mean, people,

and this is why startups are such a risk. But if you're getting that base salary, you can really look at it and say, hmm, as an employee, I'm coming to this company and I'm getting more responsibility. I'm learning. I'm taking 20, percent less cash, but I got these lottery tickets. Okay, I'm willing to make that trade off, right?

I enjoy my job here. So overall, people take these three factors into account, their cash comp, their equity comp, and then their enjoyment and their experience at the company, right, which is a serious part of it. I've seen people leave working for a Google or Facebook or Uber even, you know, where they're getting paid $250K to go work for a startup for half that amount. and they do it because they want to enjoy going to work every day. They don't enjoy going to a big company. It's just not simple. Or they're passionate about whatever, you know, the new product,

mission, exactly is at the startup. All right, listen, this has been great. Do we miss anything? Do we miss anything? I think we covered the high points. Yeah. I mean, there's lots of little nuances on option grants. Are there any edge cases on option grants?

that are becoming a trend now or things that people are dealing with that are present, you know. The post-termination period is definitely one that's hotly debatable as to whether you extend the period or not. Early exercise. If 10 new startups were starting today in Silicon Valley, how many would choose the 10-year option window

versus the 90-day? One. One would choose the 10-year. Wow. So people still go with a short one. Wow. Interesting. Yeah. Yeah. Vast majority do. Early exercise is the only other thing we didn't really talk about.

Yeah. Explain what that is in plain English. Yeah. So early exercise is a feature that you can add to the option grant. So you know, we've been talking about the vesting schedule that's associated with the option grant. And what that means is if you don't have early exercise, is that you can only exercise the option, purchase the share as underlying the option as they vest. Okay. But if you have an early exercise, what that says is from day one, you can exercise the full grant, even though you're not vested in it. And basically, those shares are just subject to repurchase by the company if you leave before the vesting occurs. But there's a couple of benefits to it. If you're willing

and wanting to write the check, a lot of those factors that we just talked about. But if you are, you could start your capital gains holding period. Maybe the check is really small at this point. It's easy enough to do it. But you can start your capital gains holding. period. There are some ISO requirements of when you buy and sell the shares so you could meet those holding periods as well, which could end up in a better tax result in M&A. So for people who don't know, there's long-term capital gains, a short-term capital gains, long-term, over 12 months, short-term under 12 months, I believe. You pay a higher rate if you're flipping stocks every year, just like people trading in the stock market or crypto or anything,

are going to be obligated to pay taxes on a short-term capital gains basis versus long-term. If you execute the shares, well, you might get to that month 12 when the company is sold. But there have been times when a company is sold, people haven't exercised their shares, and they would have to have a higher tax treatment. That's the general gist here. That's a general gist. And then on option grants, and we, this is a whole other probably a podcast, but the brief part of it is there's ISOs and there's NSOs.

Incentive stock options are only for employees. They actually have a different tax. treatment than NSOs, which are to everybody else, non-statutory options. The ISOs have some two or three different holding periods. Then if you meet those when you sell, you get a better tax outcome. We'll kind of leave it at that and there's a whole lot more to unpack it. This is employment law for people going to work at a Google or a Facebook where instead of giving you these options, they've already got a publicly trading stock. They're going to just give you stock at a certain cadence, correct? For public companies,

yeah, a totally different scenario. Really what we're talking about is the private early stage companies. Yep. Makes total sense. All right. If you want to see all of the basics that we've talked about and there are now dozens of these, you can go to this week in startups.com slash basics and we'll have them all listed there or you can go to YouTube.com slash this week in and you will see an entire playlist

of all the startup basics. Thank you, Becky de Graf from Wilson Sincini. If you would like to have great attorneys. They're mine. They do a great job. Sometimes we wind up on different sides of the same deal. I don't know what we do there, but you guys have so many customers and we refer a bunch of our startups.

I don't know how that works. We have to sign something. What is that called when you have, you're representing the, you represent so many VC firms. You represent so many startups. How do you do those, how do you handle those conflicts? Yeah, we have conflict waivers in, in place where it makes sense for us to actually be on both sides, but sometimes it doesn't make sense for us to be on both sides. And that's where, you know, one person will have to go to another firm and, yeah, it's always funny when I'm

like negotiating something for myself and then the company wants something different. And I'm like, wait a second, I'm negotiating against my own attorneys. It's like, no, your grocery gets the startup. They want these terms. All right, listen, this has been great. And overall, I think just for the entire series, if you're going to do a company, do it tight, tight is right, don't, ever skimp or make mistakes on legal issues, accounting issues, or HR issues. These things can crater a company very quickly, correct? Correct. And they can cost you a whole lot more to clean up than to just do it right the first time. Like literally 10 or 100x to clean up books or employee stock options or incorporation. Do it right from the beginning. Spend the money. Do it right.

That's my message to everybody. And don't. And there are. there are plenty of places where you can be loosey-goosey. The naming of your company, your different roadmap ideas, where are you going to do your retreat? Are you going to do it in Napa? You're going to go to Austin. You can have a lot of fun with your logo, but don't get cute or make any weird decisions with legal accounting in HR. Those have to be perfect. Tite is right. Tight is right. All right, Becky. We'll see you all next time. Bye-bye.