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Stock options are buggy

dotxlem profile image Dan ・10 min read

Or I believe them to be, anyway. Stock options have been on my mind, off and on, for roughly the last four years. For three-and-a-half of those years, I worked for a new startup, at which stock options were offered (and highly-touted) as one of the primary channels of compensation.

I didn't know what they were prior to working there, and in all the time since, I still haven't been able to quite figure out in what way they were ever going to be the proverbial goldmine I and others were promised.

The Context

I was hired as the first full-time software developer, and the second full-time employee. The two founders were both engineers (mechanical, not software), and to my knowledge this was their first job outside of a couple of school work-terms. As is often the story, I ended up in charge of all things software, writing a lot of the early prototype stuff by myself until we could hire more people to start doing things properly. I took care of hiring and things like that, and eventually became our Software Team Manager in an "official" capacity. After a couple of years, I quit management to focus on greenfield development. We were shipping a consumer electronics product (I'm being intentionally vague, sorry), and anyone who's shipped hardware before knows how hectic that can get at the best of times.

I was offered 0.5% of the company as stock options as compensation, plus salary. The options had the typical four-year vesting period, and were granted/started vesting (IIRC) after I'd been there for a year or so. As is startup tradition, salaries were below market, justified by the stock options which are supposed to make up for it.

In the early days, it was also because we didn't have any money. When we were able to find government grants, I could expect to be paid enough to live. I had some extra financial stress (as well as the regular kind) as I was finishing grad school full-time simultaneously, so it tended not to go as far as you'd hope. Otherwise, it was a "we'll pay you what we can afford" type of situation. Eventually, we raised some money and I got a stable salary.

We continued to raise more VC money, hired more people, and by all accounts things were going really well (and still are, I hear)!

The Golden Ticket

I grew up relatively poor in a very rural part of Canada -- I guess a lower-working-class type of thing if that helps you ¯_(ツ)_/¯. Not that I often knew. I'm extremely fortunate that my parents were 1) very, very good with making money go far and 2) that they chose to spend what I now know to be a considerable percentage of their income on a home computer in 1994/5.

Anyway, one of the things that happens when you grow up poor is that you start adult life with debt. In my case I have my student debt, as well as the consumer debt that not having money tends to bring along.

So at first brush to me, stock options sound like a pretty sweet deal. The elusive golden ticket, maybe. Ownership in a company isn't nothing, and while I had no idea how standard 0.5% was, if things go as well as you're lead to believe that can still be pretty life-changing.

Writing for Harvard Business Review, Steve Blank gives a much better (and more academic) dive into the mechanics of stock options, their history, purported benefits, and flaws. I highly recommend giving it a read! However to try and summarize, the hypothetical benefits of stock options as I understand them are as follows:

  • by giving employees some sense of ownership, they will feel more compelled to work harder & longer, and will be more aligned with the company overall
  • the employees get an opportunity to profit from the company's growth in the same manner as the other investors
  • companies can keep salaries lower, which helps come fundraising time
  • if everyone shares from the same "common stock" pool, it creates a sense of "we're all in it together", as Blank says

The Castles in the Sky

Founders like to set lofty goals for themselves and their corporate offspring. The goals for most startups these days, are ever-increasing fundraising rounds in the interest of finding oneself on an exponential growth curve. "Think about what your options will be worth when we're valued at $100M! Or $500M! Or $1B, or...", on and on, to ever increasing heights.

That's the idea, anyway. But, as pointed out in the piece by Blank, there are some issues with it.

For one, most startups just don't survive that long. Period. And this seems to be true regardless of private valuation. Employees who are compensated with stock options implicitly take on the risk that they may turn out to be worthless if the company folds (which I'll get into more further below).

For another, the stock isn't actually worth anything until a liquidity event -- essentially, some opportunity to sell the stock. This would most likely be an IPO or an acquisition, but VCs are incentivized to delay an IPO (and more and more companies are opting not to IPO at all). Escalating valuations reduce the number of possible buyers of your firm (they have to be big enough or otherwise have enough funding for the buy), if an exit by acquisition is the aim.

Then there's the vesting period. In my case, I would have been with the company for five years before all of my options vested -- all 0.5%. Most startups don't live that long, and most startup employees last even less.

Founders on the other hand, are implicitly there until the bitter end. No matter what, they are going to be there when the opportunity arises to turn either their stock, or the office furniture, into cash. So realistically speaking, vesting is a moot point for them and (in my opinion) the risk of folding kind of comes along with the title of founder.

So, what happens if you leave? Well, that's where the options bit of stock options comes into play. You'll have an opportunity (usually 60-90 days; I got 60 from date of resignation) to exercise your options. This means you can choose to purchase whichever options have vested, at whatever the grant price was -- the price at which the shares were valued when granted, not at their "real" price right now. This is usually referred to as the strike price. This is one of the primary drivers towards high-growth in companies with this model. The higher the valuation of the company, the higher the multiplier between the strike price and the real price. The multiplier between the earliest grants and a late-stage company can be pretty staggering.

However I guess this is the part that I take particular issue with (or one of them, at least). That if I dare leave and pursue other opportunities, I have to pay the company I helped build, in order to maybe get paid in the future for the work I did in the past at a discounted rate.

And of course, just because you get to pay a lower price for the shares, doesn't mean they are affordable. In my case, to purchase all of my granted shares would have cost approximately CDN$11,000.

Sorry, I don't have that lying around.

And I don't have any means to get it, because you know, I don't get paid enough to accumulate wealth.

In the end, I could only muster up $1000 for the options. An eleventh of my total allotment. But I still did the work, and the company is still running smoothly.

Of everyone I've been able to talk to about these options, founders and the lucky few who have already benefitted from them are the most enthusiastic about them. Those who already got lucky are obviously going to state that stock options are great. Of course they are! I don't blame them for seeing it that way.

However, founders are disproportionately moneyed already. Indeed, during the early days our founders lived in their parents house in an affluent neighbourhood, and occasionally drove the family Model S to work. Our other early employees seemed to mostly have other stable sources of income to fallback on as well. As an aside: I recall being surprised that both the founders and some of our first employees all already owned stocks in various public companies...something I once looked at and put back down, once I realized the minimum buy was going to be CDN$1000.

In the meantime, I enjoyed racking up more credit card debt and unpaid bills while we searched for more grants or investors. Or, if someone just forgot to run payroll.

And this is why I believe options are fundamentally buggy. They are only really tolerable if you already have some cash to float you through the hard times. If the hard times get to you, as they did to me, you are penalized.

In my case, the capped pay eventually contributed to issues at home. To seriously degraded mental health. The high workload that comes with trying to keep a startup running (so your shot at getting paid doesn't die altogether), coupled with unworkable finances, eventually lead to burnout. So I quit.

Altogether, when it's all said and done, it's hard not to feel a bit taken advantage of. Doing the hard work, and seeing so little benefit in the end, is disheartening.

Ultimately, this payment structure seems to be one that rewards ride-or-die loyalty to a risky venture, even when it might be harmful to ones career. Suppose that I didn't burn out; it's still advantageous to move about to different organizations for the sake of learning. I ended up moving to a larger company so that I could learn from others, instead of making things up myself and praying to one or more gods that it works in the end.

To add insult to injury, despite the fact that in many orgs everyone has the same kind of stock, the founders typically have more of it. A lot more. In my case, 70x more even if I bought all my stock. As it stands now, it's more like 800x. Did they take on 800x more risk? Did they do 800x more work?

No. And definitely no.

The Solutions

Steve Blank provides some solutions in the article I linked that involve tweaking the mechanics of stock options themselves, which I don't fully understand myself. It's not my area honestly.

What I do know is: employees are not founders. My hypothesis is that most people want to be valued in the present. Founders however, start a VC-backed company with the intention of making all of their money in the future. Stock options, in my opinion, are an attempt to pay employees on the same terms as founders even though the rules and motivations are different for each. This is advantageous to VCs and founders also as it helps normalize discounting employee pay in the present, on the grounds that higher pay isn't possible until the company starts performing to the investors' liking in the future.

For my part, I've been playing with different models of corporate governance and profit sharing (on paper, of course). What I think people are actually interested in is being compensated when they do well, in recognition of their efforts. When their good work results in profits. When it results in more capital being raised. Whatever good it brings or whatever value it generates. That should be turned into cash-equivalent income that employees can use today, to make them and their families better and healthier for tomorrow. Employees with greater risk tolerance can always choose to invest the extra income on their own, and there's nothing stopping you from still offering a stock option plan that employees can choose to buy into.

The reality though, is that we're likely pretty (maybe infinitely) far away from a different de facto system emerging to replace stock options. If you're someone in a similar situation as I, and you're looking at joining a very early startup that's offering a package like mine, I would stop and ask yourself if you're willing and able to adopt that extra risk in exchange for what are functionally lottery tickets.

However, you are also likely going to learn considerably more, faster, than you otherwise would at Big Software Co. The lessons learned while working at another's startup are beneficial, and if you have entrepreneurial aspirations of your own, leaving the CEO stuff to someone else for a while can give you kind of a dry-run for the real thing. Working at a startup like that for options will be a little bit like an unpaid internship at first, and they can be a great foot in the door. If you can afford it.

The Closer

I think it's worth saying, that I'm really very privileged to be in a position that lets me sit here, smoke a joint, and talk about this sort of thing at all. I know there are people out there for whom all the things I'm talking about...and I'm talking basic shit like job security or even job availability...are much harder to come by.

However, when I see a bug I need to try and fix it. This particular bug seems to come from an edge case. In this instance, the edge case is me. And feeling like a human edge-case (in engineering parlance, typically a problem not worth fixing)... doesn't feel great.

I believe the high-growth VC model doesn't work for people such as myself; people coming in with little money or support. People who don't have the benefit of prior financial literacy.

And I think if it doesn't work for me, a white cishet man, who else doesn't it work for that isn't getting to the surface? Who else is getting edge-cased? I can also think of cognitive conditions that might cause otherwise intelligent people to struggle in grasping the financial concepts required. That means you need a lawyer, which means you need money, which means... you see what I'm getting at.

Anyway, if you have a similar story you'd like to share, please do so! I'm here for venting. I'm also fine if you want to come here and tell me that I'm full of shit. Better still, if you have ideas about how we can build companies that are better, I'm all ears too!

I'll reply to email (eventually) at xlem@akkoro.io.

Finally, while researching I came across this blog post which talks about startup equity negotiation from a legal perspective. It may be useful if you are currently in that position yourself!

Cheers!

Discussion (2)

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stilldreaming1 profile image
still-dreaming-1 • Edited

Wow, I hadn't thought about the "options" part of stock options for employee compensation. That is definitely completely insane and unfair to the employees. The only way it might be somewhat fair is if all of that was explained to them in great detail yet simply, like someone sitting with them and making sure they really understand it before accepting employment, but I doubt it is typically done that way. If it is part of the employees compensation, they should not be receiving stock options, they should be receiving stock. The option to buy the stock is ridiculous. Even if you had that kind of money to buy the options at your opportunity, why would you want to spend your money on an unproven company that is trying to get acquired or go public what there are plenty of already proven and great opportunities on the stock market. Especially now with companies like Robinhood and M1 offering both no commission trading and fractional share investing, this is the best time in history for the average person to invest in the stock market. Just make a small deposit into your trading account every time you get paid, and have a plan in advance for what percentage of it will go into each stock, and use fractional shares to make that happen with each deposit.
Especially now when the giants make it hard for businesses to compete and they just keep getting bigger and bigger. So instead of trying to compete with them just buy their stock, even if you can only afford a small fraction at a time. Plus there are still amazing smaller opportunities that come up from time to time. Like everyone in tech knew Zoom was where it was at, even before Covid 19, so they shoulduld have bought shares when it first went public.
The founders are the ones that should be taking on the risk of a startup not the employees, that is the whole point of preferring being an employee rather than starting your own company. Otherwise they may as well start their own company and get to do whatever they want. As you described it, it sounds like the worst of both combinations. You still are working for someone else, have to answer to them and work on what they tell you to, but you also are taking on a lot of the risk of starting a company, plus they will probably never get to exercise their options anyway. So even if the company does become wildly successful, most of the employees will not benefit from that. That sounds like they are really just being bullies taking advantage of the naivety of the employees. In that sense it almost sounds like a shady business deal that is borderline stealing from the employees on an ethical level.

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robotrockk1408 profile image
robotrockk1408

Nice post! I got into startup equity topic recently and I like that you mentioned this option here. Also, I enjoyed learning about typical equity structure here tagsoft.co/typical-startup-equity-...