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.

Why Boston Startups need right-sized law firms.

Background Reading: Checklist for choosing a startup lawyer. 

The market for law firms that represent emerging companies (startups) can be split up into 3 categories, in order from smallest to largest: (i) solos / tiny firms, (ii) boutique firms, and (iii) large firms (BigLaw). Similarly, the overall cost of the services that law firms charge can be split up into 2 categories: (i) compensation, and (ii) everything else (overhead).

The first category of law firm costs, compensation, plays the largest role in determining the quality of service. Great lawyers, just like great developers, engineers, doctors, etc., expect to be paid well for their talent. There is no getting around that, and it sets a floor on what law firms employing talented lawyers can charge. The second category, overhead, is often related to law firm size, as discussed below.

Solos / tiny firms (1-5 lawyers) are typically the cheapest on an hourly basis, because they have so little overhead. For clients whose work does not require a lot of team coordination and scalability, they are a good fit. The problem is that higher-growth startups do require those kinds of resources, and we regularly see them run into issues like slow response times, and errors resulting from rushing, when using tiny firms. For that reason, solo and tiny firms are much better suited for “small businesses” than true startups.

BigLaw (>100 lawyers) is on the opposite end of the spectrum. The majority of what large, international law firms charge is not actually going to the lawyer you are directly working with, but to pay for the very high-cost, complex infrastructure needed to represent billion-dollar companies on IPOs, international mergers, etc. For companies on what we could call the “unicorn track” and who expect to raise very large, very fast rounds and eventually go public or have a billion-dollar valuation, this type of firm is the best fit, because any other kind of firm will not be able to scale at the level needed to manage the work.

Boutique firms (about 5-75 lawyers) represent a middle ground between tiny firms and BigLaw. Their smaller size allows them to eliminate a significant portion of the overhead that inflates the cost of BigLaw services, while serving clients that need more scalability than a tiny firm can provide.

Egan Nelson (our firm) is a high-end boutique firm. We take lawyers from top-tier BigLaw tech firms and place them on a lower overhead platform, using technology and process efficiency, to drop their rates by hundreds of dollars an hour, without changing their compensation. We also drop their annual billing requirements, to improve their quality of life; which we think makes them better lawyers. Our profile client is a startup for whom a $25MM to $250MM exit would be considered a win. For a better discussion on the philosophy behind the kinds of clients we typically represent, see Not Building a Unicorn. 

Historically, entrepreneurs in startup ecosystems have believed that if their company intended to achieve any level of scale, they needed BigLaw. Given the SaaS revolution and availability of new low-cost software/technology for running firms and collaborating among different firms, the emergence of the high-end boutique ecosystem has made that no longer the case. If you’re building a unicorn, yes, you probably still need BigLaw. But the “middle market” of startup ecosystems now has much better, more right-sized options.