Early stage startups
Early-stage technology companies want to attract the best talent. This is particularly hard for tech teams and even though remote work has expanded the pool of engineering candidates available, startups still compete fiercely to build winning software development teams. Once an engineering leader finds the right candidate, they want to make a very compelling offer that frequently includes stock options in addition to the typical benefits and cash compensation. Stock options (typically either in the form of incentive stock option (ISO) or non-qualified stock option (NQO) grants) sweeten the deal for the engineer and lets the company share some of the long-term financial upside with their team. Stock options are valuable because they provide access to own a small slice of the startup which could turn into a meaningful financial outcome if and when the company goes public or is acquired. However it is also one of the most misunderstood aspects of any startup employment offer.
In this article we will answer the questions that we hear repeatedly from software engineers in Latin America who are less accustomed to receiving stock options: What are they? Are they the same as equity? How do I think about the value of a startup’s equity? We will explain how to think about different compensation packages as they relate to the concept of startup equity, and we’ll clarify some of the confusion around the terms used in the offers.
How do startups attract talent? Equity and Options.
Competing for technology talent against the large tech players and other established companies is very challenging. To incentivize amazing engineers to take the leap and join an early-stage team, founders include equity as part of their offers. Equity in this context means stock or shares of the company, and when you get equity, you actually own a small piece of the company. Startups typically reserve a portion of shares for this purpose, and this is known as the “Option Pool”.
Founders want to share in the upside of a future financial outcome. The goal behind it is attracting and retaining the best teams. To do this, they give away a small part of the company to employees who join early on. The only problem is that while these startups are worth millions of dollars on paper, their shares are not easy to transact, because they are privately held and there’s no real market to sell them. In addition, there is a tax problem that must be overcome. When a private company gives you shares (which is the same as saying they give you equity), this is considered compensation, which would trigger a “tax event”; but nobody wants to get hit with a huge tax bill since the shares aren’t liquid yet (can’t be turned into cash today).
To solve this tax issue, startup lawyers came up with a creative idea. What if we give employees a document that grants them the option to buy a set number of shares at the current fair market value of those shares? As long as that option isn’t executed and the shares aren’t bought, there is no real tax event. However, as time goes by if the company is very successful and increases their valuation 10X or 100X as they go into an “exit” (going public through an IPO, or going through an acquisition), then early employees would execute the option, buy the shares at the lower price and benefit from the spread of the price difference between the time the option was issued and the price at the moment of the “exit”.
So, technically when you get an incentive stock option (ISO) or non-qualified stock option (NQO) grant, you are not getting the shares. You are getting an option to buy those shares at a set price (strike price) with the expectation that the share price will increase if the company does well. At that point, you can sell those shares and hopefully make a lot of money. One important thing to note is that if the company doesn’t do well and ends up shutting down, those option grants might be worth zero. This is another way of saying that the options grants aren’t equivalent to cash, since they present a high risk, high reward opportunity.
The reason why these ISO or NQO grants are valuable is two twofold. First, they are similar to a lottery ticket, where if things go well – and you can influence that quite a bit through your work – you can actually have significant financial upside. Second, they are hard to access, you can’t go and buy equity in a successful high growth startup easily. Of course you could become an investor, but for that you have to be qualified, get access to the deals and then the minimum investment amounts might be out of reach.
Now that we understand what the option grant is all about, let’s talk about the details. Most option grants have a feature called a vesting schedule. This is used to incentivize employees to stay with the company for a long period of time. Typical vesting schedules have 4-year vesting with a one year cliff. This means that for the first year, you don’t really get anything, but the moment you have your one year anniversary, 25% of the grant is now vested, which means it’s yours. After the first year and for the next three years, the stock options “vest” monthly or quarterly (depending on the specific document details) which means that by the end of the fourth year of employment you own the option to buy the full number of shares outlined in the grant at the strike price that was given to you.
Source: https://www.secfi.com/what-is/vesting-scheme
A Practical Equity Grant Example
Mari is a senior software developer who got matched with a promising early-stage startup through Telescoped. The company recently raised $10M in a Seed financing round and has many notable investors; they are growing exponentially and she’s excited about their future.
Mari went through the interview process and got an offer to join the company on Jan 1st 2022:
- $100K salary
- Unlimited PTO
- Incentive Stock Option (ISO) grant of 25,000 shares with a strike price of $0.40 vesting over 4-years with a 1 year cliff.
She’s excited about the opportunity and decides to join the company. The next year, things are going well, and Mari gets a promotion to Team Lead, which comes with a nice salary increase.
Two years later, the company announces that they are raising another round, this time a $40M Series A which valued the company at $200M.
At this point Mari has had other salary increases and she is very happy with her salary. Just a few years after joining the company, she’s become a key member of the engineering leadership team and her engineering career growth has been incredible.
Luckily for Mari, 4 years after joining the company, they announce that they are getting acquired by a larger player in the space for $800M. The value of the common shares was calculated at $16.
At this point Mari has vested all the shares in her grant, which means she can execute her option to buy the 25,000 shares x $0.40 = $10,000
Immediately as part of the deal, these are sold to the acquiring company for 25,000 x $16 = $400,000.
Mari is looking at a nice financial outcome of $400,000 – $10,000 = $390,000
Related reading: How to Evaluate StartUp Offers
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