Before Microsoft purchased Skypefor $8.5 billion, some of the employees who were let go in the process learned something they hadn’t necessarily realized about the options they had signed on to when they were hired.
A clause in former Skype employee Yee Lee’s stock option agreement, for instance, made even his vested options worthless.
This revelation inspired Reuter’s Felix Salmon to lambaste Skype and its investor Silver Lake to “downright evil” (they had previously been declared “pretty evil” after firing executives right before the sale, ostensibly in order to reduce their payouts).
Evilness aside, the incident highlights the purpose of DFJ Growth Associate Sam Fort’s first tip for employees who are staring down an options agreement: “Read the fine print” and “if you don’t understand it, make sure you have a lawyer or someone familiar with these types of agreements look at it.”
Here are four more basic tips for navigating an employee equity agreement.
1. Know the Lingo
The two most common types of categories of employee equity are:
- Options — The right to purchase stock at a set price for a certain period of time.
- Restricted stock — Common stock with some restrictions, like a vesting schedule or the stipulation that the company can repurchase the stock under certain conditions.
Most employee equity agreements include some sort of vesting schedule, which incentivizes employees to stay with the company by gradually granting them their equity (or removing repurchasing rights) over time.
- Vesting period — The period of time before shares are unconditionally owned by an employee. In the case of options, an employee is issued a fixed amount of shares and they become his or hers as they vest. In the case of stocks, an employee technically owns the entire amount of stock, but the company can buy back any unvested portions at the original price if the employee leaves. A common vesting period is four years with a one year “cliff.”
- Cliff vesting — A type of vesting that occurs at a specific time rather than gradually. Most employee equity plans, for instance, require that an employee be with the company for one year before any stock or options vest. At that point, they receive an entire year’s worth of equity at one time.
Some other terms to be aware of:
- Strike price — The price per share that you will pay when you exercise an option, as determined by the board of directors. It should reflect market value.
- Preferred stock— Stock that has higher claim on assets and earnings than common stock, most often held by investors.Fred Wilson, the principal investor at Union Square Ventures, explains it this way on his blog, AVC:
Let’s say you start a company, bootstrap it for a year and then raise $1mm for 10% of the company from a VC. And let’s say a few months later, you are offered $8mm for the company. You decide to take the offer. If the VC bought common, he or she gets $800k back on an investment of $1mm. They lose $200k while you make $7.2mm. But if the VC buys preferred, he or she gets the option of taking their money back or the 10%. In that instance, they will take their money back and get $1mm and you will get $7mm.
- Common stock — The stock that employees, advisors and the founders are most likely to hold.
2. Ask The Right Questions
Some things to think about when looking at an employee equity deal are:
- Does your vesting schedule make sense?While the most common vesting schedule is four years with a one-year cliff, that might not be the most fair situation for everybody.“I’d consider how long-plan your relationship with the company to last, how much work are you going to do and how much of the work you’re going to do — particularly if you’re a developer — is going to be delivered early on,” says Charles Torres, a partner who specializes in venture capital and startups at Reitler Kailas & Rosenblatt. “A lot of times people come on board for six or seven months thinking they’re going to get stock, and it never vests. Sometimes, though, they do really good work and develop a good part of the company’s IP.”
Generally, the more equity the company is granting you, the harder it will be for you to negotiate the vesting schedule, Torres says.
- Under what circumstances can the company repurchase my stock, and what is the repurchasing price?“Often companies and their lawyers will put in provisions where they can repurchase stock after somebody leaves,” Torres says. “Under certain circumstances that might be fair, but in others it might not be. ”It’s important to know when the company can purchase stock and at what price. If the stock’s value has, for instance, tripled since you bought it, whether the company repurchases it at its original price or at market value can be a huge distinction.
- Under what circumstances does the value at which the company repurchases stock change? “That often revolves around a term in an employment letter called ‘cause‘ and how that is defined,” Torres says. “The employee should be very careful about that definition because it has significant ramifications.”
3. Think About Taxes
Whether you’re getting stock, which you own immediately, or stock options, which give you the choice to buy stock later, will affect your taxes come the filing period.
In certain situations, like if you’re entering a company early on that has a low valuation, it might make financial sense to have restricted stocks instead of options. Then you pay the income tax on the shares while their value is low and the taxes for capital gains when you sell them later. If the company fails before you’ve sold the stock, you haven’t lost a ton of money on taxes. In another situation, like if you are paying high taxes for a stock grant that might not fully vest by the time you leave the company, stock options might make more sense.
“There are varying tax consequences for restricted stocks and stock options,” Torres says. “The goal of both, however, is to defer the taxable event for the employee, but which is more preferable depends on the stage of the company, its valuation, the size of the stock grant and the anticipated vesting or timing of it all. There’s no one-size-fits-all, and you really need to consult with a tax attorney.”
4. Some Words of Advice
We spoke with venture capitalists, startup founders and a lawyer about employee equity. These are a few of their suggestions for negotiating.
- “I think we’re in a competitive hiring environment right now in the Bay Area and in New York, as well,” Fort says. “If you are talented and if you can bring a lot to the table, then you are in a good position to negotiate.”
- “I think from an employee’s perspective, you need to be realistic about where the company is in stage,” says Jay Levy, principal at Zelkova Ventures. “A company that is funded by a late-stage VC at X million and has revenues that are stabled is ‘less of a startup’ than a startup that is raising the 500,000 in seed money. To go into a fully funded company and expect two points, is unrealistic.”
- “When you are issued employee equity, be prepared for dilution. It is not a bad thing. It is a normal part of the value creation exercise that a startup is. But you need to understand it and be comfortable with it,” writes Fred Wilson in a blog post that aptly explains what to expect.
- “The biggest upside to a startup outside of culture is the chance for a massive payday if you’re company executes beautifully (with the employee’s help),” says Aviary founder and CEO Avi Muchnick. “An employee who isn’t interested or doesn’t understand that upside is not going to be motivated in the same way someone else is.”