Treat Your Options Like Lottery Tickets
Equity options are no longer a valuable wealth creation vehicle. Here’s why the expected value of your options is not all the substantial.
Naval Ravikant, CEO of AngelList, wrote a tweet storm that went viral entitled “How to Get Rich (without getting lucky)”. His core message around generating wealth was to “own assets that work while you sleep”. That usually means owning a business or owning equity in a business which will appreciate over time. This is why financial advisors advise regular saving, investing in a diversified stock portfolio and taking a long-term view.
Beyond investing the savings from our cash compensation in equities or businesses/real estate, the other wealth creation opportunity many people have is through option grants awarded to them by their employer. Option grants are an important element of total compensation at privately-held, venture-backed start-ups.
Start-ups tout option grants to employees as a valuable asset with a lot of potential upside value to be realized upon an IPO or a sale. Sometimes, companies offer more senior new hires multiple compensation packages from which to choose — the alternatives offer additional option grants in exchange for lower cash compensation. During a recruiting process or in an effort to retain productive employees, founders/CEOs paint a vision of the company being worth over $1 billion in the future. In their zeal, they encourage: “Join us (or stay longer); your options will be worth a lot of money — and, we’ll give you more options as your work longer at the company.”
Sadly, equity options are no longer a valuable wealth creation vehicle for start-up employees. They aren’t even a meaningful addition to a total compensation package. Here’s why the expected value of your options (in the most likely outcome) is actually not all that substantial.
First, don’t expect to vest all of your option grant. The industry standard vesting period for options is 4 years. While, the median job tenure for all employees in the US is 4.2 years (BLS), at start-ups, the median tenure is only 2.0 years (Carta). That implies, for start-up employees such as you, only half your options will typically vest before you leave a job.
Second, when leaving your job, you have only 90 days post-termination to choose to exercise some (or all) of your vested options. Exercising means you pay the exercise price (or strike price of the option) for each option you elect to buy. Buying options converts them into common stock which you now own. This IRS rule around a limited time to exercise was mandated to permit options to get more favorable tax treatment than regular cash compensation (salaries and bonuses). These options are called ISOs (Incentive Stock Options). The vast majority of options issued to employees are ISOs.
Companies can issue another class of options — NSOs (Non-qualified Stock Options). Advisors and consultants receiving options as part of their compensation for services are issued NSOs. NSOs can also be issued to employees. NSOs receive less favorable tax treatment but can qualify for longer post-termination exercise windows (up to the term of the option as specified by the employer). Fewer than 100 out of the thousands of start-ups, have structured their option program to provide longer exercise periods after an employee leaves a job.
Most employees face two major problems in deciding whether to exercise their options — (i) What is the value of the common stock of their (former) employer?; and, (ii) When will they be able to convert the private company stock into cash?
Unless you are a very senior executive, you likely don’t know details about the financial performance and prospects for the company beyond what was shared in the most recent “All Hands”. There is no mandated disclosure for private companies around financial and operating performance. As a result, you will have little sense of the value of your private company stock at any point in time.
And, you can’t typically sell your options or the shares you receive upon exercise of your options in a private market transaction. Today almost anything and everything can be listed and sold through some internet marketplace. Not private company stock though, because of the terms governing its issuance. A few private companies have done a partial buy-back of options and shares to provide long-tenured employees some liquidity. But this is the rare exception.
Getting to an “exit”, when your private company stock can be converted to cash, takes a long time. A recent study of publicly listed technology companies by Sammy Abdullah at Blossom Street Ventures suggests getting to an IPO requires 7 to 12 years from founding.
And, don’t hold your breath for the big exit — IPO or sale. TechCrunch analyzed the outcomes of 15,600 US-based technology start-ups founded between 2003 and 2013. Fewer than 1 in 5 start-ups actually gets acquired at any point in their life.
Most start-ups either go out of business early-on, before raising a Series B round, or get acquired before that point, albeit for a modest value. PitchBook data shows only 3% of venture-backed companies in the last decade eventually went public. There were between 20 and 40 technology company IPOs in each year of the past decade.
In summary, if you decide to exercise your options: (a) you will need to invest your cash to buy the stock; (b) you will own an illiquid security; (c ) you will have little sense of the value of your private company stock at any point in time; and, (d) you will need to be prepared to hold your stock for a long-time before receiving any cash or public stock in return.
Given all these factors, I would advise most start-up employees to place limited value on their options. The exception to this advice would apply to really early employees at a start-up who:
Received meaningful grants (as a % of fully diluted equity) when the company valuation was low
Feel highly confident that the company value has materially increased
Have not suffered too much dilution (from subsequent funding rounds); and,
Believe that there will be an exit event (typically a sale) in the relatively near term
That is a lot of caveats.
My ask of all the participants in the venture capital ecosystem — VCs, LPs, founders and lawyers who advise all these parties — please rethink the terms around which option programs are structured. Try harder to fairly compensate employees for the value they add to private companies through their work. Allow employees to exercise their vested options at any point through the option life (typically 10 years from the grant date) by converting vested ISOs into NSOs, as has been done by a few companies such as Square and Pinterest. The upside of this change will far outweigh any downside.
Were this to become standard practice, employees would not be asked to either bet blindly on the future of a company when they leave a job and tie up their own funds or forfeit potential compensation they have earned through their contributions in the workplace.
Start-ups craft what they say are competitive compensation packages by offering option grants, to offset cash compensation that is lower than at more established, publicly-traded businesses. They sell “hope” about future earnings potential from these option grants.
In reality, employees are not being treated fairly from a total compensation standpoint by the current terms governing their options. It is time we fix this. Employees should receive enough data and time to make informed decisions prior to buying their vested options. Employees shouldn’t have to tie up their hard earned cash to purchase a lottery ticket (when they exercise their options) and wait years hoping they get back some value.