How Startup Options (and

Ownership) Works
by Scott Kupor
One of the things that struck me most during our recent pieces on startup employee
option plans is how things that impact the value of those options aren’t well
understood, even if communicated or known at the onset. Many people reported
feelings of a sort of “sticker shock” (or reverse!) on leaving their first startup.
Meanwhile, founders genuinely want to do right by their employees and other
stakeholders — but owning part of a company isn’t a static, fixed thing; it’s fluid, and
there are a number of factors that could change the overall ownership equation over
time.

Part of the problem is the sheer amount and complexity of information required to
understand equity and ownership in the first place. Which is why many founders are
working hard to build trust while navigating shifting ownership — their own, their
employees’, their co-founders’, their investors — along the way, often dedicating
resources to educating folks. There are also some
great overviews, guides, templates, and tools out there now that cover how options
and compensation works. So we thought we’d share more here about how
the economics behind startup options and ownership works…

Cap Table

The capitalization or “cap” table reflects the ownership of all the stockholders of a
company — that includes the founder(s), any employees who hold options, and of
course the investors. For most people to understand how much of a company they
actually own, all they really need is the fully diluted share count, the broader
breakout of ownership among different classes of shareholders, and a couple other
details. The fully diluted share count (as opposed to the basic share count) is the
total of all existing shares + things that might eventually convert into shares: options,
warrants, un-issued options, etc.

Let’s introduce a hypothetical example that we’ll use throughout this post. Here’s a
new company that has no outside investors, and existing stock allocated as follows:
If someone were offered 100 options, those shares would come out of the 1,000-
share option pool, and so they’d own 100/10,000 or 1.0% of the fully diluted
capitalization of the company.

But that’s just the starting point of ownership, because any analysis of percent
ownership in a company only holds true for a point in time. There are lots of things
that can increase the fully diluted share count over time — more options issued,
acquisitions, subsequent financing terms, and so on — which in turn could decrease
the ownership percentage. Of course, people may also benefit from increases in
options over time through refresher or performance grants, but changes in the
numerator will always mean corresponding changes in the denominator.

Financing History

For each financing round (of convertible preferred stock), there’s an original issue
price and a conversion price:

 The original issue price is just what it says: the price per share that the
investor paid for its stock. This price tells us what various financial investors
believe the value of the company was at various points in time.
 The conversion price is the price per share at which the preferred stock will
convert into common stock. Remember, “preferred” stock is usually held by
investors and has certain corporate governance rights and liquidation
preferences attached to it that the rest of the “common” stock does not
have.

In most cases, the conversion price will equal the original issue price, though we’ll
share later below where the two can diverge.

The exercise price of employee options — the price per share needed to actually
own the shares — is often less than the original issue price paid by the most recent
investor, who holds preferred stock. How much of a difference in value depends
upon the specific rights and the overall maturity of the company, and an outside
valuation firm would perform what’s called a 409a Valuation (named for a specific
section in the IRS tax code) to determine the precise amount.

Dilution
Dilution is a loaded word and tricky concept. On one hand, if a company is raising
more money, it’s increasing the fully diluted share count and thus “diluting” or
reducing current owners’ (including option-holding employees’) ownership. On the
other hand, raising more money helps the company execute on its potential, which
could mean that everyone owns slightly less, but of a higher-valued asset. After all,
owning 0.09% of a $1 billion company is better than owning 0.1% of a $500 million
company.

If the company increases the size of the option pool to grant more options, that too
causes some dilution to employees, though hopefully (1) it’s a sign of the company’s
being in a positive growth mode, which increases overall value of the shares owned
(2) it means that employees might benefit from those additional option grants.

Let’s return to the example we introduced above, only now our company has raised
venture capital. In this Series A financing, the company got $10 million from
investors at an original issue price of $1,000 per share:

The fully diluted share count increases by the amount of the new shares issued in
the financings; it’s now 20,000 shares fully diluted. This means the employee’s 100
options now equate to an ownership in the company of 100/20,000, or 0.5% — no
longer the 1% she owned when she first joined. But… the value of that ownership
has increased significantly: Because the price of each share is now $1,000, her
stake is equal to 100 shares * $1,000/share, or $100,000.

While not all dilution is equal, there are cases where dilution is dilution — and it
involves the anti-dilution protectionsthat many investors may have. The basic idea
here is that if the company were to raise money in a future round at a price less than
the current round in which that investor is participating, the investor may be
protected against the lower future price by being issued more shares. (The amount
of additional shares varies depending on a formula.)

Most anti-dilution protections — often called a weighted average adjustment — are

less dilutive to employees because they’re more modest in their protection of
investors. But there’s one protection that does impact the other shareholders: the full
ratchet. This is where the price that an investor paid in the earlier round is adjusted
100% to equal the new (and lower) price being paid in the current round. So if the
investor bought 10 million shares in the earlier round at a price of $2 per share and
the price of the current round is $1 per share, they’re now going to get double the
number of shares to make up for that, equaling a total of 20 million shares. It also
means the fully diluted share count goes up by an additional 10 million shares; all
non-protected shareholders (including employees) are now truly diluted.

By the way, this isn’t just theoretical: We saw the effects of such a full ratchet in
the Square IPO, where the Series E investors were issued additional shares
because the IPO price was half the price at which those investors had originally
purchased their shares.

Ideally, anti-dilution protections wouldn’t come into play at all: That is, each
subsequent round of financing is at a higher valuation than the prior ones because
the company does well enough over time, or there aren’t dramatic changes to market
conditions. But, if they do come into play, there’s a “double whammy” of dilution —
from both the anti-dilution protection (having to sell more shares, thus increasing the
denominator of fully diluted share count) as well as the lower valuation.

Liquidation Preferences

Some investors may also have liquidation preferences that attach to their shares.
Simply put, a liquidation preference says that an investor gets its invested dollars
back first — before other stockholders (including most employees with options) — in
the case of a liquidity event such as the sale of the company.

To illustrate how such a preference works, let’s go back to our example, only now
assume the company was sold for $100 million. Our Series A investor — who
invested $10 million in the company and owns 50% of the business — could choose
to get back its $10 million in the sale (liquidation preference), or take 50% of the
value of the business (50% * $100 million = $50 million). Obviously, the investor will
take the $50 million. That would leave $50 million in equity value to then be shared
by the common and option holders:

Given the high sale price for the company in this example, the liquidation preference
never came into play. It would, however, come into play under the following
scenarios:

Scenario 1. If the sale price of a company is not sufficient to “clear” the liquidation
preference, so the investor chooses to take its liquidation preference instead of its
percentage ownership in the business.
Let’s now assume a $15 million sale price (instead of the $100 million) in our
example. As the table below illustrates, our Series A investor will elect to take the
$10 million liquidation preference because its economic ownership (50% * $15
million = $7.5 million) is less than what it would get under the liquidation preference.
That leaves $5 million (instead of the $50 million) for the common and option holders
to share.

Scenario 2. When a company goes through several rounds of financing, each round
includes a liquidation preference. At a minimum the liquidation preference equals the
total capital raised over the company’s lifetime.

So, if the company raises $100 million in preferred stock and then sells for $100
million, there’s nothing left for anyone else.

Scenario 3. There are various flavors of liquidation preference that can come into
play depending on the structure of the terms. So far, we’ve been illustrating a 1x
non-participating preference — the investor has to make a choice to take only the
greater of 1x their invested dollars or the amount they would otherwise get based on
their percentage ownership of the company.

But some investors do more than 1x — for instance, a 2x multiple would mean that
the investor now gets 2x of their invested dollars off the top. The non-participating
can also become “participating”, which means that in addition to the return of
invested dollars (or multiple thereof if higher than 1x), the investor also gets to earn
whatever return their percentage ownership in the company implies. The impact of
this on other stockholders can be significant.

To isolate the effects of these terms, let’s first look at what happens when our Series
A investor gets a 2x liquidation preference. In the $100 million sale scenario, that
investor will still take its 50% since $50 million is greater than the $20 million (2 x $10
million liquidation preference) it’s otherwise entitled to. The common and option
holders are no worse off than they were when our investor had only a 1x liquidation
preference:
But, if the sale price were the much lower $15 million, the investor is going to capture
100% of the proceeds. Its 2x liquidation preference still equals $20 million, but
there’s only $15 million to be had, and all of that goes to the investor. There’s
nothing left for common and option holders:

Finally, let’s take a look at what happens when we have participating preferred,
colloquially referred to as “double dipping.”

In our $100 million sale scenario, the Series A investor not only gets its $10 million
liquidation preference, but also gets to take its share based on its percentage
ownership of the company. Thus, the investor gets a total of $10 million (its
liquidation preference) plus 50% of the remaining $90 million of value, or $55 million
in total. Common and option holders get to share in the remaining $45 million of
value:

In the $15 million scenario, the common and option holders get even less. Because
the Series A investor gets its $10 million in preference plus 50% of the remaining $5
million in proceeds, for a total of $12.5 million, only $2.5 million is left for the rest of
the shareholders:
IPOs

There are a bunch of non-economic factors — legal, tax, and corporate governance-
related issues — that we aren’t addressing here: which stockholders are required to
approve certain corporate actions like selling the company; raising more capital; and
so on. They’re important considerations, but we’re focusing here only
on economic factors in options and ownership.

However, there is one factor still worth paying attention to because it’s really an
economic issue cloaked as a governance issue — the IPO auto convert. This is the
language that determines who gets to approve an IPO. In most cases, the preferred
stockholders, voting as a single class of stock, get to approve an IPO: Add up all the
preferred stockholders together and the majority wins. This is a good check on the
company as it ensures one person/one vote, though each preferred stockholder has
a say proportional to their economic ownership of the company.

Sometimes, however, different investors can exercise control disproportionate to

their actual economic ownership. This typically comes into play when a later-stage
investor is concerned that the company might go public too soon for them to earn the
type of financial return they need having entered late. In such cases, that investor
may require that the company get its approval specifically for an IPO, or if the price
of the IPO is less than some desired return multiple (like 2-3x) on its investment.

And that’s how a seemingly governance-only question quickly turns into an economic
one: If an investor’s approval is required for an IPO, and that investor is not happy
with its return on the IPO, this control can become a backdoor way for the investor to
agitate for greater economic returns. How would they do this? By asking for more
shares (or lowering the conversion price at which its existing preferred shares
convert into common). This increases the denominator in the fully diluted share
count.

To be clear, none of this is to suggest nefarious behavior on the part of later-stage

investors. After all, they’re providing needed growth capital and other strategic value
to the business, and are looking to earn a return on capital commensurate with the
risk they’re taking. But it’s yet another factor to be aware of among all the other ones
we’re outlining here.
ISOs vs non-quals (and exercise periods)

Besides the financing and governance factors that could impact option value, there
are also specific types of options that could affect the economic outcomes.

In general, the most favorable type of options are incentive stock options (ISOs).
With an ISO, someone doesn’t have to pay tax at the time of exercise on the
difference between the exercise price of the option and the fair market value (though
there are cases where the alternative minimum tax can come into play). Basically,
ISOs mean that startup employees can defer those taxes until they sell the
underlying stock and, if they hold it for 1 year from the exercise date (and 2 years
from the grant date), can qualify for capital gains tax treatment.

Non-qualified options (NQOs) are less favorable in that someone must pay taxes
at the time of exercise, regardless of whether they choose to hold the stock longer
term. Since the amount of those taxes is calculated on the exercise date, employees
would still owe taxes based on the historic, higher price of the stock — even if the
stock price were to later fall in value.

So then why don’t all companies only issue ISOs? Well, there are a few constraints
on ISOs, including the legal limit of $100,000 of market value that can be issued to
any employee within a single year (this means getting NQOs for any amount over
$100,000). ISOs also have to be exercised within 90 days of the employee’s leaving
the company. With more companies thinking about extending the option exercise
period from 90 days to a longer period of time, companies can still issue ISOs — but
if they’re not exercised within 90 days of exiting the company, they convert to NQOs
regardless of the company’s exercise time, at least under current tax law.

M&A

One of the most frequently asked questions about options is what happens to them if
a startup is acquired. Below are some possible scenarios, assuming four years to
fully vest but the company decides to sell itself to another company at year two:

Scenario 1. Unvested options get assumed by the acquirer.

This means that, if someone is given the option to stay with the acquirer and choose
to stay on, their options continue to vest on the same schedule (though now as part
of the equity of the acquirer). Seems reasonable… Unless of course they decide this
wasn’t what they signed up for, don’t want to work for the new employer, and quit —
forfeiting those remaining two years of options.

Scenario 2. Unvested options get cancelled by the acquirer and employees get a
new set of options with new terms (assuming they decide to stay with the acquirer).

The theory behind this is that the acquirer wants to re-incent the potential new
employees or bring them in line with its overall compensation philosophy. Again,
seems reasonable, though of course it’s a different plan than the one originally
agreed to.

Scenario 3. Unvested options get accelerated — they automatically become vested

as if the employee already satisfied her remaining two years of service.

There are two flavors of acceleration to be aware of here, single-trigger acceleration

and double-trigger acceleration:

 In single trigger, unvested options accelerate based upon the occurrence of

a single “trigger” event, in this case, the acquisition of the company. So
people would get the benefit of full vesting whether or not they choose to stay
with the new employer.
 In double trigger, the occurrence of the acquisition alone is not sufficient to
accelerate vesting. It must be coupled with either the employee not having a
job offer at the new company, or having a role that doesn’t quite match the
one they had at the old company.

Note, these are just general definitions. There are specific variations on the above
triggers: whether everything accelerates or just a portion; whether people accelerate
to some milestone, such as their one-year cliffs; and so on — but we won’t go
through those here.

Not surprisingly, acquirers don’t like single triggers, so they’re rare. And double
triggers give the acquirer a chance to hold on to strong talent. Still, it’s very unusual
for most people to have either of the above forms of acceleration. These triggers are
typically reserved for senior executives where it’s highly likely in an acquisition
scenario that they won’t — or literally can’t (not possible to have two CFOs for a
single company for example) be offered jobs at the acquirer — and thus wouldn’t
have a chance to vest out their remaining shares.

The simple way to think about all this is that an acquirer typically has an “all-in price”
— which includes up-front purchase price, assumption of existing options, new
option retention plans for remaining employees, etc. — that it is willing to pay in the
deal. But how the money ultimately gets divided across these various buckets can
sometimes diverge from what the initial option plan documents dictate as acquisition
discussions evolve.

* * *

As mentioned earlier, anything related to compensation and ownership boils down to

building and navigating trust — whether it’s through education, communication, or
transparency. There’s also an important S.E.C. rule that is in play here: Rule 701,
the exemption for issuing employee stock options. This rule says that up to about $5
million in annual option issuances, a company must provide the recipient a copy of
the options plan; and then once a company goes beyond the $5 million annual limit,
it must also provide a summary of the material terms of the plan, risk factors, and
two years worth of GAAP financial statements. Which is great.
But times have changed, and the 701 requirements that were put into effect April
1999 have failed to keep pace. Companies are now staying private longer and are
therefore raising more capital, often from new entrants to venture investing with more
complicated terms. So simply reviewing a company’s last two years of financial
statements doesn’t say much about the ultimate potential value of options. Rule 701
should be updated to better reflect the information people need to understand
options.

The good news is that if a company goes public, all of the above different rights that
preferred stockholders have go away because everyone’s shares convert into
common shares. There may still be different classes of common stock (such as dual
classes with different voting rights to protect founder-driven long-term innovation) —
but those don’t impact an individual’s economics.

Startup outcomes are, by definition, unpredictable. Every startup is unique, every

situation has unknown variables, and new data will always change the economic
outcomes. Working at a startup means getting in early for something that has yet to
be proven, which means it could have great risks … and potentially, great rewards.

Source : https://a16z.com/2016/08/24/options-ownership/