Startup equity basics on employee equity grants and stock option plans

1. Startup Equity 201:
Stock Options
for Founders and Employees
May 22, 2013
by Jamie Lee
@jieunjamie
with ZekeVermillion
www.adlervermillion.com
Thursday, May 23, 13

2. Disclaimer
Hi! I’m not an accountant or a lawyer.
The information contained herein and ensuing discussion
should NOT be considered tax or legal advice.
The information is intended to help you get familiarized with
general concepts in startup finance, which may or may not
apply to your situation.
Thank you!
Jamie Lee
@jieunjamie
jieunjamie.com
Thursday, May 23, 13

3. Before joining a startup, ask
•Do I trust this team? Is this the right company?
•What is my percentage of ownership?
•What is market rate salary and equity comp?
•What is the estimated valuation at exit?
•Do I need a lawyer or accountant (because devil’s in the details)?
•How long is my vesting schedule?
•What are tax implications?
•Can I make 83b election for restricted stock grants?
•Can I exercise my options early?
Startup Equity: More ART than SCIENCE
Key questions to ASK for Founders and Employees
Thursday, May 23, 13

4. Startup Equity: More ART than SCIENCE
but still need to do the MATH
1) Ownership = # Shares Granted toYou
Total Capitalization
Formulas Example
1) 1% = 100K Shares Granted
10M Total Shares Outstanding
2) Dilution Factor =
(#Your Future Shares + Future Investor Shares)
Total Cap. + #Your Future + Future Investor Shares
2) 0.17% = (50K + 2M)
(10M + 50K + 2M)
1% - 0.17% = 0.83% New Ownership
3)Your Payday at Exit* =
(Your Ownership X Company Exit Price)
– (Total Exercise Price)
3) $99K* =
(0.83% X $30M) - ($150K)
*Assuming $1 strike price and company acquisition price of $30M
BEFORE taxes, very rough est.
Thursday, May 23, 13

5. Real Life Example: Tumblr Acquisition by Yahoo!
How much does Founder David Karp take home?
• David Karp, CEO of Tumblr, is said to
have owned about 25% of Tumblr at
time ofYahoo! acquisition
• Total acquisition price = $1.1 Billion
• Total funds raised = about $125 Million
• Quick math:
$1.1 Billion total price
- 0.1 Billion returned to investors
(assuming 1x liquidation preference)
$1.00 Billion for shareholders
x .25 owned by David Karp
$250 Million payout approximately
Thursday, May 23, 13

6. Real Life Example: Tumblr Acquisition by Yahoo!
Words of co-founder and first hire, Marco Arment
Link to blog
“As for me, while I wasn’t a “founder” financially, David was generous with my employee
stock options back in the day. I won’t make yacht-and-helicopter money from the
acquisition, and I won’t be switching to dedicated day and night iPhones. But as long as I manage
investments properly and don’t spend recklessly, Tumblr has given my family a strong
safety net and given me the freedom to work on whatever I want.”
Thursday, May 23, 13

7. High
(1)
High Return
Low Risk
(2)
High Return
High Risk
Low
(3)
Low Return
Low Risk
(4)
Low Return
High Risk
Low High
risk
return
Back to Earth: Think like an investor
Consider the risk profile of your investment.
Your startup is like your baby.
But let’s face it, most of us won’t work
at the next Facebook or Google or
Tumblr.
Brave souls featured in
Read Write’s “8 Real-
World Stories Of Why
Startups Fail”
Failure is like a badge of
honor, and a great
teacher. Financially
speaking, it means no
return.
Yup, that’s
me.
Thursday, May 23, 13

8. High
(1)
High Return
Low Risk
(2)
High Return
High Risk
Low
(3)
Low Return
Low Risk
(4)
Low Return
High Risk
Low High
risk
return
Back to Earth: Think like an investor
Consider the risk profile of your investment.
Your startup is like your baby.
But let’s face it, most of us won’t work
at the next Facebook or Google or
Tumblr.
Brave souls featured in
Read Write’s “8 Real-
World Stories Of Why
Startups Fail”
Failure is like a badge of
honor, and a great
teacher. Financially
speaking, it means no
return.
Yup, that’s
me.
Thursday, May 23, 13

9. High
(1)
High Return
Low Risk
(2)
High Return
High Risk
Low
(3)
Low Return
Low Risk
(4)
Low Return
High Risk
Low High
risk
return
Back to Earth: Think like an investor
Consider the risk profile of your investment.
Your startup is like your baby.
But let’s face it, most of us won’t work
at the next Facebook or Google or
Tumblr.
Brave souls featured in
Read Write’s “8 Real-
World Stories Of Why
Startups Fail”
Failure is like a badge of
honor, and a great
teacher. Financially
speaking, it means no
return.
Yup, that’s
me.
Thursday, May 23, 13

10. Startup Equity Review:
Owning a piece of the pie
Let’s say your startup is like
a pizza pie you and your
team make from scratch.
Individual slices are owned
by different people, but the
team’s goal is to grow the
pie as a whole.
As more people get
involved and invest, your
slice may get skinnier, and
the pie bigger.This is called
dilution.
Founders**
55% Investors*
25%
Employee Pool
20%
*Hypothetical situation where investors
have bought a quarter of the pie.
**If you own 51% and more of a
company, you own controlling interest.
“Employee ownership is
such an important part of
startup culture. It reinforces
that everyone is on the
team, everyone is sharing in
the gains, and everyone is a
shareholder.”
- Fred Wilson,AVC.com
Thursday, May 23, 13

11. Review: Employee Stock Ownership
at aVC-funded tech startup
Typically, total non-founder employee
equity pool tends to fall between
10% - 20%.
Title
Of
Total Shares
CEO 5.00 - 10.00%
C-level Executives 1.00 - 3.00%
VP, Directors 0.50 - 2.00%
Managers 0.25 - 1.00%
Board Directors 0.50%
The details of who owns what kind of
ownership is spelled out in
capitalization table, or cap
table. It’s considered private and
sensitive information.
Thursday, May 23, 13

12. 1. Founders and founding members receive common
stock. Special vesting schedule applies.
➡ TIP: draw up and execute a partnership agreement as soon as
humanly possible.
2. Restricted stocks are ownership interest issued to
employees at early stage companies while the value of
stock is low. Granted with certain restrictions, usually
vesting, sometimes performance. Deemed taxable
property.
➡ TIP: Make an 83B election within 30 days of grant to limit
future tax liability
3. Stock options are the most common form of
employee equity. Options grant the right to buy stock
at a pre-determined price, and is deemed taxable
property of grantee.Vesting restriction is standard.
➡ TIP: Exercise early.Ask for cash bonus to cover the exercise cost
Types of Employee Equity
Apple Computer, Inc.
Incorporated on Jan 3,1977
Stock value: $0
Thursday, May 23, 13

13. Review: Vesting Schedule
4 year vesting with 1 year cliff is common.
1 year cliff means you don’t vest during
the 1st year. If you leave during this period,
you leave with no equity.
Unvested equity may be repurchased by the
company and returned to the employee
pool.
Idea is to avoid a “hit and run” situation and
to retain talented employees.
Oops
27.1%
+1 mo.
Day 1 1st year 2nd year 3rd year 4th year
0% 25% 50% 75% 100%
0 2,500
2,710
5,000 7,500 10,000
Vested
Shares
Generally, option strike price will not change throughout vesting schedule.
Thursday, May 23, 13

14. $0
$25
$50
$75
$100
2013 2014 2015 2016
Company XYZ Share Price
FMV Cost to EE
100 shrs granted to EE at FMV of
$1.00 with 4 year vest. EE files
83B Election recognizing income
of $1 (FMV) - $1 (shr price) = $0
At end of 1 year anniversary,
25 shares vested to EE.
FMV rose to $5/shr.
($5 - $1) x 25 shares = $100
Don’t owe taxes until you sell.
After 2 years, 50 shares vested to EE.
FMV rose to $25/shr.
($25 - $1) x 50 shares = $1,200 value.
Don’t owe taxes until you sell.
Restricted Stock Example: 83B Election
Thursday, May 23, 13

15. Startup Equity Taxes 101
• Ordinary income tax = 10% - 39.6%
➡ Taken out of your paycheck
• Short term capital gains tax = 10% - 39.6%
➡ When you have owned equity for less than 1 year and sell it for profit
• Long term capital gains tax = 0% - 20%
➡ When you have owned equity for more than 1 year and sell it for profit
• Alternative Minimum Tax (AMT)
➡ Due on exercise of Incentive Stock Option. Complex adjustment required. CONSULT an
accountant
link to About.com page
So complex, the IRS has
a special online
calculator for AMT
Assistance.
Thursday, May 23, 13

16. Stock Options
Options give you the right to buy equity, not the equity out right.
Exercising your option is when you buy the underlying stock at strike price.
Consider:
•Restrictions, such as vesting or performance
•Strike price must equal Fair MarketValue at time of grant
•Cost of exercising option
•Tax liability at exercise
•Tax liability at sale of underlying equity
‣Earn or vest it
‣Exercise it & pay taxes
‣Hold stock
‣Sell stock & pay taxes
Thursday, May 23, 13

17. $0
$15
$30
$45
$60
$75
$90
2013 2014 2015 2016 2017 2018
Company ABC Share Price and Options
FMV SOP ISO
100 options granted to EE at FMV of
$10.00 with 4 year vest. Strike price is
equal to FMV at time of grant, $10.This is
called “At the Money”
25 options vested to EE. She can buy 25
shares at $10 and realizes gain: (FMV $25 -
Strike price $10) X 25 shares = $375
This spread between FMV and strike price
will be taxed.
If she sells the underlying stock, she will be
taxed again for the profit.
2 years in, management decide to incentivize
the EE with Incentive Stock Options. Similar 4
year vest.At this time, FMV is $53, so strike
price of ISO set to $53.
“Spread”
Thursday, May 23, 13

18. ISO vs NSO Summary
Check out this chart for full comparison
ISO = only employees
•Complex holding periods, annual limitations
•Spread on exercise can incur Alternative Minimum
Tax (AMT), a complex minefield best navigated by
experienced accountants
•Selling underlying stock at long-term capital gains tax
rate ONLY if holding periods are met. If not, then a
mix of short-term and long-term capital gains tax
rates.
•Not tax deductible to employer
NSO = employees and non-
employees
•More straight-forward and less complicated
•Spread on exercise will be taxed at ordinary income
tax rate
•Selling underlying stock will incur either short-term
or long-term capital gains tax depending on holding
period
•Deductible to employer
Thursday, May 23, 13

19. Equity Compensation: the Negotiables
Best if hire is C-level or executive-level, and company is pre-Series A fundraising.VC’s term sheet details can change
what’s negotiable and what’s not.
• Size of grant
• Equity grant upfront (Founders stock, not options)
• Early exercise of options
• Partial vesting on the grant date
• Borrow strike price against proceeds of liquidity event, in order to exercise without being
“out-of-pocket”
• Accelerated vesting if terminated without “cause”
• Accelerated vesting if company is acquired and there is change-of-control
• Single and double trigger
• Other negotiables: base salary, title, benefits and other perks
Thursday, May 23, 13

20. Startup Equity RECAP: More ART than
SCIENCE but still need to ASK and do the
MATH
Before joining a startup, ask
•Is this the right team and company for my success?
•What is my percentage of ownership?
➡ # shares you own / total shares issued
•How long is my vesting schedule?
➡ 4 years with 1 year cliff is standard
•What are tax implications?
➡Restricted stock: make 83B elections
➡Option holders: liable for capital gains tax at
exercise of NSO and when stock is sold for
both
•What is total company capitalization?
•What is the estimated valuation at exit?
•What do I need to do when I leave?
If you’re a founder or prospective
employee,
•Research market rate salary and equity comp
➡See appendices for references
•Read the partnership and employment agreements
•Negotiate like a business person
•Consult a lawyer or tax accountant
Thursday, May 23, 13

21. Sources
- Andy Payne, Startup Equity for Employees: http://www.payne.org/index.php/Startup_Equity_For_Employees
- Chris Dixon, The One Number You Should Know About Your Equity http://cdixon.org/2009/08/27/the-one-number-
you-should-know-about-your-equity-grant/
- Fred Wilson, MBA Monday Series on Equity: http://www.avc.com/a_vc/2010/09/employee-equity.html
http://www.avc.com/a_vc/2008/11/restricted-stoc.html
- How Stuff Works, Stock Options:
http://money.howstuffworks.com/personal-finance/financial-planning/stock-options1.htm
- Infochachkie, What The Heck Are My Startup Stock Options Worth?! Seven Questions You Should Ask Before Joining
A Startup: http://infochachkie.com/options/
- Paul Graham, Equity Equation: http://paulgraham.com/equity.html
- Startup Company Lawyer, What is an 83b Election?
http://www.startupcompanylawyer.com/2008/02/15/what-is-an-83b-election/
- Startup Law Blog, Incentive Stock Options vs Nonqualified Stock Options http://www.startuplawblog.com/
2013/05/15/incentive-stock-options-vs-nonqualified-stock-options/#comment-899265747
- Tax & Business Professionals, ISOs Versus Non-statutory Stock Options? http://www.unclefed.com/AuthorsRow/
TaxBusProf/stockoptions.html
- Wealthfront, Manage Your Tech Career: https://blog.wealthfront.com/startup-employee-equity-compensation/
- Wealthfront, The 12 Crucial Questions About Stock Options: https://blog.wealthfront.com/stock-options-package-
valuation/
- Wikipedia, Restricted Stock: http://en.wikipedia.org/wiki/Restricted_stock
Thank you!
Thursday, May 23, 13

22. Appendix A: LLC v. C Corp
Thursday, May 23, 13

23. Appendix A: LLC v. C Corp
Type of
Entity
Limited Liability Company (LLC) C Corporation S Corporation
Ownership
Unlimited members. Members
own “units.”
500 shareholders if private. No
limit on shareholders if public.
Up to 35 shareholders, one class
of stock allowed.
Liability
Members not liable for company
debts.
Shareholders not liable for
company debts.
Shareholders not liable
Taxes
No entity tax; profits and losses
are passed on to members.
“Double taxation” Company is
taxed as an entity. Shareholders
are also taxed.
“Double taxation” Company is
taxed as an entity. Shareholders
are also taxed.
Management
Designated in Operating
Agreement. May be managed by
Member or Manager.
Managed overall by Board of
Directors. Officers manage day to
day.
Managed overall by Board of
Directors. Officers manage day to
day.
Thursday, May 23, 13

24. Appendix A: LLC v. C Corp
Type of
Entity
Limited Liability Company (LLC) C Corporation S Corporation
Ownership
Unlimited members. Members
own “units.”
500 shareholders if private. No
limit on shareholders if public.
Up to 35 shareholders, one class
of stock allowed.
Liability
Members not liable for company
debts.
Shareholders not liable for
company debts.
Shareholders not liable
Taxes
No entity tax; profits and losses
are passed on to members.
“Double taxation” Company is
taxed as an entity. Shareholders
are also taxed.
“Double taxation” Company is
taxed as an entity. Shareholders
are also taxed.
Management
Designated in Operating
Agreement. May be managed by
Member or Manager.
Managed overall by Board of
Directors. Officers manage day to
day.
Managed overall by Board of
Directors. Officers manage day to
day.
Thursday, May 23, 13

25. Appendix A: LLC v. C Corp
Type of
Entity
Limited Liability Company (LLC) C Corporation S Corporation
Ownership
Unlimited members. Members
own “units.”
500 shareholders if private. No
limit on shareholders if public.
Up to 35 shareholders, one class
of stock allowed.
Liability
Members not liable for company
debts.
Shareholders not liable for
company debts.
Shareholders not liable
Taxes
No entity tax; profits and losses
are passed on to members.
“Double taxation” Company is
taxed as an entity. Shareholders
are also taxed.
“Double taxation” Company is
taxed as an entity. Shareholders
are also taxed.
Management
Designated in Operating
Agreement. May be managed by
Member or Manager.
Managed overall by Board of
Directors. Officers manage day to
day.
Managed overall by Board of
Directors. Officers manage day to
day.
Thursday, May 23, 13

26. Appendix A: LLC v. C Corp
Type of
Entity
Limited Liability Company (LLC) C Corporation S Corporation
Ownership
Unlimited members. Members
own “units.”
500 shareholders if private. No
limit on shareholders if public.
Up to 35 shareholders, one class
of stock allowed.
Liability
Members not liable for company
debts.
Shareholders not liable for
company debts.
Shareholders not liable
Taxes
No entity tax; profits and losses
are passed on to members.
“Double taxation” Company is
taxed as an entity. Shareholders
are also taxed.
“Double taxation” Company is
taxed as an entity. Shareholders
are also taxed.
Management
Designated in Operating
Agreement. May be managed by
Member or Manager.
Managed overall by Board of
Directors. Officers manage day to
day.
Managed overall by Board of
Directors. Officers manage day to
day.
Thursday, May 23, 13

27. ACME, LLC
Annual net profit: $100M
No corp tax
Appendix B: LLC Tax Passthrough
•Members taxed for ACME’s profit (or loss) proportionately
•Members receive K1 tax form (and tax assistance from entity,
depending on terms of agreement)
A:10%
$10M
B:10%
$10M
C:80%
$80M
Tax Liability Tax Liability
Thursday, May 23, 13

28. ACME, Inc.
Annual profit: $100M
Corp tax: $35M
Net profit: $65M
dividends paid out to shareholders
(taxed on individual level)
Appendix C: C Corp “Double Taxation”
•Both ACME, Inc. and shareholders taxed
•No tax assistance from entity to shareholders
dividends dividends
Thursday, May 23, 13

29. Appendix D: Recommended Online Resources
• Check out Anonymous Startup Salaries, Stock Options and Equity on Ackwire.com
• Check out Fred Wilson’s Cap Table Template on Google Docs
Thursday, May 23, 13

30. Appendix E: Recommended Online Resources
• Check out Patrick McKenzie’s Salary Negotiation: Make More Money, Be More
• Check out David Weekly’s An Intro to Stock Options
Thursday, May 23, 13