Options v. Stock for early Startup employees

Additional reading:

Equity compensation is a core component of how startups recruit and retain talent. The two most common types of equity compensation at early stage are Options and Stock.

An option is the right to purchase stock at some point in the future, at an “exercise price.”

Stock, on the other hand, is a full voting security in the company, with all of the economic rights of ownership. 

The core driver of whether companies award stock or options to early hires is taxes. No one wants to have to pay the IRS tax for receiving equity, but under the broad framework of how IRS rules work for compensation, if you receive something (from your employer) worth more than you pay for it, the spread (the difference in value) is compensation, and therefore you owe taxes on it; even if you only got, in a sense, a “paper” gain.

At the very early stages of a startup, the “fair market value” (FMV) of stock is very little from an IRS perspective, because revenue is low or non-existent, and there hasn’t been much financing setting a third-party price. Issuing stock to employees is therefore fairly easy to do without a big tax hit, because the recipients can just pay the FMV of the stock; typically par value or close to it – fractions of a penny. No tax problem. 

As the company increases in value, however, having people pay the FMV is no longer feasible; it could mean having to pay thousands of dollars, or more, for the stock. This is what drives startups to switch to options.

Without getting too in the weeds, the IRS has certain “safe harbor” rules that allow employees to receive options on a tax-free basis as long as certain conditions are met, and one of those conditions is that the exercise price equals the fair market value on the date of grant. This safe harbor is the reason options are the primary form of equity compensation for post-seed stage startups; to avoid sticking recipients with a tax bill.

A company can be worth millions of dollars, but as long as its option grants have a FMV exercise price, employees receiving those options can (i) pay nothing to get the option (though they’ll need to pay to exercise it), and (ii) not owe the IRS anything for receiving the option. 

An equity incentive plan (the broad term for the legal paperwork behind “option pools”) is not a simple document. Specialized law firms and services have equity plans that have been vetted by appropriate tax counsel to ensure compliance with tax rules. Do not just pull something off of google and use it. You won’t like the long-term results.

Seed Financing Structures for Boston Startups

Background reading:

The three most common options that, from our experience as a top-tier emerging companies boutique firm, make up 95+% of seed rounds are: Equity (Preferred Stock), Convertible Notes, and SAFEs (Simple Agreement for Future Equity).

If you want a deeper dive into their pluses and minuses, read the above-linked posts. Generally speaking, stock (equity) is the most expensive and complex to do, but the main benefit is that post-closing everyone has greater certainty around ownership % and rights. The larger the round (particularly >$2MM), the more likely it is to close as a preferred stock round.

“Seed equity” is a subset of equity financing using slimmed down, highly standardized documentation that can be closed much more quickly (with lower legal fees) than a full VC-style equity round. When rounds below $1.5-2 million are to be closed as an equity round, we see Seed Equity being increasingly utilized as an option.

Aside from preferred stock described above, convertible notes and SAFEs (collectively often referred to as “convertible securities”) are the 2 dominant forms. Convertible securities are much simpler to draft (lower fees) because they defer a lot of the hard issues/negotiations to the future.  But the tradeoff is more uncertainty, and also somewhat more dilution. 

A convertible note is basically a debt (loan) instrument that, instead of actually being paid back, intends to convert into equity in the future, when a larger financing occurs; that converting financing is referred to as a “qualified financing.” It has a maturity date (typically 18 months to 3 years) that sets a deadline on the company reaching that milestone financing, or else a discussion/re-negotiation with the investors needs to happen.

SAFEs are effectively convertible notes without a maturity date; a structure invented by Y Combinator in Silicon Valley. They also convert into equity in the future, but there is no “deadline” of a maturity date, which is much more company favorable, and investor unfavorable.

recent survey of seed financing structures reveals that in California, where the volume / density of seed investment is magnitudes higher than the rest of the country, and competition among seed investors is dramatically higher, SAFEs are well on their way to becoming a dominant seed round instrument.

A key takeaway from that survey, and which I’ve emphasized several times before, is that entrepreneurs in Massachusetts, Colorado, Texas, and other ecosystems should be very careful to not assume that market conditions in their local ecosystems parallel Silicon Valley. Among convertible security seed rounds, convertible notes are far more preferred by seed investors here than SAFEs.

I don’t represent any tech investor funds, for reasons I’ve written about in How to Avoid “Captive” Company Counsel, which means I have no reason to be biased in favor of investors; and with that being said, I still think SAFEs are extraordinarily, some might say ridiculously, anti-investor and pro-company in their terms.

Convertible notes, which are the dominant convertible seed financing structure, represent a balanced trade-off. Investors get up-front stronger “pay back” protection than an equity holder would, and in exchange they get fewer voting and other rights.  Upon conversion, that stronger protection goes away, and they become stockholders.  A SAFE basically tells an investor to accept all of the downsides of convertible notes, without any of the benefits. Hope for the best.

It’s no surprise that SAFEs came from YC. Already within California, the extreme density of startup activity means competition among investors to get into top startups is more fierce, slanting the market toward companies. By being the elite of Silicon Valley at early stage, Y Combinator takes company leverage up several notches. But it’s dangerous for more “normal” companies outside of SV to take their cues from such a different environment from the one they’re operating in.

Still, as the data shows, while SAFEs are a minority structure, we still see them. But the core point here is to not get too hung up on them. We regularly see founders think they can get a SAFE closed, and then mid-way they are forced to re-do everything because a serious investor balked. Our advice is that, if you are going with convertible securities, stick to convertible notes, unless you are 100% certain that all investors you intend to raise money from will accept a SAFE.

As long as the maturity date is far off enough (2-3 years), the difference from a SAFE is minimized, and yet you’ll see far less friction from investors.

Legally Forming Your Boston Startup

Background reading:

If you are in the formation stage of your startup, here are a few key points to keep in mind to avoid legal pitfalls.

Formation/Organization and Incorporation are not the same thing. 

When you file a “Certificate of Incorporation” in Delaware, you are “incorporating” your company. It takes a few minutes, and a small filing fee, to do it. It also leaves 99% more work to do before the company is properly “organized,” including from an equity, control, and IP perspective.

When comparing offerings from different firms for organizational legal costs, pay close attention to what is actually included in their “formation package,” because it’s easy for firms to leave things out in order to appear to offer a lower price; while making you pay more later on to get everything done properly.

Don’t assume you want a “standard” Delaware C-Corp.

If you read info from Silicon Valley, you’d think 100% of tech startups are C-Corps. That’s not true. Yes, a majority are, but your particular business model and growth trajectory may make it a less obvious choice. See: More Tech Startups are LLCs. 

Be aware of fully automated options.

There are automated and safe options like Clerky, if you are comfortable with a fully template-based structure with no customization whatsoever. If keeping legal costs to an absolute minimum is a top priority, Clerky is far safer than a DIY project with Word-based templates.

Tech entrepreneurs should not use LegalZoom or Rocket Lawyer, both of which are designed for non-tech small businesses (think coffee shops), and lack much of the documentation you’ll need.

Most startups hire law firms. Hire one right-sized for what you’re building in the next 5 years.

See: Checklist for Choosing a Startup Lawyer and Why Startups hire law firms, not a lawyer.   Most startup-specialized firms have formation packages that will allow for more flexibility/customization (and guidance) than an automated formation, without incurring excessively high costs.

Why so many Boston Startups incorporate in Delaware

Background reading: Should I incorporate in my home state or in Delaware?

Why has English become a uniform standard for business language around much of the world? Because without a common language, it can be incredibly inefficient for companies doing international business to communicate. 

In the United States, Delaware has evolved to become a kind of national standard for corporate law. Having a standard used by everyone around the country streamlines deal-making, and reduces legal fees. 

A large majority of angel and VC-backed tech startups in the U.S. are incorporated in Delaware, regardless of their physical geographic location. That’s why serious startup lawyers in any U.S. state are very familiar with Delaware corporate law. 

There are of course other reasons why Delaware is preferred by so many companies and investors, much of which are explained in the above-linked post. But the main point for founders to understand is that scaling Boston startups have good reasons for starting out in Delaware.

Delaware can save you money long-term.

Given how much of the startup ecosystem is built on Delaware corporation law, all serious startup lawyers have large sets of form documents and processes built around Delaware law. Taking advantage of those forms and processes will save you legal fees.

Both in the short term and long-term, Boston founders intending to build companies looking to scale faster than a typical small business should strongly consider Delaware.

Sidenote: See also: Not Building a Unicorn for a discussion on how, while being a “startup” means going after some amount of scale, it doesn’t have to mean a Silicon Valley-style hyper growth trajectory.