This article is a translation. Original: How Startup Options (and Ownership) Works - Andreessen Horowitz, Cover Photo by Nicholas Cappello on Unsplash

One thing that struck me most about articles on stock option plans for startup employees is that the various factors affecting the value of these stock options are difficult to understand. Even if one tries to understand them when receiving stock options initially, they often remain half-understood. Later, when leaving their first startup and trying to exercise the stock options from their original offer, they are shocked by the price or value of the entire stock option package. At this point, company founders hope to properly handle equity distribution issues with employees and investors, but the total value of equity and options owning company stock is not constant. Equity value fluctuates, and with the company’s operation, many factors may affect the value of the original stock equity and ownership.

Part of the problem is that understanding the relationship between equity and ownership is too large and complex. This is why many founders, when transferring equity, must use significant communication efforts to gain the understanding and trust of those with equity and ownership, such as the founder’s own equity, their employees’ stock options, co-founders’ equity, and their investors. Nowadays, some people with these equity resources and education provide many summaries, guides, and templates to explain how stock options and equity compensation work. So I want to share here more about how the actual economics behind startup stock options and stock ownership work.

Cap Table

Capitalization or Cap Table can reflect the relationship of all stock and equity owners of the company, including founders, employees with stock options, and company investors. For most people, it’s about understanding how much company equity power they actually possess, the number of shares they will truly be diluted by, the relationship of equity division among different classes of shareholders, and other detailed changes.

Fully Diluted Shares (as opposed to basic shares) = Sum of all existing shares + shares that could eventually be converted (options, warrants, unissued options).

Let’s look at the example we will use throughout this article. This is a new company with no external investors, and the existing stock distribution is as follows:

If someone is offered 100 stock options, these stocks will come from the option pool of 1000 above. Therefore, after receiving this option, they will own 100/10000 or 1.0% of the company’s stock capital.

But this is just the starting point of stock ownership, because the analysis of company ownership weight is limited to the situation at a certain point in the company’s operation. As the company operates, many events may cause the company’s share count to be diluted, such as issuing more options, the company being acquired, subsequent financing terms, etc., which will cause the ownership percentage of original equity to be reduced. Of course, original shareholders may also benefit from equity changes caused by the company’s operation, but changes in the numerator of equity quantity are often accompanied by changes in the denominator.

Financing History

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

• The original issue price is exactly what it means: the price per share that investors pay for company stock. This price lets us know what different investors think the company is worth at different points in time.

• The conversion price is the price per share for converting preferred stock into common stock. Remember, preferred stock is usually held by investors and has corporate governance rights and liquidation preferences that other common stock does not have.

In most cases, the conversion price will equal the original issue price. We will explain the differences later.

• The exercise price of employee stock options: the price per share required to actually own the stock.

It is usually lower than the original issue price paid by recent investors holding preferred stock. How large the value difference is depends on the company’s specific rights and overall maturity. External valuation firms will perform a so-called 409a valuation (named after a specific section of the IRS tax code) to determine the precise valuation amount.

Dilution

Dilution is a heavy word and a tricky concept. On one hand, if a company raises more funds, it will increase the number of shares and dilute the proportion of existing shares. Dilution reduces the total equity of current equity owners (including employees holding options). On the other hand, raising more funds helps the company grow and reach its potential, which may mean everyone owns slightly less but more valuable equity assets. 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 so that it can grant more options to future employees, this will also cause a certain degree of dilution to the options owned by existing employees. So the hope is that the company’s current situation is:

1. The company is currently in a positive growth mode, thereby increasing the overall value of the shares owned.
2. Meaning employees may benefit from these additional option grants.

Returning to the example introduced above, now our company has just raised venture capital. In this Series A financing, the company obtained $10 million from investors at an original issue price of $1,000 per share:

With the increase in the number of fully diluted shares due to new financing, there are now 20,000 fully diluted shares. This means that the 100 options owned by the employee account for 100/20,000 or 0.5% of the company’s total shares, no longer the 1% they owned when they first joined. However, the value of these 100 options has increased significantly because the price per share is now $1,000. The employee’s shares equal 100 shares * $1,000/share, which is $100,000.

Although not all dilution is equal, in some cases, dilution is simply dilution. Equity involves anti-dilution protections that many investors may have. The basic idea here is that if the company raises funds at a price lower than the current investor price in a future financing round, current investors can be protected by issuing more shares to avoid the impact of lower per-share financing amounts on the value of original investors’ stock. (The number of additional shares issued varies by formula.)

Most anti-dilution protections are usually called weighted average adjustments, which have a lower degree of dilution for employees because their protection for investors is milder. But there is a protection measure that does affect other shareholders - Full Ratchet. This adjusts the price paid by the previous round of investors to match the share price of the new financing round. Therefore, if the previous round investors bought 10 million shares at $2 per share, and the new round price is $1 per share, then the previous round investors will receive 2 times the number of shares to match the value of the previous round investment, meaning the previous round investors get a total of 20 million shares. This also means that the fully diluted share count increases by 10 million shares, and the value of shares owned by other shareholders without protection mechanisms (including employees) is truly diluted.

Incidentally, this is not just a theoretical situation: we saw the impact of Full Ratchet clauses on equity in the Square IPO, where additional shares were issued to Series E investors because the IPO price per share was half of the Series E investor price.

In a perfectly ideal scenario, anti-dilution protection would not come into play at all: that is, the valuation of each subsequent round of financing is higher than the previous round, because the company improves with progress and operational growth over time, and the market does not undergo dramatic changes. But if anti-dilution protection really comes into play, it causes a double whammy for share dilution:

1. Anti-dilution protection requires selling more shares, thereby increasing the denominator of fully diluted shares and reducing the share percentage.
2. Lower valuation leads to a decrease in the stock value of original equity owners.

Liquidation Preferences

Some investors may also have liquidation preferences associated with their stock. In short, liquidation preference means that in the event of a company liquidity event (such as selling the company), investors with liquidation preference can recover their original investment amount before other shareholders (including most employees with options).

To illustrate how liquidation preference works, let’s go back to the example above. Suppose the company is sold for $100 million. Our Series A investor invested $10 million and owns 50% of the shares. They have two choices: choose to use the liquidation preference to recover the originally invested $10 million, or take the stock value of their 50% share ownership ($100 million * 50% = $50 million). Obviously, the Series A investor will choose the $50 million stock value of the 50% shares which is more beneficial to them. The remaining $50 million will then be distributed among those owning common stock and options.

Because the price after the company sale is higher than the original Series A financing price, liquidation preference has no effect in this case. However, it will come into play in the following situations:

Scenario 1

If the price the company is sold for is not higher than the Liquidation Preference price, then the Series A investor will choose to use the liquidation preference instead of using the stock value of 50% shares for liquidation.

Suppose the company is sold for $15 million instead of $100 million. As shown in the table below, the Series A investor will choose to accept the $10 million liquidation preference instead of the stock value of 50% shares (50% * $15 million = $7.5 million), because this amount is lower than the liquidation preference amount. The remaining $5 million will then be distributed among those owning common stock and options.

Now let’s assume the sales price in the example is $15 million (instead of $100 million). As shown in the table below, our Series A investor will choose to accept the $10 million liquidation preference because their economic ownership (50% * $15 million = $7.5 million) is lower than their return under liquidation preference. This leaves $5 million for common stock and option holders (instead of $50 million).

Scenario 2

When a company goes through multiple rounds of financing, each round includes liquidation preferences. Liquidation preferences are at least equal to the total capital raised during the company’s lifecycle.

Therefore, if the company raised $100 million in liquidation preferred stock, and then the company is sold for $100 million, then everyone else gets nothing.

Scenario 3

Depending on the structure of the terms, there can be various liquidation preferences. So far, we have been explaining 1x non-participating preference, where investors must make a choice: take only 1x the original investment amount, or choose the larger amount based on the percentage of share ownership in the company.

But some investors require an investment return of more than 1x, for example, a 2x multiple investment return liquidation preference, meaning investors will receive a liquidation value of at least 2 times their original investment amount. This means that in addition to the return on investment, investors can earn investment returns included in their percentage of share ownership in the company, which can have a significant impact on other shareholders.

To distinguish the impact of these terms, let’s first see what happens when our Series A investor gets a 2x liquidation preference.

In the $100 million company sale scenario, the investor will still hold their 50% stake because $50 million is greater than the 2x return liquidation preference of $20 million (2 x $10 million liquidation preference).

Common stock and option holders are no worse off than if investors only had a 1x return liquidation preference.

However, if the company sells for less than $15 million, the investor will get 100% of the proceeds. Their 2x liquidation preference is still $20 million, but only $15 million is available, so the entire amount the company is sold for goes to the Series A investor. Common holders and option holders get nothing:

Finally, let’s see what happens when we have participating preferred stock, commonly known as Double Dipping.

In our $100 million sale scenario, the Series A investor not only gets the $10 million liquidation preference but also receives their proportional investment return based on their ownership percentage of the company. Therefore, the investor receives a total of $10 million (their liquidation preference) plus 50% of the remaining $90 million value, totaling $55 million. Common stock and option holders can share the remaining $45 million value:

In the case where the company sells for $15 million, common and option holders get even less. Because the Series A investor gets the $10 million liquidation preference plus 50% of the remaining $5 million earnings, totaling $12.5 million, leaving only $2.5 million for the remaining shareholders:

IPOS (Initial Public Offering)

There are many non-economic factors, such as legal, tax, and corporate governance issues, that we haven’t discussed here: such as which shareholders need to approve certain company decisions, like selling the company, raising more funds… etc. They are important considerations, but here we focus only on the economic factors in options and ownership.

However, there is one more factor worth noting because it is actually an economic issue of company management: IPO auto convert. In most cases, preferred stock investors can approve the company going public and convert their original shares into a single class of stock. Most investors owning preferred stock will win, and an IPO is a good test for the company, ensuring a 1 person / 1 vote situation, although every preferred shareholder has a voice proportional to their operating ownership in the company.

However, sometimes different investors may exercise corporate operational control disproportionate to their equity percentage. When late-stage investors worry that the company might go public too early, resulting in an inability to obtain their required investment return, the control of these late-stage investors comes into play. The company will need their approval to conduct an IPO, usually happening when the IPO price is lower than the originally expected investment return (like only a 2x-3x return).

This is a situation where a seemingly corporate governance issue becomes an economic issue. If an IPO requires investor approval, and that investor is unsatisfied with their IPO return, this control can become a backdoor way for investors to try to fight for greater investment returns. So what will they do? By demanding more shares (or lowering the conversion price of their existing preferred stock to common stock). This will increase the denominator of the fully diluted share count.

To be sure, none of this implies that late-stage investors are acting maliciously. After all, they are providing the capital and other strategic value needed for the business to grow, and hope to receive a return on capital corresponding to the risk assumed by the investment. But this is another factor to note among all other factors we outline here.

ISOS VS NON-QUALS

• ISO (Incentive Stock Options)
• NQO (Non-Qualified Stock Options)

In addition to financing and corporate governance factors that may affect the value of options, there are specific types of options that may affect economic outcomes.

Generally speaking, the most favorable type of option is the Incentive Stock Option (ISO). People using ISOs do not need to pay tax on the difference between the option price and the subsequent public market price after exercising the option (although in some cases, the Alternative Minimum Tax may come into play). Basically, ISO means startup employees can defer paying these taxes until they sell the stock. If they hold for 1 year from the date of exercise (2 years from the date of grant), they can qualify for capital gains tax treatment.

Non-Qualified Options (NQO) do not have this benefit. Regardless of whether they choose to hold the stock for the long term, they must pay tax when exercising the option. Since these taxes are calculated on the exercise date, even if the stock price falls later, employees still pay tax based on the historically higher price of the stock.

So why don’t all companies just issue ISOs? This is because there are some limits on ISOs. Only $100,000 of ISOs can be granted to employees in a year (meaning any amount over $100,000 is NQO). And ISOs must be exercised within 90 days after an employee leaves the company. As more and more companies consider extending the option exercise period from 90 days to a longer time. Companies can still issue ISOs, but under current tax laws, regardless of the company’s ISO exercise time limit, if the option is not exercised within 90 days of leaving the company, that amount will be converted to NQO.

Mergers and Acquisitions (M&A)

One of the most frequently asked questions about options is, what happens to options if a startup is acquired? Here are some possible scenarios, assuming full vesting of all options takes 4 years, but the company decides to sell itself to another company in year 2:

Scenario 1. The acquirer assumes unvested options.

This means that if someone chooses to stay with the acquirer and remain employed, their options will continue to vest according to the same schedule (although now as part of the acquirer’s equity). Seems reasonable… of course, unless they feel that being acquired was not the purpose of the original signed offer, don’t want to work for the new employer, and choose to resign, giving up the remaining two years of options.

Scenario 2. Unvested options are cancelled by the acquirer, and employees receive 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-incentivize potential new employees or align them with its overall compensation philosophy. This seems reasonable, although it is certainly different from the planned purpose of the originally agreed offer contract.

Scenario 3. Unvested options accelerate, and all options automatically belong to the employee, as if the employee had already completed their remaining two years of work.

There are two types of acceleration to note here, single trigger and double trigger acceleration:

Single Trigger

In single trigger, unvested options accelerate based on the occurrence of a single trigger event, in this case, the acquisition of the company. Therefore, regardless of whether people choose to stay with the new employer, they will receive the benefit of full vesting of original contract options.

Double Trigger

In double trigger, the occurrence of an acquisition alone is not enough to accelerate option vesting. The employee must not have a corresponding job opportunity at the new company, or it must not fully match their role at the old company.

Note, these are just general definitions. The above trigger conditions will have specific situations: whether all options accelerate or only a portion, whether specific milestones or goals are met, like a restriction of at least 1 year of tenure… etc., but we won’t discuss these here.

Unsurprisingly, acquirers don’t like single trigger accelerated options, so this situation is relatively rare, while double trigger gives acquirers a chance to retain strong talent. Nevertheless, for most people, having any of the above forms of acceleration is still a very unusual situation. These trigger conditions are usually reserved for senior executives. In acquisition scenarios, they likely will not, or actually cannot, obtain a job at the acquirer (for example, a company cannot have two CFOs), so there will be no chance for them to obtain the remaining stock options.

A simpler way to consider the impact of all these situations is that the acquirer usually has a Total Price, including upfront purchase price, assumption of existing options, new option retention plans for remaining employees, etc. The acquiring company is willing to pay these costs in the deal. But as acquisition discussions develop, how funds are ultimately distributed among these different types of payment amounts sometimes differs from the provisions of the original option plan documents.

As mentioned earlier, anything related to compensation and ownership boils down to building and guiding trust, whether through education, communication, or transparency. There is also an important S.E.C. rule applicable here: Rule 701, Exemption for Issuance of Employee Stock Options.

This rule states that for issuing up to about $5 million in options annually, the company must provide a copy of the option plan to recipients; once the company exceeds the $5 million annual limit, it must also provide a summary of the plan’s material terms, risk factors, and two years of GAAP financial statements.

This is great.

But times have changed. The 701 requirements effective in April 1999 have failed to keep up with the times. Companies are now staying private longer, so they are raising more funds, usually from new entrants to venture capital with more complex conditions. Therefore, simply reviewing a company’s financial statements for the past two years does not indicate the ultimate potential value of options. Rule 701 should be updated with the times to better reflect the information people need to understand option choices.

The good news is that if a company goes public, all the different rights of preferred shareholders mentioned above disappear because everyone’s shares convert to common stock. There may still be different classes of common stock (such as dual classes with different voting rights to protect founders driving their continued innovation), but these do not affect the value of everyone’s equity.

Startups by definition bring unpredictable results. Every startup is unique, every situation has unknown factors, and new equity changes will always change economic outcomes. Working at a startup means participating early in unproven products, meaning it may bring huge risks… and may bring huge returns.

Reference

• How Startup Options (and Ownership) Works - Andreessen Horowitz
• Compensation at Startups - Quip
• 16 Things To Know About The 409A Valuation - Andreessen Horowitz
• a16z Podcast: On Recent IPOs and Comparing Private vs. Public Valuations - Andreessen Horowitz
• How Startup Options (and Ownership) Works - Andreessen Horowitz