Options 301: Meta-Optionality and Avoiding Handcuffs

November 11, 2019

Extra Disclaimer: I already have a disclaimer, but this topic probably warrants extra emphasis. I’m not a lawyer, a CPA, your tax advisor, and this isn’t advice and it certainly isn’t contextualized to your situation. I might even have done the math wrong. I’m just telling you about some of my personal experiences which may prove relevant to yours.

There’s a lot on the internet already covering most of the basics of stock options and joining start-ups. I’m not going to recap that, instead I’ll just link to a few resources that cover the basics and I’ll assume that I can use that terminology freely in the rest of my post.

Options 101 🔗︎

The first stage of understanding start-up options is “Your company isn’t going to be the next Google, so your options are probably worthless. Don’t get suckered into believing you’re going to be a millionaire and working for nothing.” There are a few articles around the internet with this message:

I think this is a helpful message, since I’m sure many startup employees have been misled into unrealistic dreams of riches. However, I’ve anecdotally noticed the attitude of “Stock options aren’t worth anything, and I’m just treating it like a lottery ticket” becoming more prevalent, and I worry that this is intellectual disengagement and results in some employees short-changing themselves by not making the most of their equity.

Stock options are a financial instrument, and the better you understand how to interact with them and how to derive value from them, the better the outcome you’ll be able to achieve for yourself, even if the probabilities are low.

Options 201 🔗︎

The next step is to understand the basic mechanics of equity compensation. There are a number of guides around the internet, I’ll just share links to a few:

From this point on, I’ll assume you understand things like:

  • The difference between stock and options, the mechanics of options (such as the strike price).
  • Vesting schedules, 83b early exercise, and options expiration.
  • Calculating your percentage ownership, understanding the liquidation overhang, whether the preference is participating.
  • The 409A valuation (or FMV: Fair Market Value), taxes at time of exercise, taxes at time of sale.

Options 301 🔗︎

There are a few considerations in evaluating equity packages that I’ve run into at the last couple of companies I’ve joined - hopefully you can learn from my mistakes.

So congratulations! You’ve got a hypothetical offer, and it’s got some stock options. You’re savvy, so you’ve asked good questions.

  • You’re getting 100000 ISOs, with a strike price of 20 cents.
  • You’ve figured out your ownership represents .25% of the company.
  • Let’s say there’s no liquidation preference (just to make things simple).
  • It’s a standard 4-year vest, 1-year cliff, a 90-day expiry window, and you have the option to 83b early exercise.

Dollars and Cents 🔗︎

It’s always helpful to start by just mapping out some concrete scenarios (what if the company gets X big and what does that mean for me?) - for each of those, guess how much you’ll get diluted before the exit, and then use your ownership percentage to guesstimate your financial outcome.

I like to use the rough shortcut of “$100,000 per basis point (.01%) of ownership per billion ($) of valuation”. This assumes your strike price is insignificant relative to the outcome - if it isn’t, then make sure to also subtract it!

So in our example offer, you may get diluted another 50% on the way to a billion dollar exit, so we’re looking at 12.5 basis points of a billion dollar valuation, or ~$1.25 million before taxes (and you can subtract $20,000 for your exercise costs if you want to be more precise).

Do this for a few different scenarios and you’ll get a rough map of what your possible outcomes are (and then you’ll want to guesstimate probabilities for those outcomes).

Meta-Optionality 🔗︎

The (hopefully new) idea I’d like to introduce is as follows.

When you compare the numbers generated by this process to the RSUs you get from working at a megacorp, the math very rarely looks good, and this is reasonably used as justification for not working at startups.

There’s one form of value this calculation fails to incorporate, however, which is that a start-up will typically engage you for a 4-year stock grant, and this represents a kind of asymmetric contract. It’s pretty uncommon for successful start-ups to fire (well-performing) employees that are part-way through their vesting schedule just because the valuation is high, while it’s perfectly regular for employees to leave failing start-ups part-way through their vesting schedule.

That means you have extra optionality in the form of your vesting schedule, and the more potential volatility there is in the company’s valuation, the more value this optionality holds. It’s very risky optionality, but if you’re looking to maximize your financial outcomes from working at start-ups, then it’s worth thinking about how to acquire the will and financial flexibility to leave and find a new job if things don’t go well, because this represents a non-trivial portion of the value of an equity package.

Taxes, Capital Outlays, and Handcuffs 🔗︎

Something else I see is failing to plan out a strategy for balancing your tolerance for capital risk with your tolerance for handcuff risk.

Specifically, the form of handcuffs I refer to here is due to the options expiry window, which is typically 90 days after you leave a company - some companies are performing the gymnastics required to remove this constraint, but as of the time of writing, it’s a US law governing ISOs that require them to expire within 90 days of leaving the company.

At this point, you’ll be required to exercise or lose your options, and exercising generates a taxable event, which can be extremely problematic if you’ve held on to all of your options, the fair market value has appreciated a lot, and the stock is not liquid and cannot be sold. You’ll therefore be stuck either losing your deep in-the-money options or paying a large tax bill on stock you can’t sell to cover the tax bill, which can be an effective deterrent for your ability to take a different job.

Conversely, if you were to 83b early exercise your entire grant as soon as you could, you may pay a minimal tax bill and avoid tax handcuffs, but in our example offer, you’d be putting $20,000 of your own money at risk in a start-up that could be worth nothing.

You therefore have two forms of risk you’re taking on: The first is the obvious risk - losing money you’ve put into a company that becomes worthless, the second is the possibility of being stuck in a job longer than you want to be there.

When evaluating your offers then, in addition to the company outcome and the probability of the company reaching that outcome, you have to consider a third outcome - which is whether you will make it to that outcome with your full equity package. When evaluating the final financial outcomes, the strike price is usually not extremely relevant because your shares had to appreciate quite a bit to achieve those results, but the strike is quite relevant when evaluating your capital and handcuff risk tolerance.

In particular, Strike * Total Options, which I’ll call your Total Personal Outlay, is a useful number to consider. This is the number that you would have to personally put at risk if you were to leave the company prior to a liquidity event. You need to look at that number and decide for yourself if it’s a number you’re comfortable with risking (at some point in the company’s future), because if it isn’t, then you’re either committing to stay at the company until it’s liquid, or you’re leaving with only some of your equity.

Once you’ve figured out the answer to that question, the rest becomes a bit fuzzier. You want to roughly map out how you’ll avoid the tax handcuffs problem: are you more willing to risk some of your money or be stuck at your job? You’ll want to consider factors such as how stable the company’s current trajectory is, how far out a liquidity event might be, how much you actually want to be at the company and anticipating your feelings about that into the next couple of years. What your current personal cashflows look like and what they might look like in the future. So on and so forth.

Are you willing to risk some money at the current stage of your company in order to minimize your chances of being stuck later? Then perhaps you’ll early exercise or exercise as you go (this incidentally also spreads the exercise income out over more years).

Are you willing to walk away from some of your equity later on because you need cash now? Then don’t worry about it too much (but also maybe consider taking a different job).

Are you keeping close tabs on the FMV of your company from month-to-month and it hasn’t substantially increased so there’s minimal handcuff risk at the moment, but you’re ready to exercise an appropriate fraction of your options if it starts to increase? Good for you.