Start Up Hiring: Understanding Risk vs Reward from an Employee Perspective
Why determining net present value is the best way to evaluate employee options
A Recent Phone Call
“Hi Nathan. I’ve a bit of a conundrum as I’m considering two employment offers. Got a second?”
“Sure John Q Startup - What’s up?”
“I’m trying to trade between an offer from Yutz SaaS and Chelm SaaS. The two companies are in the same vertical, but are at different stages - Yutz is post Series A trying to raise a B; Chelm just got their seed done by a top tier firm.
They are offering me more or less the same salary/benefits, but the options packages are vastly different. Yutz is offering me only 45 basis points of ISOs but they are further along and seem less risky; Chelm is offering me 125 basis points but they are pre-revenue and that seems quite risky, but they are backed by Michigas Ventures, a top tier firm with more money than Croesus. What do you think?”
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Options are not intuitive
I’m sure many of you reading this have been on either the giving or receiving side of this same conversation I’ve tipped off above.
Almost everyone who is monetarily motivated joins a start up because of the promise of their stock being worth a ton of money someday. This almost always comes with a sacrifice of immediate salary and benefits. This upside generally comes in the form of stock options: something which at one point during the dot com bubble were considered so valuable, a Bond villain even asked for them as ransom.
But all the talk about number of shares and percentages, ISOs vs NSOs vs RSUs, and of course the almighty strike price, can quickly go down a rathole and can cause the uninitiated to draw completely wrong conclusions about what the true Net Present Value (NPV) - the most likely value at the present moment - of your options is. I get a lot of calls from friends and acquaintances in my network weighing options that are often gauging between two different offers and scratching their head going “what the heck does this even mean?” So I figured it was worth a Substack to put my own lessons learned in writing.
Before we get started, let me caveat that I am not a corporate tax attorney nor accountant, merely an entrepreneur with some mileage on my tires, so my advice here is worth what you pay for it.
Basics
A stock option is exactly what it sounds like: an option to buy stock at a certain price. But estimating the value of that option, particularly for an early stage company for which virtually no market exists for trading it in, is particularly difficult. It’s confounded people since Thales of Miletus placed the first options contract on the use of Olive presses 2500+ years ago. This is particularly nerve-wracking if you are joining an early stage start up (or even growth stage for that matter) and discovering you lack a clear way of estimating the value of your options in the event of not just a nominal, but an outsized outcome.
The downside value of these options is fairly obvious: zero.
Unlike say, stock in Meta, for which options are more readily calculated using something called the Black-Schole’s model, start up options are really hard to estimate the value of. People purchase the right to buy (or sell the right to buy - known as a put) in commonly traded stocks every day. But as a privately held start up employee, you may get the right to purchase their stock for free!
Estimating the upside value of early stage options can be difficult. Estimating the downside value is easy: zero.
The simple reality is that most companies (unlike Meta) will not be worth more than a trillion dollars. But what if they are worth 100? or 10? or 1? What does that mean for me?
Let’s first talk about the basic types of start up options: Incentive stock options (ISOs), Non-qualified Stock Options (NSOs) and Restricted Stock Units (RSUs) - the latter of which aren’t options at all but sometimes get lumped in because most of us group them all together as stock based compensation. Let’s also briefly touch on QSBS qualification and what this means.
One caveat I’ll add to RSUs is that a certain category of RSUs that are often issued in pre-seed (never priced) companies, sometimes referred to as founder’s stock, allow you to file an 83(b) election and effectively own the stock for a de minimus amounts and start your tax clock immediately.
TL;DR: for those of you who don’t want to read all the mumbo jumbo, Vince McMahon’s enthusiasm here is a good heuristic for attractive the different categories of stock are.
Restricted Stock Units (RSUs)
This is stock directly awarded from the company’s share pool and is treated as regular income if awarded and as an investment if purchased. Some late stage companies will distribute RSUs instead of options because of concerns about the options being too expensive to exercise (more on this later).
Price is based on the fair market value (FMV) of the shares, typically determined through something called a 409a appraisal which most start ups do either annually or whenever they close a round of funding.
Non-qualified stock options (NSOs)
Non-qualified stock options (or NSOs) are basically just regular options with no favorable tax treatment. These are typically issued to advisors or contractors who are not employees of the company but are receiving a share of the upside. When you exercise these options, you pay the difference between the strike price on the date they were issued and the strike price when they were exercised as ordinary income -ouch.
In states like CA this could be as bad as 52% on any upside you would have in what could very well be a non-liquid asset depending on when you exercise. If that doesn’t make you want to join the Howard Jarvis Taxpayer’s Association…not sure what does.
To compensate for this unfavorable tax treatment, and also to somewhat compensate for the fact that most advisory agreements don’t come with other compensation besides options, they usually don’t have a cliff so that you can begin exercising immediately.
Fortunately, most direct hires don’t need to worry about NSOs, with two exceptions. The first is if you leave the company but continue vesting as an advisor for some period of time, especially as severance, then your options will be NSOs. The second is if you exercise more than $100k in options in a calendar year (e.g. exercising your whole nut is something you might do as part of a liquidity event). This may help you appreciate why, if you have the cash and the options are relatively cheap (a couple grand at most), it makes good sense to early exercise if its available as an option.
Incentive Stock Options (ISOs)
Incentive Stock Options (or ISOs) are a special category of options carved out of the tax code which provide large incentives for privately held start up employees to share in an outsized outcome from an exit (or at least secondary tender). The key advantage of ISOs vs NSOs is that when you exercise, the difference between the strike and the fair market value is not taxable as ordinary income (though it is subject to AMT, so be mindful of that if you have early exercise opportunities). This is a huge deal because it means that as long as the company stays private and you stay an employee, you can effectively exercise your options at any time and start the long term capital gains close.
The key advantage of ISOs vs NSOs is that when you exercise, the difference between the strike and the fair market value is not taxable as ordinary income.
ISOs come with several other caveats - there is a limitation on how much you can shelter in a year (as mentioned in the NSO section above), they have to be priced at Fair Market Value using a “safe harbor” appraisal process known as a 409a (more on this later) and to count as Long Term Capital Gains the stock has to be held for at least two years after the option is granted and one year after it’s exercised. Again, this is why you’ll hear many start up veterans proclaim “exercise early and often” (more on this later).
Incentive Stock Options (ISOs) that are Qualified Small Business Stock (QSBS) Eligible
I’ve written quite a bit about QSBS before and what a powerful incentive it creates for investors, founders and early employees to get on board with early stage companies. In summary, if you hold on to a QSBS eligible stock for 5 years or more after you receive it or exercise your options to purchase it, the first $10 million in capital gains or 10x the investment amount is shielded from federal capital gains taxes, whichever is greater. This means that basically you’re stock is worth 20% more in a windfall situation.
But how do you know if the company’s stock is QSBS qualified?
The company has to have less than $50M in assets at the time of the last 409a (Fair Market Value appraisal, more on this later). This is actually a “rep” or “representation” that will often be made in financing docs, but from your standpoint as a prospective employee the easiest rule of thumb is if they have raised less than $50M to date. For most companies Series A or earlier, this is likely the case.
For later stage companies, sometimes you’ll get lucky and they will have spent enough of the funds raised between rounds that this is less of an issue, but you probably don’t want to be reading balance sheets as part of your offer consideration process, so I’d recommend just explicitly asking “are the options still QSBS qualified?” as part of the interview process and if you really want to be nosey, ask to see the 409a.
Pre-seed start ups and the 83(b) hack (Founder’s Stock)
If the company is super early (think pre-seed) and hasn’t done a priced round yet (i.e. raised on a note or a SAFE or hasn’t raised at all) there is an unusual loophole that allows you to purchase your options immediately for a few dollars as Restricted Stock Units (RSUs) which you purchase and then your vesting begins immediately towards that five year QSBS threshold.
Founder’s stock is about the closest thing there is to free money in this lifetime- if the company succeeds
A lot of people refer to this as “Founder’s stock” and the key hack here is that you are paying taxes on the amount you are paying for the stock up front (kind of like a Roth IRA) to buy into it - a few dollars at most, which you do through a piece of paper you file with the IRS known as an 83(b) election. I’ve gone into more detail on this elsewhere.
What isn’t always obvious to prospective employees however is that prior to a priced round and the establishment of an options pool, early stage employees (and advisors!) can share in the same “founder’s stock” benefits as the founder’s. This is the closest thing there is to free money in this lifetime - assuming the company succeeds and a real incentive to join a pre-seed start up despite the significant risk.
Founders stock is so valuable that some people will even go to the extent of distributing it across multiple stacked trusts to try and multiply their $10M exemption by distributing their stock across their children or other family members.
Understanding where strike prices come from
Another key consideration of any options is their strike price. This is the price that employees and other common share options grantees pay for the same shares (albeit with less favorable liquidation rights) that preferred shareholders have. The strike price for start up stock is determined using an appraisal process known as a 409a (named after the section of the tax code that it originates from) which defines the “safe harbor” value for ISOs.
I could spend a lot of time here going into how 409a’s are calculated, but almost always as a start up CEO you want to fight to make the price as low a percentage of what the last round of preferred paid as possible. It makes it easy to attract top talent by giving them more upside.
The company’s valuation from a 409a perspective is based on a complex system of appraisals, taking into account not the face post-money valuation of the round, but what the actual asset value of the company is (which is generally much less). As a general rule of thumb, the more mature the company, the higher the percentage that number is, generally reflected in an arcane term referred to as “discount for lack of marketability (DLOM)” - in other words, you are getting a discount because no one wants to (is foolish enough?) to pay full freight for the stock given the immaturity of the company. For very early stage (Seed, Seed+) I’ve seen the DLOM be as large as 60% and it will drop to 30 or even 20% as the company grows.
For seed stage companies, the strike price should be about 20%-25% (or less) of whatever preferred paid. By Series A it may grow to 1/3 the value and by later rounds it can even approach 50% depending on capitalization.
A high strike price can be a trap
Senior employees joining later stage companies may find themselves in a “ride or die” situation where they have to hang on until exit for their shares to be worth anything. This is because ISOs in most cases require you to exercise your options within 90 days of leaving the company or they expire and can’t be exercised. If you have hundreds of thousands of shares with a strike price of a dollar or more, you may have to practically take out a loan to exercise your options if you get off the bus early - oof. Many people fall into this trap because they foolishly fixate on the value of the stock on paper without factoring in the cost of exercise and the potential risk of exercising early.
Say for example you have a 50 basis point grant in a company which just raised at a $500M valuation. Your options on paper entitle you to $2.5M - you’re rich! Not so fast. The 409a valuation is at 30% of the preferred share price - meaning you need $750,000 to exercise those fully vested options should you decide to leave early (ouch).
If you have a significant stock grant in a later stage company, you could be looking at a six figure bill to fully exercise if you have to leave the company prior to IPO - or forfeit your options.
Contrast this with early stage company with a $10M valuation - here the 409a may be at less than 10% of that top line valuation. 1% of the company in options is often exercisable for less than ten thousand dollars at that strike price - which won’t change when the company is worth $100M, or a billion. The economics of this is certainly worth considering when you are weighing offers. With a typical four year vest, there’s a non-zero chance (indeed probably a 60% or more chance) that you will leave early and have to exercise or lose your options. In a later stage company, the cost of doing so may make them essentially a write off.
Many later stage companies will issue RSUs instead of options for exactly this reason but as I mentioned above those come with their own problems: specifically you are granted stock that has value and is therefore immediately taxable, but have no market to pay the taxes.
Bringing it all together: Net Present Value is the Most Important Metric
Ok, so now that I’ve bored you to death with the different types of options, what’s the best method for comparing one company’s options to another?
Billy Gallagher and his team at Prospect have done the Lord’s work in trying to give start up employees the tools to make these decisions more rationally. They also have some first rate analysis based on looking at older vintage companies which I’ve pulled from one of their blog posts below. The data below is a little dated because of the vintage but starts to give you an idea of the multiples we are talking about here. What Billy is calling Weighted Growth I refer to as net present value: a composite of the mean valuation multiple and the exit rate.
The numbers are even more dramatic when you look at companies with a $500M or greater exit where John Q Startup could expect to fetch a hefty payday rather than just pay for an Alaska cruise:
Judging by these tables, you’d think Series C was your safest bet. However this fails to take into account a couple things. Because they have to look at exit valuations, they are forced to use data from a vintage that is at least ten years old and the start up environment is dramatically different for then versus now. Many of the Series D and earlier companies today weren’t in existence in 2014 or 2015 and its a completely different environment fundraising and exit environment now than then.
Also, many companies of Series B or C maturity today likely last raised at least once in the 2020-2023 timeframe when valuations were historically inflated. In general, valuations have slipped 50-75% or more since then and may have a down-round (or at least significant sideways) round ahead of them, which could make these options even more worthless in the long run or at least a lot less valuable.
One powerful point from the Prospect dataset show that is worth pointing out: who your investors are has a huge impact on not just your probability of an exit, but your outcome as well.
Who your investors are matters: Tier 1 firm backed start-ups have 2-3 times the net present value outcomes of the general start up population
Companies raising from Tier 1 firms (that’s your Sequoia, Founder’s Fund, Khosla, Lightspeed, 8VC, etc) with larger amounts of capital to deploy and reserves to back up their investments. Another factor biasing the data in favor of Tier 1 firms is that they have a greater ability to access the hottest deals with the best teams, which tend to have much better outcomes, approaching 2x at Series C versus the overall market and almost 3x for Seed deals. This is the wisdom of the so-called “follower funds” who primarily seek to invest behind Tier 1 VCs.
Wrapping it up - back to John Q Start Up
“Hi John. TL;DR - the earlier stage offer likely has not just more potential upside for you (almost 3x more stock- wow!) but may also have a higher probability of a payout as well because Top Tier firms tend to have better outcomes for their portfolio companies in general - sometimes 2-3x as much. In short, the options have a higher net present value, by quite a bit. If you are taking a start up job because of the promise of future upside, having as large of a hunk of the company, as early as possible is a great heuristic for deciding between offers.
If you are taking a start up job because of the promise of future upside, having as large of a hunk of the company, as early as possible is a great heuristic for deciding between offers. Also who the company’s investors are matters a lot
It’s also important to understand that there are many variables at play in trying to evaluate the value of options. An earlier stage company is not necessarily higher risk - in today’s environment later stage companies may actually have a HIGHER risk of your options being underwater since the last 409a valuation may not be reflective of the current value of the company if and when they finish a financing round. A lot of companies last raised at valuations they may have real trouble raising/will never fill into, and if they have to take a down round and the ensuing dilution, your options may be underwater/worthless. The earlier stage company is not only at a lower valuation, so it’s much harder for your newly issued options to go underwater.
There is also the risk that if you should have to leave the company for any reason, you’ll have to cough up an impossibly large amount of cash in a short period of time to exercise your options or you lose them and they are worthless.
For these and other reasons, I’d actually say the earlier stage company’s options have a significantly higher net present value for you, even if the company is pre-revenue and doesn’t have product market fit yet.”
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