Silicon Valley Legal Bible（9）The Most Complete Explanation of Options is Enough in This One Article
The tech startup boom is so prevalent now that a bunch of CEOs have been thrown over the wall, and "all-stock ownership" of tech companies is nothing new. As a founder, how much option pool should you set aside for your company? How many options should be allocated to different levels of employees? As an employee of a startup, when facing a bunch of so-called "option contracts" thrown to you by HR, are you actually getting options or not? You will be happy to receive the options and work hard for 4 years, but why you may leave empty-handed in the end?
Today, we will talk about those things about options.
1.What exactly is an option?
In the specifics of options, we have to first understand what in the end is options, there are many people said half a day options this, options that, in the end, told me that he took to the option after the Merril Lynch (Merrill Lynch) has been sold how much money. What kind of options are they? Options can only be liquidated the moment your company acquires or goes public, otherwise they have no liquidity. The one you guys are talking about that can be sold on the brokerage platform is called a Restricted Equity Unit (RSU), which sounds awkward, but yes it doesn't have an acronym, the name is just that long.
There is also another concept that some people get confused about, which is the founder's equity, called Restricted Stock. Together with the previously mentioned Stock Option, there are now a total of three concepts. People will confuse these concepts, is because they all have a four-year Vesting Schedule (maturity/vesting period), many people will have a misunderstanding that as long as there is this word, that is employee options, but in fact, there are many other mechanisms will be used Vesting Schedule (maturity/vesting period). For example, the typical 401(k) (Retirement Plan) and Pension Plans (Pension Plans) will also have a Vesting Schedule, where the employee does not enjoy all the benefits as soon as he/she starts working, but gradually gets more and more as he/she works for more and more years.
There are also, for example, family trusts in the United States, parents will set up different levels of Vesting Schedule (maturity/vesting period), for example, the child will get a fortune when he/she becomes an adult at the age of 18, and then at the age of 25, and then at the age of 35, he/she will get a fortune again.
Therefore, it should be said that Vesting Schedule is a kind of time scale, because the benefits can not be given to you all at once, but have to be sent out in batches, so as to play an incentive role.
And in fact, Vesting Schedule (maturity/vesting period) is not necessarily 4 years, and even can not necessarily according to the year to count, there are many different variants, the specific you can see my Silicon Valley treasure dictionary forty-two chapters of the sixth lecture.
Then understand the Vesting Schedule (maturity/vesting period) is not necessarily an option, we will look at the three easily confused concepts just mentioned.
1.1 Stock Option
Let's start with the most popular one, which is Stock Option. From the name "option" can be seen, this is not equity, we can understand the option as "expect the power of the shares", which means that, compared with equity, options are a kind of off-site queuing status, is not yet a formal on-site audience.
To give a more relevant example, the people in line at the entrance of the movie theater to buy tickets, waiting for four hours, finally shot to the box office, this time the people in line to get what? In fact, they have not got the right to go in and watch a movie ticket, they have just got the right to buy a ticket. To go in and watch a movie ticket, it is not enough to just put in the effort to wait for four hours under the wind and the sun, they still have to spend money to buy a movie ticket at the ticket office before they can go in and watch it.
In fact, in the course of giving this example, I have brought out several key words of options, namely Grant, Vest and Exercise.
The day of the grant is just the day the company gives you a chance to start lining up, meaning that there are enough seats in the queue for you to start lining up.
So what is the four-hour long waiting process? It's the vesting/maturation (Vest) process, it's not like every time your line advances a little bit, you automatically get a piece of movie ticket crumbs, wait until the end of the four hours and then put the movie ticket crumbs together into a whole movie ticket, right, so in fact, this vesting/maturation (Vest) is just a dry wait. As the hours go by, you get just one step closer to being able to buy the movie tickets, that's why it's called an option, you get the right to look forward to more shares.
Four hours have finally passed and the right to buy movie tickets is fully vested/ripe (Vest), the most critical action at this point is to Exercise, which is to put it bluntly, pay a sum of money for the shares. If you have been waiting impatiently and left without buying the ticket, then the 4 hours of queuing in front of you would have been for nothing.
What? What kind of logic is this? So what's the difference between an employee who waits in line for half a day to buy a ticket and a random person on the road who comes to buy a movie ticket? There is a big difference: on the one hand, stock options are issued by startups, i.e., companies that are still in the private stage, i.e., only internal employees can buy them, and the company won't buy stock for just anyone on the road. In other words, it was a movie shown in the workers' cultural palace in a factory, not in a commercial movie theater in the community.
On the other hand, the stock of a startup company is getting more and more expensive, which means that the price of this movie ticket is actually getting more and more expensive over time, and the advantage of being a big employee is that when you line up at the door of the movie theater, you don't need to pay according to the price of the movie ticket at this moment, but you can still pay according to the low price of 4 hours ago.
That's four years of dedicated work for you as an employee, and the only perk is that you get a lower stock purchase price instead of stock for nothing.
1.2 Restricted Stock
Let's talk a little bit more about this Restricted Stock, Restricted Stock is the only one of the three sets of concepts we're comparing right now that ends up on top of STOCK, which means it's a true equity, and it's the only true equity out of all the common incentive methods. The first day the company gives you 100 shares of Restricted Stock, you are already a shareholder of those 100 shares. So why is it even called Restricted Stock? What exactly is RESTRICTED about this RESTRICTED?
Because it also has a four-year Vesting Schedule, which is a four-year period in which the company loses its right to buy back your shares.
What does that mean? That is to say, as a founder of the benefits is, you can start from the beginning to sit directly in the movie theater to watch a movie, but there will be someone in the four hours at all times to check whether you watch the movie is serious, if the watch is not serious, you can let you leave the movie theater. Therefore, Restricted Stock is a system of giving you benefits first and then taking them back if you don't perform well. You can imagine how difficult it is to get something back that was given to someone else, so the reason why Restricted Stock is so generous is because Restricted Stock is given to the founders, not to the general staff.
Note that both Restricted Stock for founders and Stock Options for employees are issued at the startup stage when the company is still privately held and not liquid. In other words, it is the exclusive movie ticket for the company insiders, you can't say you got the ticket but don't want to see it, so you can just sell it to your neighbor's friend.
When a company goes public, there is another form of equity incentive, Restricted Stock Unit.
1.3 Restricted Stock Unit (RSU)
Restricted Stock Unit (Restricted Stock Unit) is abbreviated as RSU, and if you hear employees of Google, Microsoft, or Amazon say that they have received "options" from the company, then they are actually mistaking RSUs for options.
Restricted Stock Unit (Restricted Stock Unit) also has a four-year Vesting Schedule (maturity/vesting period), but the operation mechanism of this is very different from the previous two. It is neither to let you outside in the sun and wind for four hours and finally have to pay for a movie ticket, nor to let you sit in the cinema to watch a movie at the beginning, and then kick you out if you don't watch it seriously. Rather, it is the first impression of the general public that "options" should be like, that is to say, you don't have to pay for a movie ticket after queuing up, you can just go in and watch it when you are in the queue. That's why so many people mistake RSUs for options and the best part is that they are not just internal movies shown in the Worker's Cultural Palace, but in commercial movie theaters, so if an employee in line doesn't want to watch a movie, he can sell the ticket to a third party to cash in his stock. That is to say, employees working in Google, after four years of work without spending money can get once again stock, and because of restricted equity units (Restricted Stock Unit) are issued by the listed company, the queue of employees can also immediately put this stock on the stock market to sell to make a fortune.
But do not be too happy, there is no free lunch, Restricted Stock Unit (Restricted Stock Unit) of this labor for shares. This leads to it in the tax calculation according to labor income, that is, will be classified as general income tax (Ordinary Income Tax), super progressive tax rate, that is, the higher the salary the higher the tax rate, especially can afford to issue restricted stock unit (Restricted Stock Unit) of the company, are large companies, the salary level of the staff are higher, and ultimately, it is also As a result, the tax rate for Restricted Stock Units often reaches 40-50%.
The first two types of Restricted Stock and Stock Option are paid to buy stock, which will be realized when the company acquires and goes public, and will be taxed according to the capital gain tax, with a maximum of 20%.
2. How big should the option pool be? How many options to give to different levels of employees
Since we're focusing on options today, here's a little more about options-related content.
Options are the primary way startups incentivize their employees, and a must-have knowledge as a startup founder.
Option pool is not as big as you want to set up, the general market is more common proportion is 5-20%, more suitable for the startup stage of the option pool is generally 10%-15% of such a proportion. It is not recommended to set the option pool too high or too low. Because if it is too high or too low, when you look for investors, investors may have more concerns, and you will have to spend a lot of time explaining to investors why you want to design an option pool that is not in line with the status quo of the market. Entrepreneurs should still spend more time on presenting their projects rather than option pools.
After the total number is set, then we can see what percentage of employees should be given for each position. Here we take the example of a company in the Series A stage, because the further the company goes, the more the equity will be diluted. Here to give you an approximate range as a reference:
General CEO chief executive officer ratio is 5-10%. Some people will say that the CEO of the startup company is not the founder himself? The founder would have had the equity, can still get options? The answer is yes. The founder of many companies CEO and CTO will also take options. Of course, there are some startup founders of the CEO in order to encourage more employees, they do not take options, both are feasible.
Then there is the CTO and COO, technical director and operations director, usually 2%-5%. Still like the example of the CEO above, CTO and COO is not the founder does not directly affect the question of whether or not you can take options.
Then there is the VP vice president level, is 1-2%. General startup VP level most of the founders are not the founder, is later recruited, so often is no equity only options.
Then there is the board of directors, consultants, special core employees is generally 0.5%-1% range.
Other employees, we all basically have a number, is not more than 0.5%.
Because the example we cited in this place is the A round, the company should not have too many employees, the further back the employees that the lower.
Note that the percentage in this place is based on the company's entire existing Issued and Outstanding Stock as the denominator, not the total number of shares in the option pool, i.e., the percentage I mentioned above is based on 100%, not 20%.
3. The Maturity/Vesting Period (Vesting Schedule) is calculated this way
Just now we frequently mentioned the four-year vesting period (Vesting Schedule), but usually options (Stock Option) as well as the other two types of equity incentives in front of the Vesting Schedule (Vesting Schedule) are not a simple four years, we generally called the industry four-year term including a one-year cliff (Four Years with). Four Years with One Year Cliff)
This cliff (Cliff) is what is going on, that is, the first year to get 25%, after each month to get 1/48.
Every time I talk about this place, someone will say 1/48 of a month, then a year is not 25%? Why do you have to split it into the first year and the next three years. Note that the first year is not you stay in the company a day he gave you a day of options, but you stayed a full year when the company gave you 25% at once, if you stayed for 11 months and left, then nothing. That's why the first year is called cliffcliff. and from the second year onwards, you get 1/48 for one month in the company, so if you work for 13 months, it's 25%+1/48, which is still a big difference. You can also see from this design that the company is doing this to retain employees, so that they can get their foot in the door for a year before they think about jumping ship.
4.Why would someone not Exercise?
Many people may not understand the value of the concept of Exercise, why set up a last minute barrier to restrict someone? After waiting outside in the sun and wind for four hours for a movie ticket and being able to buy it at the same low price as four hours ago, why would someone in line not buy it? It's not a four year ordeal down the drain if you don't have the right.
Because in fact, 4 hours before the exercise price is often not very cheap, compared to the founder of the price is still expensive, usually employees of startups to get the option, do the math, to exercise the right to say, or to spend a few thousand dollars, that is also considered a sum of money, to stay to buy some what not ah. As I said earlier, the option is a private company, there is no liquidity, if you leave the company if you pay the money, exercise the right to become a shareholder, and then the company is not well run, closed down, you are the equivalent of thousands of tens of thousands of dollars for a null and void stock.
And if an employee leaves the company, often because of the company's future is not optimistic, think the company's stock will not go up, so often at this time to give up. If you look at it that way, options are not too pitiful.
When are options more useful? It is when you have been working in the company, for example, you work to the fifth year, the option also in the end of the fourth year when all the hands. At this time the company was acquired, or listed, originally 3 cents a share of now 3 dollars or even 30 dollars a share, then you will net profit, and this time there is no risk.
So if as a start-up company employees, if you are hesitant to need to exercise the option to see the company has not been what acquisition or listing signs, it is still important to weigh. After all, 4 years of dedicated work has been the sunk costs of the past, if you spend thousands of dollars that is even more can not return to the capital.
5. Option Pools in China and the U.S. Are Very Different
Here is a brief piece of trivia, that is, in the U.S. law allows companies to set aside a portion of their stock as an option pool in advance, and then slowly send it to employees. In China, however, because Chinese law does not allow the practice of setting aside shares in advance, it is more popular for Chinese startups to set up a separate limited partnership to hold 15% of the company's stock, and then gradually distribute the limited partnership's share to employees.
The Silicon Valley Legal Bible with Forty-Two Chapters, a customized legal encyclopedia for founders. I'm U.S. attorney Liu Xiaoxiao, and we'll see you next time.
