Startup Stock Options: How Did a Good Deal Go Bad?

One of the top posts on Hacker News yesterday made the point that stock options aren't a great deal for startup employees these days. That thesis is entirely correct and is quickly becoming conventional wisdom around Palo Alto. But I raised my eyebrows at the article's description of the cause:

VCs have intentionally changed the ~50-year-old social contract with startup employees.

I this is inaccurate or at least incomplete. VCs are providing the funding that lets companies stay private indefinitely, and that has driven down the practical value of stock options. But two other key factors that are far beyond the control of investors. One is a technical change to a the tax code; the other is the out-of-control cost of living in the Bay Area.

Let's start with the tax issue. Since the 80's, the IRS has required companies to grant options with strike prices at the "fair market value" of the shares, but initially they didn't define "fair market value." So prior to the early 2000's, startups could issue stock options (for common stock) with exercise prices dramatically below the prices paid by investors for preferred shares. The rule of thumb was to issue options with a share price of just 10% (!) of the investor price. That deal worked pretty well for both employees and the startups. Employees got options that were far more likely to actually be worth something, while companies could provide tremendous value to employees in exchange for relatively little equity. To top it off, the income from those options was frequently taxed at the (much lower) capital gains rate. The only downside of the low strike price for either party was that the company received less cash at the time of exercise, but if that happened in parallel with an acquisition or IPO, it hardly mattered.

In a series of rule changes, though, the IRS cracked down on this. This abbreviated history is interesting in a dry, "I can't believe I'm reading about the history of the tax code" kind of way. The bottom line is that employee stock options today have strike prices very similar to the share prices investors pay. That represents an over-correction. Common stock is probably worth more than 10% the value of preferred shares - which is why stock options were so valuable 20 years ago - but now we're in a world where employees at companies with "successful" exits still see their options become worthless. A company's value has to go up a lot (30%? 50%?) before a new hire's options really start capturing value.

This has huge implications for a company's compensation strategy. Holding everything except tax regulations constant, options are now worth a fraction of what they used to be. As a result, companies that give the exact same options (liquidation preferences, time to liquidity, etc) to employees now provide them with a fraction of the value. Prior to 2000, the most efficient way for a company to deploy its equity was to offer it directly to employees as compensation. Apparently in 2019, the most efficient use of equity is to sell it to investors and pay employees higher salaries with the proceeds.

Of course, the backdrop for all of this is growing Bay Area housing prices and the not-entirely-unrelated growth in engineer salaries. Options have become less valuable at precisely the same time that employees need a lot more cash just to maintain a basic standard of living. They also have better access to that cash than ever before: Facebook, Apple, and Google seem happy to pay senior engineers half a million dollars in cash + fully liquid stock. The story isn't about VCs and startups unilaterally reducing the attractiveness of options packages. It couldn't be. The hiring market in the Bay Area is really competitive; if employees wanted to take lower salaries in exchange for meaningful options packages, they'd get it. But Palantir is the only company I know of that significantly reduces cash compensation to make options (or options-like equity instruments) a core piece of compensation packages, and even they have seen employee frustration over that at times. If anyone knows of other companies that heavily weight options (as opposed to RSUs) in their compensation, I'd be curious to hear about them.

(Speaking of Palantir, the long time to IPO isn't necessarily as much as a problem as it seems. In addition to internal share buybacks, various hedge funds and secondary buyers have stepped in to fill that hole; my friends at Palantir receive constant LinkedIn messages from would-be purchasers. In Silicon Valley c.a. 1999, a company would reach a few hundred million dollars in valuation, IPO, and provide liquidity for employees. The current model seems to be that companies reach the billion dollar mark and then undergo a shadow IPO where they raise a ton of money from SoftBank and their employees start getting liquidity from private investors. It's not a perfect solution, but it's a solution.)

Even if the decline in the relevance of options isn't entirely the fault of investors and companies, they don't seem to have done much to fight against it. Investors get byzantine liquidity preferences that make it hard for employees to understand the value of their shares. 90-day exercise windows create cash crunches for employees who leave even if they're fully vested. What I find particularly grating is founders arranging to sell their own shares as part of funding rounds while denying employees that same opportunity. Liquidity is a real problem; I have exactly no idea what to do with the shares I own from my last company. The original article's suggestions seem like they would help. Specifically, more companies should grant RSUs and provide employees with chances to sell vested shares. I don't know if that can perfectly recreate the upside-oriented alignment of incentives generated by stock options 20 years ago. But it would be a start.

Again - the collapsing value of options is a huge problem for Silicon Valley startups. My one sentence version of economics is "people respond to incentives", and options have historically done a great job of aligning incentives. If the changes to the tax code mean that options can't play that role anymore, then Sand Hill Road had better come up with something that can.