Should I choose shares or options when joining a startup?

June 6th, 2015

I was offered to join a startup of 2 people at the very beginning, but they're talking about giving me options rather than actual equity. No salary or any alternative compensation is expected any time soon.

If I understand correctly, the options and equity are similar in terms of vesting and the returns in case of an exit, but options are translated to shares only after I leave the company, and also I have to pay some nominal amount (plus taxes) to turn options into shares or I get nothing. Also, I guess it means that options give me no voting rights at the company.

Is all this correct? And which would you have preferred in my place - options or actual shares? And why?

Michael Barnathan Adaptable, efficient, and motivated

June 6th, 2015

This is a fairly complex topic. I prefer shares to options myself, but it's very situation dependent. Sometimes options are the only way you can avoid paying a huge amount of tax on shares that you can't sell yet. Also, figure out whether you're getting ISOs or NQSOs, as they're taxed differently.

The high-level summary is: options provide you with the *gains* from a set strike price, and you're taxed on those gains (usually at the ordinary income tax rate) when you exercise the options. Exercising gives you shares, and you can then choose to hold on to those or sell them immediately. If the shares rise in value, you pay capital gains taxes on the rise, just like you would with regular stock.

If the stock drops below the strike price, your options are worthless!

Shares, on the other hand, are pieces of the whole company, not just the part that grows after you join. They therefore have value at grant, whereas the initial value of an options grant is usually $0. They're taxed either at grant (if you make an 83(b) election), or at vest (if you don't). Shares can drop below the grant price and still have value, albeit probably less than you were originally expecting. Usually (but not necessarily) they carry voting rights, whereas options don't.

In a small startup, it's almost always most favorable to take the shares and make an 83(b) election within 30 days of grant, since the value of the startup is very small and you'll be taxed at the much more favorable long-term capital gains rate if you sell more than a year later.

In a company that's already large, coming into a large amount of stock is a windfall - unfortunately, you probably can't afford the taxes on your unvested stock since it isn't liquid. In this situation, you can either have the stock taxed at vest (i.e. no 83(b) election) and run the risk of a paying more taxes later, or take the options and lose out on capitalizing on the existing size of the company.

* I'm not a tax professional and you should seek one if you're looking for tax advice.

Georgi Matev VP of Product Management at Carrum Health

June 6th, 2015

Michael gave you a good starting point above.

One additional thing to consider is that if you are getting options, for an early stage company which seems to be the case for you, you can have them behave similarly to restricted stock by negotiating for an "early exercise" clause which will allow you to exercise these options immediately. You will be issued the stock but the stock will be restricted subject to your vesting schedule (making it very similar to a restricted stock grant).

The differences are the following:

You will have to pay the exercise price of these options. If the company is pre-funding, this will likely be a very small amount, but you are risking some money which you may never see again
For NQSO options, you will be taxed on the difference between the fair market value (FMV) of the stock and the strike price. The good news is that if you do this immediately (if you are not worried about risking the amount mentioned above), the value of the two should be the same and you will owe nothing. It is VERY IMPORTANT to do 83(b) filing withing 30 days with the IRS to lock in your cost basis for the resulting restricted shares

With respect to voting rights, this will usually be subject to the particular agreement that specify what voting rights if any are attached to the restricted stock.

Generally speaking, I think for a 2 person pre-funding startup, most companies will offer restricted stock subject to a vesting schedule and not options. The primary reason is that options come with the burden for the company to show that the strike price is not less than the FMV at the time of grant (failure to do so may result in a tax bill depending on the situation). Establishing a FMV for option granting purposes, is typically done by an external company specializing in 409A valuations which I doubt has been done based on how early the company is. If I were you I would ask about the method that the company has used to set the strike price and FMV of the options here.

I'm not a lawyer or a tax accountant so the above does not constitute legal or tax advice.

George Calvert

June 8th, 2015

I think you, Michael and Georgi have nailed the differences between shares and options. "Options" are call options for shares in the company. As they vest, you gain rights to buy shares (at their strike price) but you don't own any equity until you do. There are lots of tax nuances and you'll want a tax attorney to review the agreement during negotiations.

One thing I'd point out is that, typically, options can be exercised as soon as they've vested (not only once you've left the company). Most agreements do put an expiration date on the options (e.g. 5 or 10 years) to limit the company's financial exposure (as it's paying the difference between the strike and current prices).

The lead founder's rationale is not unreasonable, but the structure does seem more vulnerable to shenanigans than just giving him a controlling interest. For instance, he can give you a juicy percent now on paper but then dilute you whenever it suits him -- something that otherwise might require your consenting vote.

If you go forward with options, beware this approach may entail agreements that define as an employee (rather than award you co-founder rights). IMHO terminating an employee is lots easier than removing a founder against his will -- and a lot less vulnerable to actionable dispute, particularly given a state with at-will employment laws.

Lastly, I'm a little fuzzy now on whether there's a third founder. If there is, I'd expect consistent structure for the two of you.

Yury

June 7th, 2015

Michael, Georgi, why are you talking about taxation of stock at issue time when it happens "at the very beginning" of a startup?

We even do not know whether this startup was already incorporated.

Dimitry Rotstein Founder at Miranor

June 8th, 2015

George, you're right. Normally, I wouldn't agree not to have a real equity share, but in this particular case we're talking about a very formidable founder and a high-potential venture, so I'm willing to forgo control if the only alternative is to walk away. So far he told me that he wants to keep 100% control of the venture and only give me options. I'll try to change his mind or negotiate some other perks in exchange, but either way I need to understand all the subtle differences between shares and options (I've never considered taking options before so I never bothered to go into these details until now).

George Calvert

June 8th, 2015

Shares. Shares (should) give you voting rights, and it is that increased control over one's destiny that is a big plus of founding a start-up.

Also -- taking your "at the very beginning" at face value -- it's a red flag for me that the other founders want you treated differently. It's understandable that different founders receive different ownership (%) based on what they bring to the table. As addressed in other threads, there is always buyback (reverse vesting) to deal with premature departures -- so what's the rationale for them getting shares and you getting options?

Dimitry Rotstein Founder at Miranor

June 8th, 2015

Yes, there is a third guy, and it is my understanding that he and I are expected to join on similar structures. Of course, I will check all the details once the "trial period" is over.

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