Aug 30 2023
Amanda DeMatteis: Hi, Josh.
Josh Goodbaum: Hi, Amanda. What are we talking about today?
DeMatteis: Well, I saw an article in the New York Times recently called, “The Hidden Risk of Getting Paid in Stock Options.” And it really got me thinking: with all the startups that we have here in Connecticut, what do employees need to know about getting paid in stock, and how that might impact them?
Goodbaum: Yeah, it’s not uncommon for employees to be paid in stock. But it’s important for them to know that not all stock is created equal. So, let’s start with some background information.
There are basically two kinds of stock or equity. One is a grant. The other is options. A grant is, “Here, have this stock, we’re giving it to you, now you own it.” Options is “Here’s an opportunity to buy stock at some future time.” Grant = you already get it; you own the stock. Options = you have to exercise the options (by taking money out of your own pocket) in order to own the stock.
The second important distinction is between public and private companies. Public companies are the ones traded on the New York Stock Exchange or NASDAQ or other stock exchanges around the world. Private companies almost always also have stock in that they are corporations, but there’s no market for them. You can’t sell your stock once you have it. So, once you have the stock in a private company, assuming you get it, what do you do with it? The answer, usually, is just to wait.
According to recent research in the Journal of Law, Economics, and Organization, when it comes to compensation, startup employees in particular are having problems understanding their risk because they commonly respond to economically irrelevant signals and misinterpret other important signals.
Startup employees tend to be really impressed when they’re given options in particular, especially if the options are a huge number. They might receive, say, 1 million options. But the number of shares they get or the number of options they get is irrelevant unless they also know the total number of outstanding shares, right? So, are their options worth 1% of the company, or 0.000001% of the company?
And also, is the company promising that they’re not going to dilute those options or shares further? If you get in early in a startup, you might own 25% of the company. But as the company is raising more money, the company has to create more shares in order to incentivize investors to come in. And now the 25% you used to own becomes 20, then 10, and then five, and then two percent, right? That’s called dilution. And that happens all the time in the process of startups raising money.
Keep in mind also that options often have deadlines for an exercise, meaning if you separate from the company – that’s usually the triggering event for the deadline to exercise the option – you have to take money out of your own pocket to buy that stock. And once you own it, you probably can’t sell it because if it’s a private company, like almost every startup is, there’s no market to sell the stock.
So, you’ve got to take money out of your own pocket to buy stock in a company that may not be worth anything five or 10 years from now. And keep in mind also, when you take the money out of your pocket and buy the stock, that means you own the stock, and it’s a taxable event to you. And so you have to pay taxes on the stock you got, the options you got as compensation for the work you’ve done. So, although we’re not tax lawyers or accountants, there are tax implications here, and it’s important for employees to be aware of that as well.
So ultimately, what I say to my clients is, you should view the equity in a startup as essentially a lottery ticket. It’s potentially very valuable, but it’s probably no more likely to be worth anything than a lottery ticket is. The best move for employees, if at all possible, is to be paid in cash, particularly if you’re talking about a startup, particularly if you’re talking about one that remains privately owned and where you can’t liquidate the stock and turn it into something you can actually use to buy the things that you and your family need.
DeMatteis: Really great advice.
As you were talking, it got me thinking of a really famous example of this, which was turned into a major motion picture called The Social Network, where the Facebook stocks were just diluted and diluted and diluted and diminished down. And one of the founders was pretty famously cut out until, of course, he brought a lawsuit.
Which brings me to my piece of advice on this. If you are an employee that finds yourself with a proposed employment agreement or some type of stock option agreement, talk to an employment lawyer. The best time to understand what you’re signing is in the beginning, not after you’ve already signed. So, reach out to us’ we’re happy to take a look at that for you.
Really great advice, Josh, thank you so much for telling our Connecticut employees what they need to know. We’ll see you guys next time.
Posted by Garrison, Levin-Epstein, Fitzgerald & Pirrotti, P.C. in Commentary
Tagged Amanda DeMatteis, Joshua Goodbaum
