Question: (org. on Quora)
Answer (by Dan Walter)
Question: (org. on Quora)
Answer (by Dan Walter)
Question: (org. on Quora)
The most common company policy for RSUs follows the basic structure below:
1) Award of RSUs, generally to be settled in stock when they vest (some companies convert the RSUs to cash)
2) Vesting schedule of 3 years (annually increments or cliff vested) (this period can vary widely). Vesting is may also be restricted to ONLY occur after a period of time AND a liquidity event like and IPO or Change in Control. — this is becoming far more common.
3) When RSUs vest they are “converted” to real stock and delivered to the participant (or held in electronic book entry).
4) When the individual leaves the company the unvested RSUs are forfeited back to the company. The vested RSUs are now shares (usually of common stock) and the individual is therefore a shareholder.
5) Most companies let people who hold shares keep the shares. They also usually restricted any transactions so the shareholders have little or no liquidity until a major event.
6) It is uncommon, but not unheard of, for companies to take back vested and delivered shares. When they do they usually pay the individual the current market price.
NOTE: There are a ton of exceptions to every single statement above. The statements above may not represent the best strategy for every (or any) company. Equity compensation is Variable, Variable, Variable, Variable (and up to three more variables) compensation. The type of equity, the number of shares/units/options/etc., the price at the time granted, the price when vested, the currency at the start and end, the vesting schedule and several other components can all be variable within a single award. “Normal” is often not synonymous with “best”.
Question (Orig. on Quora):
How have you seen Stock Options or Performance Rights grants change for employees from Pre-IPO to Post-IPO? What are the triggers and how have the amounts differed? Building out our long term comp strategy. Thanks!
Answer (by Dan Walter):
First, it must be clarified that this answer refers to “pre-IPO” as companies with a realistic chance of an IPO, not simply any company (tech or not) that is not currently publicly traded. This distinction is important since it plays directly into many of the design goals and trends for equity compensation. I can cover non-pre-IPO companies in a separate post)
Second, the difference between pre-IPO companies and so-called “unicorn” (>$1B) pre-IPO companies is also a significant differentiator in equity plan design and use.
For most pre-IPO companies these are fairly basic. MOST TYPICAL… They may be ISO or NQSO. They are granted with a strike price equal to the IRC 409A) compliant Fair Market Value of the companies common stock. They vest over time. Usually over 4 years. Sometimes 25% each year, sometimes 25% at the end of the first year and monthly for 36 months after that. We are also seeing more grants with a secondary event-based goal that has to be met before final vesting takes place (typically Change in Control). Leaving the service of the company usually ends up with the individual losing all unvested options and having a limited period to exercise vested options (usually 3 months for termination in good standing, 0 for cause, 1 year for death or disability). Grant size is generally determined as a % of outstanding shares for early employees and some formulaic number of shares for later employees. Exercises, if allowed before the IPO, usually require cash paid directly by the optionee to the company. The optionee is no longer an employee the cash payment may also include taxes due (since withholding may be difficult or impossible). In a small percentage of companies still optionees are allowed to exercise unvested optionees and hold the remaining shares until they are vested.
So what is different for post-IPO options?
Often not much. The grant price becomes driven by the stock price traded on the open market (usually closing price on the date of grant). Vesting is generally the same schedule as pre-IPO (although many companies do away with allowing exercise of unvested options). Vesting for post-IPO seldom requires any trigger other than time. Leaving the service still ends up with the option losing unvested options and having a limited time to exercise vested options. GRANT SIZE: once a company is public grant size is most commonly driven at least partially by the black scholes value of the options at the time of grant. Values are less likely to be based on percentages or fixed formals and more likely to be based on compensation dollar values. Exercises become much easier with the addition of same-day sales and net settlement methods for payment. But, with public trading comes insider trading policies, black-out windows and, for some officers, SEC filings for nearly every transaction.
Back to pre-IPO companies
But, companies that stay private for a long time AND have a lot of employees AND grant a lot of equity may find themselves running out of stock options to grant. This is one of the two biggest drivers for the pre-IPO move to Restricted Stock Units (RSUs). The other major driver is the fact that most options allow for a voluntary exercise transaction. These transactions create shareholders. Too many shareholders means the company must file information with the SEC that may be available to competitors. So, companies move to RSUs and restrict the vesting event to occur only after a period of time (usually at least 3 years) AND after the company choose to file publicly. This can simplify the process for the company, but removes a lot of flexibility and leverage for the individual. But, it still beats giving no equity at all.
More recently companies have been granting RSUs with performance-based vesting (most often also requiring a period of time to pass as well, typically at least a year). Performance criteria for these pre-IPO performance-based RSUs are usually focused on internal financial and operational metrics. Companies love metrics like EBITDA, but we recommend metrics that are more closely aligned with the jobs people do and decisions they make, rather than something like EBITDA that is a result of many things, but may not be understood or feel like it can be personally impacted by individuals.
Performance equity is still relatively uncommon in pre-IPO companies, except officers, but it is a growing trend.
So what about Public companies?
Public companies who moved to RSUs pre-IPO usually stick with them after the IPO. Most of these companies also add and ESPP (Employee Stock Purchase Plan) that is focused on the rank and file.
At the time of IPO most companies create entirely new plans that are built to conform with public companies rules and best practices. These plans also can include an “evergreen provision that automatically increases the pool of shares available to grant on an annual basis. Evergreen provisions usually expire before the start of the 4th fiscal year after IPO (shareholders and the advisors kind of hate them).
It should also be noted that overhang changes pre and post-IPO. This is partly due to the different ways overhang is calculated pre and post-IPO. But it is also due to the fact that once a company goes public people start exercising options and RSUs start vesting. Every exercise of options or release of vested RSUs moves equity from one side of the overhang calculation (outstanding equity) to the other (outstanding shares). SO, the impact of exercises and releases is double that of equity cancelled for a terminated employee which only impact the outstanding equity side of the equation. The quick movement in transaction during the first year after IPO reduces overhang quickly at many companies, giving them more room for new grants (as long as they have new shares coming through something like an evergreen provision.)
Now if you have gotten this far you are probably taking this seriously. So you should know a little secret. While all of the above is true it doesn’t mean that it is right.
The most common methods of using equity compensation are often not supported by any evidence of effectiveness. They are follow-the-leader approaches that many lawyers and compensation consultants throw out to companies to create average solutions (and great consulting fees).
The real process to determine a long-term compensation strategy requires a true understanding of your company culture and strategy. It requires know how and why each equity instrument works and it requires a communication program that ensures that your employees perceive the value of equity in a manner similar to your intent for that equity. The end result is a program that is unique to your specific facts, circumstances and goals.
I can go on (I have co-authored books on this topic), but I will wait for any follow-up questions first.
The most common question asked about equity compensation is only two words: “How much?” For private companies, it is frustratingly hard to answer. The crux of every equity compensation conversation is how much to give. The answer leads to the best equity instrument to use, features of the plan, expected exit strategy, or time to liquidity. Determining levels for private companies is never as simple as Continue reading
Question: (org. on Quora)
Answer (by Dan Walter)
This is a great question and an important fact for Incentive Stock Option (ISO) holders to be aware of.
When you exercise an ISO the spread is an Alternative Minimum Tax Income preference item. If you simply exercise and hold you will be required to perform an AMT tax calculation (there are lot’s of posts and discussions about tis, so I won’t go into the details.
If you sell, gift or “otherwise hypothecate” your exercised ISOs within 2 years of the grant date and 1 year of the exercise date you have disqualified them from preferential tax treatment (a “disqualifying disposition”).
A disqualifying disposition that occurs in THE SAME CALENDAR YEAR as the exercise that caused the AMTI preference items, negates the AMTI preference item and no AMT calculation is required when preparing your taxes in the following calendar year. BUT, if you forget and hold the shares until even January 1 of the calendar year following the exercise, you will be forced to do the calculation and, perhaps, pay the associated taxes.
The trick is this.
IF you exercise and ISO and choose to hold any or all of the resulting shares in order to potential receive the tax benefit of avoiding ordinary income taxes in favor of capital gain taxes…
THEN you should have a tax professional or a qualified investment advisor of some sort help you evaluate the resulting shares in early December of the same year as the exercise.
IF the AMT risk seems high, it may make sense to get rid of the shares, take the ordinary income hit and pay the associated taxes.
If the AMT risk seems low, it probably makes sense to hold the shares and take advantage of the great saving that capital gains rates offer you.
NOTE: I am not a qualified tax advisor or attorney or financial advisor. While I do have extensive knowledge of these issues nothing here should be considered advice or guidance. You must speak to your own advisors about your specific facts and circumstances to get advice about this issue.
Question details (original on Quora)
Basically my question is: how do I calculate the expected return of my stock?
Answer, by Dan Walter
This is a more nuanced question than many people may imagine. There are certain things that truly are important to know before you make this decision.
1. Shares outstanding. While others have said this is not important, it is actually critical. Currently companies in strong IPO tend to have an IPO price of between $15 and $18 per share. Given your strike price the company likely has far fewer outstanding shares than it will have at the time of IPO. This is probably a good thing. You will likely end up with far more shares after the split (lower price = more shares since total value won’t really change). To get to a price of $17 given todays price of $1250 you would have to multiply the outstanding shares by about 73.5 times. Since we have no idea how “accurate” the current value is, it would be hard to provide great advice on this point.
2. Rules regarding your grant. Can the company buy back your VESTED and EXERCISED shares? If so, at what price? While this is not common, it has happened at some high profile companies over the past decade. You may find yourself spending your money, then simply getting back in a couple of years. You may have to write off losses and deal with the lost time-value of your money. Without fully understanding your plan details, it is hard to know how this will work.
3. You haven’t mentioned whether you have ISO or NQSO stock options. If you have ISOs then you won’t be paying taxes at the time of exercise, but there may be an issue with AMT if something great happens with the company before the end of the year. With NQSOs the spread (right now $600 per share) will be taxed as ordinary income. This will be paid at the time of exercise, and likely via withholding by the company. They may allow you to have some of your vested shares withhold to cover the taxes, but more likely they will require you to add around 40% to the total exercise cost.
4. An IPO two years out is unlikely to be a 70% probability. There are, of course, exceptions to this rule of thumb, but if the IPO is planned and being worked on for execution within the next 12 months, I would lower your expectations. A lot can happen in 2 years…
And with all of that being said… You have options that are already almost 50% in the money. It sounds like you have enough of them to make the exercise a burden, but perhaps not a life changing risk. If you had 500 stock options exercisable you would be looking at an exercise cost of $325,000, plus taxes due (assuming an NQSO) of around $120,000, having a value of $625,000. So a net value at the time of exercise of $205,000. Of course we have no real idea of the potential future vaue since we have no idea of the current company value. A $10B value in two years won’t mean much if today’s value is $7.5B.
I hope this gives you some good information to ask the company some specific questions.
Additional Question details (orig. on Quora):
CEO was only getting 3-5%. If that is the case, I can’t imagine they would give an advisor more than 1% which seems low.
Dan Walter’s Answer
I think that it is impossible to answer this question without far more information. This is a common issue that start-ups must address and it is often done without enough forethought. Here are just a few questions.
Michael Wolfe’s answer of 0.1% may be perfect. Brian Schuster may also be right at 3%.
This huge discrepancy is easily explained by not knowing the underlying details.
What will be your part in getting the company to $500MM? Is all $450 increase dependent on your actions? Your ideas? Is there a reasonable percentage of the gain that will be able to be demonstrably attributable to you?
Will this role be full time? Are there already multiple rounds of financing in place? Given that the CEO only has 3-5% I am assuming he/she is not a founder. If they are, then they probably have at least 5 rounds of financing in place (which seem pretty high for a $5M company.)
What is the likelihood of actually attaining $500M? How long will it take? Does this value include any the value of any potential future acquisitions or mergers (and their associated costs / dilution)?
I am sure their are tons of experts on Quora who can each add at least as many questions as I have in this quick post.
If the potential is 3% of $500M ($15M), it pays to do the groundwork in advance. If the potential is only 0.1% of $500M ($500K) then it pays to set limits on your effort.
Question from Quora
As a software developer I worked at companies both large as well as small and I can tell that the former have a greater diversity of projects and technologies compared to smaller ones.
I consider diversity of experiences an important part of a professional’s improvement because I met people that mastered well one technology but lacked the overview that a wider range would give.
Having said the above, do you consider wise to join a small startup (before A series) early in your career (after college)? If you were to stay for 4 to 5 years there, I think that lack of diversity can put an upper bound on one’s learning. For senior guys (10+ years) it might not be a problem to go deep into an area but for a graduate, diversity is quite crucial.
What’s your opinion about this?
Dan Walter’s Answer
Diversity of projects at a small company comes in a far different form. I wrote an article about this a few years ago and thought it might be good to provide a summary here.
At a small company you may be focused on a single technology or single product, but you will likely be involved in far more aspects of that single thing. It is common to have a voice in the product name. But at a small company you may also find yourself designing a logo, or working directly with internal or external market experts to get the word out. You will learn more about the nuances of sales and finance and probably how to change a roll of toilet paper and how to make good coffee.
As a company grows your job become more focused, even as you use more (and sometime better) technology. Some people love the ability to contribute to almost every piece of a company. Some people like the deeper dive that a big company has to offer.
When hiring people it is a good policy to dig into these questions. Hiring a people that matches the reality of your company is the best way to succeed.
Question: I am writing my business plan now and I want to do some analysis on what other startups in Silicon Valley or other cities in the USA offer. Thanks! (see orig,. post on Quora)
Answer by Dan Walter
I work with a ton of early-stage companies. This is a “Top 5 Question” for nearly all of them but the answer can be a bit murky
Question (orig. on Quora):
What factors should be considered when deciding between NQSOs, ISOs, RSUs, etc.? Also, what is a reasonable valuation method for determining the FMV without doing a formal 409A valuation?
Answer: The recommended type of equity will vary based on your long-term goalls