Podcast

Equity at startups – what does it all mean? (Zac Henderson & Michael Mizrahi)

Episode introduction

Show Notes

Lots of words get thrown around in the startup world: angel investors, runway, venture-backed, and more. In this episode, Levels Head of Operations, Michael Mizrahi, and Head of Legal, Zac Henderson, sat down to discuss the technical intricacies of a monetary concept that relates to employees: equity. In this episode they cover what it is, how it works, and the value behind it.

Key Takeaways

04:43 – What is equity ownership?

People that work for venture-backed startups tend to get equity as a form of compensation.

Equity is just ownership. So when you think about how you get paid in the non-startup context, you’re getting paid, usually, cash for work. If you do it especially well there might be a bonus at the end of the year, something like that, but you pretty much know the value of your compensation package on day one and chances are it’s not going to change down the road. That’s not a great fit for a startup company that maybe doesn’t have a whole lot of cash to spend but is looking to grow. Often, relatively quickly. In that context, equity is a great way to compensate employees because by giving them a piece of ownership in exchange for work they have. And by they, I mean the employee, has the opportunity to benefit from the upside of the company’s growth. So that’s the short answer, equity is actual ownership of the company.

05:51 – How public companies are valued and owned

In the public markets, companies are on the stock market, and anyone can buy and sell shares.

It can get pretty complicated, but on the public market, the simplest way to think about it is a public company is publicly traded. That means anybody with access to the public markets, you, me, anyone else, can actually own shares in that company. And the value of the public company really comes down to what people, like you and me, decide the value is. So if today, the shares of a public company is $20 a share and you are like, hey, that’s a good price. I’ll buy it at $20 a share. Then you’re declaring, or a large number of people are declaring, that the value of this company is $20 a share times how ever many shares there are. The share price will go up or down, depending upon how much interest there is in buying those shares or how much interest there is in selling. So that’s how value more or less works for a public company.

08:20 – Private companies have disclosure requirements

The shares of a public company are traded on a stock exchange, while private companies are not. The main difference is in terms of SEC required disclosures.

The core differences between how private companies and public companies work in terms of equity and company ownership, it can get complicated, but one of the main reasons why it’s more complicated has to do with the disclosure requirements that the Securities and Exchange Commission require for public companies versus for private companies. I won’t get into this too much, but basically if you are a big public company, the Securities Exchange Commission expects for you to be very public about your financial situation, because investment is open to basically everyone. So there are lots of rules forcing a lot of disclosure, but that’s really expensive and really difficult. Many small companies simply don’t have the resources and employee power to publish quarterly or more frequent reports detailing all of their internal financials and maybe a private company isn’t in a position where they even can do that just yet so regulations are trickier.

10:39 – The vesting process

One of the most exciting aspects of joining a startup is getting stock options. It gives you ownership in the company and aligns incentives between management and employees.

Vesting is the process by which your equity grant becomes formally and totally yours over a period of time. So think of it this way, this company wants to pay you an equity, but they don’t want for you to get your shares, and then one week later you end up leaving. And maybe your weekly salary, you only collected one paycheck. But gosh, now you have those 1,000 shares of equity. What’s going on there? Well, vesting is what ensures that is given to you at a pace that aligns with some period of time. So four-year vesting means those shares will become formally and totally yours over that four-year period of time. Miz, you used another word you said, I think, one-year cliff. So the way that most equity packages work at startup is equity is given over a four-year period with what’s called a one-year cliff. And what that basically means is for the first year, none of your equity vests each month, but once 12 months hit you hit a cliff and your past 12 months, which is to say your first year of equity, immediately vests at that point.

14:44 – The two types of stock options

Zac says that incentive stock options are the most common, followed by non-qualified stock options. They are similar except for the tax implications.

There are different implications for these different forms of equity. So let’s start with incentive stock options. The reason why I think we should start there is far and away this is the most common way that startup employees receive equity. So there are two kinds of options that an employee might encounter. There are incentive stock options. Those are the most common. And there are what are called non-qualified stock options. Basically, incentive stock options are only available to a company’s employees and they have some pretty distinct tax benefits. Non-qualified stock options are the kinds of options that can be given to others, for example, consultants, or just other folks involved with the company, and they functionally operate the same as any old option, but their tax implications are different. And I think like you mentioned earlier, we’re not going to go all the way down the taxes rabbit hole today, but those are some things worth looking into.

20:26 – The advantages of ISOs

You are not taxed on ISOs until you actually sell the underlying shares.

This is one of the advantages of ISOs. As opposed to non-qualified style options, where it’s basically, as soon as you see a value increase between your strike price and the actual value of the underlying shares. With non-qualified stock options, as soon as you see that you start to owe taxes in that year. It can be really tough. But with ISOs, you really aren’t going to owe taxes until you actually sell the underlying shares. So just exercising your options is not a taxable event. Once you actually sell the underlying shares, that’s a taxable event. Now, quick qualify it here. There’s something called the alternative minimum tax that affects some but not everyone, and it’s created a lot of problems for employees even just exercising their options. So this is why it’s still always a good idea to just quickly run your situation by a CPA before you exercise your options. In theory, it should be as simple as you exercise and you don’t taxes on ISOs until you actually sell the underlying shares.

33:18 – How companies use crowdfunding

The SEC recently chose to expand regulation crowdfunding, which has big implications for startups.

Public companies are permitted by the SEC to put their shares out on the public market, mainly because the SEC feels comfortable. They have forced those companies to be very, very, very transparent, but the SEC doesn’t force private companies to go through all of that rigmarole and produce documents all of the time and make all of these filings and disclosures. And so because private companies are able to keep their information pretty close to their chest, the SEC’s put limits on what they can do. If a private company wants to raise money, then they have to turn to the SEC and one of the SEC’s investment exceptions. So traditionally, the main ways that investors have invested in private companies is through what’s called Regulation D and basically, this is an exception that the SEC has created to let really high net worth people who ostensibly have a lot of financial savvy to invest in private companies. And so Levels did recently work with a company called Wefunder. And we actually raised five million dollars from our members in something like five and a half hours. So we had a whole lot of interest and it was pretty exciting, but basically this is a really neat development, especially through a company that is so transparent by its nature, like Levels. It’s a pretty cool way for us to confidently get our members involved in just a really good faith way. So hats off to the SEC.

38:10 – Fair market value

Fair market value is the price of an asset when buyer and seller have reasonable knowledge of the asset and are willing to trade without pressure.

There’s a concept in economics generally, and it certainly purveys the startup world called the fair market value, right? And the fair market value is, in many contexts, it’s kind of like a range. It’s a number that’s if a thing sold for that price, a reasonable person would agree, hey, that was roughly a fair price. It might be $3. It might be $10, but if it’s $3 or $10, it’s certainly not a $1,000 dollars. That wouldn’t be fair, if $3 and $10 are also fair. If that makes sense. So when we think about the strike price, that relates to our common stock, right? And as you can imagine, common stock is going to be less valuable than preferred stock because preferred stock has these extra bells and whistles, right? So the fair market value for your common stock is going to be your strike price.

46:03- The role of pro-rata

Pro-rata can be valuable for major investors, allowing them to maintain a percentage of ownership in a company as it grows.

That’s an anti-delusion term. Specifically, that’s a pro-rata right. It’s a right that certain, usually, very prominent or your investors negotiate where in the event that there’s a new fundraising round of some sort, they’re really interested in keeping their percentage ownership. And so they ask for a contractual right to basically be a part of that next round, such that they can buy up to their current percentage. So if they own 20 percent right now, and new round comes along, they want to be able to make sure that they keep that 20 percent. And they do that by being permitted to buy shares in the new round to maintain that. And this makes sense, usually, this is going to occur for major investors that want to maintain voting rights or a sort of a prominent position on the cap table. Because you can imagine maybe you have voting rights today, but if you don’t maintain your percentage ownership, maybe you don’t have voting rights tomorrow. So pro-rata can be pretty valuable for major investors.

Episode Transcript

Zac Henderson (00:06):

Pretty recently, the SEC has decided that it wants to open things up a little bit more. And so it has allowed something called regulation crowdfunding, which has been around for a while, they’ve allowed it to expand. So now, private companies can raise up to about five million from everyday people, regardless, whether they’re an accredited investor or not, so long as there are just some income tiers in place. So if you make a certain amount of money, you can invest up to a certain amount. And so Levels did recently work with a company called Wefunder, and we actually raised five million from our members in something like five and a half hours, so we had a whole lot of interest and it was pretty exciting. But basically this is a really neat development, especially through a company that is so transparent by its nature, like Levels. It’s a pretty cool way for us to confidently get our members just a really good faith way. So hats off to the SEC.

Ben Grynol (01:04):

Here at Levels, we’re building tech that helps people to understand their metabolic health and this is your front row seat to everything we do. This is a whole new level.

Ben Grynol (01:34):

Hey listeners, Ben [Grynol 00:01:35] here, part of the early startup team at Levels. A few weeks ago, we decided to undertake an equity, crowdfunding campaign. What is that? Well, it’s when you tap into the community. It’s when you offer people in the general public, the opportunity to invest in a company at an early stage. And so as part of our series A, the latest fundraising round that we’re doing, we decided to carve out some room in the round for general members, for people in the community to participate, to be involved in what we’re doing. And it’s something that is sometimes technical. These questions are natural. We get them often too, as all of our early team members, well, they have equity as part of their compensation at Levels. And questions come up around, what is equity? How does it work? What is a strike price? What is vesting? What a one year cliff? These are all words that can be pretty confusing and make equity seem convoluted. And that’s not something that we want to have. We always want things to be transparent. We want to make sure that people understand what it means.

Ben Grynol (02:36):

What the value of equity is and why they would want it as part of their compensation or from a community perspective, why would community members want to invest in a company at an early stage? How can they get liquidity? Well, Zach Henderson, Head of Legal, and Michael Mizrahi, [Miz 00:02:53], Head of Operations, the two of them sat down to discuss everything further, to give more insight around some of these mysteries around the idea of equity. They deconstructed everything in pretty deep detail.

Michael Mizrahi (03:09):

We’re going to talk about equity ownership in a company. So employee equity, all the terminology that you might have heard thrown around, exercising, vesting, 409A, strike prices, options, awards, grants, acceleration, liquidity. It can be a confusing world. There’s a lot of competing resources out there. A lot of SEO optimized blog posts that aren’t particularly helpful, but a lot of great resources as well. We just want to do something specific for the Levels startup context for current employees for perspective candidates that are considering offers from Levels or from other startups, as just a resource to explain our philosophy on this, break down some of the terminology and just explain and add more helpfulness to the space. Which can be overwhelming from the surface, but once you get into the details ends up making a ton of sense.

Michael Mizrahi (03:57):

Worth adding this is not tax or personal finance advice. Everyone’s situation is different and so we encourage you to seek out help where you might need it, not to take anything that you’re hearing here as professional advice, and don’t make any really important decisions based on what you’re hearing here definitely do your homework and research on your own. So it’s a little disclaimer there. But otherwise I think we’re ready to get started. Should we hop into it Zac?

Zac Henderson (04:19):

Yeah, let’s go for it.

Michael Mizrahi (04:21):

Cool. We’ll try to keep this as basic as possible. People in startups that work for tech companies for venture backed companies—we need to define that at some point—tend to get equity as a form of compensation. So instead of just getting a salary, a paycheck, along with some benefits, like health insurance or a 401k plan, they also get a chance to get equity in the company. What does that mean?

Zac Henderson (04:43):

Yeah. So equity is just ownership. So when you think about how you get paid in the non startup context, you’re getting paid, usually, cash for work. If you do it especially well there might be a bonus at the end of the year, something like that, but you pretty much know the value of your compensation package on day one and chances are it’s not going to change down the road. That’s not a great fit for a startup company that maybe doesn’t have a whole lot of cash to spend but is looking to grow. Often, relatively quickly. In that context, equity is a great way to compensate employees because by giving them a piece of ownership in exchange for work they have… And by they, I mean the employee, has the opportunity to benefit from the upside of the company’s growth. So that’s the short answer, equity is actual ownership of the company.

Michael Mizrahi (05:37):

And so companies are owned how? If we think about this in the public sector, you have companies… In the public markets, rather. You have companies that are on the stock market. What are the basics of how that company is valued and how the company is owned?

Zac Henderson (05:51):

Yeah. It can get pretty complicated, but on the public market, the simplest way to think about it is a public company is publicly traded. That means anybody with access to the public markets, you, me, anyone else, can actually own shares in that company. And the value of the public company really comes down to what people, like you and me, decide the value is. So if today, the shares of a public company is $20 a share and you are like, hey, that’s a good price. I’ll buy it at $20 a share. Then you’re declaring, or a large number of people are declaring, that the value of this company is $20 a share times how ever many shares there are. The share price will go up or down, depending upon how much interest there is in buying those shares or how much interest there is in selling. So that’s how value more or less works for a public company.

Michael Mizrahi (06:48):

So that sounds pretty similar to how it works in a private company, right? There’s X number of shares in the company. This one has some value, the only difference being… And maybe I’ll simplifying this, is that access to buy those shares in the private market are a little bit different and they’re regulated in different ways, right? So I can’t just open up my Robinhood app as a public consumer and buy shares, retail, quote, unquote, in Levels. I have to have access to get those shares. But this is where it starts to get tricky, so if I’m starting as an employee or even… We have investors that buy shares in the company with the hope that the company value will go up over time and they’ll make money. As employees, we have the option to own some of the company too. And there’s a bunch of reasons to do this. You touched on some of them. One part of it is that companies at an early stage don’t have as much cash as they do equity to offer. Right?

Michael Mizrahi (07:40):

And so if we’re trying to preserve the company’s runway, we have two years left of cash, paying someone a much higher salary is going to eat into our runway. And so we won’t be able to last as long if we need to stretch it on the edges, but we do have equity to offer. We have pieces of the company that we can give away that don’t actually cost us money and don’t impact our ability in the long term to run the company. So why is it more complicated than in the private space for employee equity? Why can’t you just say, here’s a bunch of shares that you have the right to buy or maybe you do? Yeah. I’ll stop there. How does that work?

Zac Henderson (08:17):

Yeah.

Michael Mizrahi (08:18):

The employee getting an offer that includes equity?

Zac Henderson (08:20):

Yeah. The core differences between how private companies and public companies work in terms of equity and company ownership, it can get complicated, but one of the main reasons why it’s more complicated has to do with the disclosure requirements that the Securities and Exchange Commission require for public companies versus for private companies. I won’t get into this too much, but basically if you are a big public company, the Securities Exchange Commission expects for you to be very public about your financial situation, because investment is open to basically everyone. So there are lots of rules forcing a lot of disclosure, but that’s really expensive and really difficult. Many small companies simply don’t have the resources and employee power to publish quarterly or more frequent reports detailing all of their internal financials and maybe a private company isn’t in a position where they even can do that just yet so regulations are trickier.

Zac Henderson (09:22):

Private companies—trying to touch on another one of your questions. When it comes to how a private company sort of values itself, it really comes down to what it believes its growth trajectory is going to look like. And whether its outside investors believe that it will grow at that pace, grow at a faster pace, or grow at a slower pace, but really particular large investors are typically the source of the valuation of a private company. Did I answer all your questions there or was there one I might have missed?

Michael Mizrahi (09:56):

Kind of. No. I think you touched on it broadly, but let’s get into the specifics. So I’m an employee and I have an offer on the table from X company for a 100,000 dollars in salary a year, and that’s paid biweekly, so it’s a standard salary, and then I have an option for a 1,000 shares over four years. I have a four year vesting plan for a 1,000 shares with a one year cliff and my strike price is $2. Okay. So, whoa. That’s already a lot. Yeah. So I have a offer for equity in the form of… Some form, we can get into that. Let’s start with the four year vesting with the one year cliff. What’s going on here?

Zac Henderson (10:34):

Yeah. So that right out the gate sounds complicated, lots of words we aren’t familiar with. So vesting let’s talk about what that means first. Vesting is the process by which your equity grant becomes formally and totally yours over a period of time. So think of it this way, this company wants to pay you an equity, but they don’t want for you to join, get your shares, and then one week later you end up leaving and… maybe your weekly salary, you only collected one paycheck for. But gosh, now you have those 1,000 shares of equity. What’s going on there? Well, vesting is what ensures that is given to you at a pace that aligns with some period of time. So four year vesting means those shares will become formally and totally yours over that four year period of time. Miz, you used another word you said, I think, one year cliff. So the way that most equity packages work at startup is equity is given over a four year period with what’s called a one year cliff.

Zac Henderson (11:38):

And what that basically means is for the first year, none of your equity vests each month, but once 12 months hit you hit a cliff and your past 12 months, which is to say your first year of equity, immediately vests at that point. So you can think about what are the incentives here? This is a way to really motivate new hires, to stay for at least one year. And once they hit that one year cliff mark, at that point, typically their equity starts vesting each month. So if you consider… You have a four year package, your first 12 months vests at the one year cliff, then you have 36 months and one thirty-sixth of that 36 months left will vest every single month. That’s how that works.

Michael Mizrahi (12:25):

Got it. That makes sense. So if I take a position, I have a 1,000 chairs granted to me, and I decide that the roles not a fit and I leave at the 11th month mark. I’ve got my salary for the past 11 months, but I don’t have any equity. I’m walking away before I’ve reached the cliff and so I’m empty-handed in terms of equity in that case. If I leave in month 13, I’ve got… Or let’s simplify it, like after the one year mark, I’ve got 25 percent of that equity now belongs to me. I own it. I can leave the company and it comes with me. I think it’s worth adding here that this is the standard format is the four year 25 percent each year, one thirty-sixth after the first year. But there are companies that do this differently, right?

Michael Mizrahi (13:06):

And so I’ve seen environments where there’s a one year cliff, but you only invest 10 percent the first year, 20 percent the second year, 30 percent the third year, 40 percent the fourth year. So 10, 20, 30, 40 in kind of a ladder and it only vests let’s say on the annual basis. And so if you leave at the year and 11 month mark, you’ll still only have the first year of vesting, so there’s only annual vesting, not monthly vesting. So there are differences here. Some of these set up with different incentive structures and different amounts of like employee friendliness versus optimizing for other things. The example we’re using here isn’t necessarily the standard, but it is pretty commonplace.

Zac Henderson (13:44):

Yeah, exactly.

Michael Mizrahi (13:45):

Let’s back up already because we’ve already gotten into a world where I own equity after the one year mark, but there’s different ways of a company granting equity for a bunch of different reasons, right? Some to terms I’ve heard thrown around, there’s options. So there’s equity [crosstalk 00:13:59]… So equity as an umbrella term. There’s equity grants. So this is where we’re granting the equity and we can grant it in different ways and some of the basic ones. So we have ISOs, incentive stock options. I’ve heard RSAs, restricted stock awards. I heard RSUs, restricted stock units and there’s a whole bunch more. So I guess between those three, let’s start there, options, awards, and units. What’s the most common? And what’s the difference between them and why do these exist? Like if you’re giving me shares in a company, why can’t you just give me the shares in the company?

Zac Henderson (14:32):

Great questions. And this really is some of the most important stuff and we’ll circle back because this definitely dovetails with the idea of vesting and what happens when you leave a company, because as it turns out, there are different implications for these different forms of equity. So let’s start with incentive stock options. The reason why I think we should start there is far and away this is the most common way that startup employees receive equity. So there are two kinds of options that an employee might encounter. There are incentive stock options. Those are the most common. And there are what are called non-qualified stock options. Basically, incentive stock options are only available to a company’s employees and they have some pretty distinct tax benefits. Non-qualified stock options are the kinds of options that can be given to others, for example, consultants, or just other folks involved with the company, and they functionally operate the same as any old option, but their tax implications are different. And I think like you mentioned earlier, we’re not going to go all the way down the taxes rabbit hole today, but those are some things worth looking into.

Zac Henderson (15:43):

So what is an option in the first place? Well, what an option is it’s basically a right for you buy a stock at a fixed particular price, even if the value of that underlying stock increases in the future. So let’s say you are issued 1000 incentive stock options, 1000 ISOs, and the strike price, which is to say the value at the time of grant, of those ISOs is let’s say 10 sets, right? Really reasonable. You can imagine that maybe the strike price is extremely low in a very early startup, right? So you’ve gotten into the startup fairly early, as a part of your equity package you’ve received 1000 stock options. Cool. Let’s say three years down the road, you are ready to actually buy your stock options and own the underlying stock. Well, let’s say maybe the price of the stock has got up to $10. So you went from 10 cents a share, now you’re up to $10 a share. The cool thing about the stock option is you get to buy those shares at the 10 cents per share strike price.

Zac Henderson (16:54):

You have the option to do so, which is why we call them options. So we [crosstalk 00:16:58].

Michael Mizrahi (16:58):

I don’t have to buy those, right? So if I start, and let’s say, I don’t have the cash on hand, or I want to wait to see how this is going to play out I’m not sure if the company’s value will absolutely be there. I have an option to buy the shares at the strike price that’s written down at the time, which was 10 cents, and I can buy that forever? Does that expire at some point? If I leave the company, can I still buy those? How does that work and what are the terms of that contract where we’ve agreed that I could buy these if I wanted them?

Zac Henderson (17:27):

So the specific terms are going to depend upon the stock purchase agreements that you entered into when you joined your company, as well as the equity incentive plan. So we can’t talk to specifics, but usually, you have the right to exercise… And exercise just means to buy those options. You have the right to exercise so long as you’re an employee, and for ISOs, for about three months after you’ve left the company. And that can be tricky, obviously. It’s one of the down sides of ISOs is unlike non-qualified stock options, where maybe you have a lot more time after you leave the company to exercise size your options and buy the underlying shares, you only have three months to do it after you leave the company with ISOs. So you really have to be prepared to be able to exercise.

Zac Henderson (18:17):

And again, there are some tricky tax options when it comes to exercise that you definitely want to be aware of. So for anyone listening to this if you have options and you’re thinking about what to do there, it’s definitely worth some time to do some independent research and to speak to a CPA to figure out exactly what it would look like for you if you were to exercise.

Michael Mizrahi (18:37):

Cool. So let’s even go a little bit back on that one.

Zac Henderson (18:40):

Mm-hmm (affirmative).

Michael Mizrahi (18:41):

And for simplicity, I’m exercising at the strike price. So my exercise price, my strike price, those are the same, right?

Zac Henderson (18:48):

That’s right.

Michael Mizrahi (18:48):

Great. That makes it easier. So let’s use that example we had where I was given the option to buy a 1,000 shares at 10 cents each, and I don’t do it on day one. Let’s say I do it on year three where these shares are now worth $10 a piece instead of 10 cents a piece. I can still buy them for 10 cents a piece. Why does the $10 value matter and what’s the implication of that amount being different? What if they were still worth 10 cents three years later and I bought them at that point in time. Is there a difference there?

Zac Henderson (19:20):

It’s a great question. This comes down really to the idea behind an option in the first place, right? An option is a right to buy shares and if the share price were to go down in the future, you wouldn’t want to exercise your option, right? Let’s say you’re at this company, you start off the 10 cents a share, and it goes down to five cents a share. Do you want to exercise? Probably not, because then you’re paying 10 cents a share to own something that’s only worth five cents a share. You’re throwing some money away. So why would you want to exercise? You’d want to exercise if the value goes up. You really want a piece of the $10 a share ownership. That’s a really good deal, right? Your company just went up a 100 X in that scenario. So let’s say you exercise those 1000 options. Now, you own a 1,000 shares at $10 a share. So obviously, you now own some real equity and there’s a lot of the value there. That’s why you would want to exercise and why you would choose to.

Michael Mizrahi (20:17):

Got it. My spidey senses are tingling because if there’s a lot of value there and I paid less for what they’re worth, sounds like I owe some taxes.

Zac Henderson (20:25):

Yes. So this is one of the advantages of ISOs. As opposed to non-qualified style options, where it’s basically, as soon as you see a value increase between your strike price and the actual value of the underlying shares. With non-qualified stock options, as soon as you see that you start to owe taxes in that year. It can be really tough. But with ISOs, you really aren’t going to owe taxes until you actually sell the underlying shares. So just exercising your options is not a taxable event. Once you actually sell the underlying shares, that’s a taxable event. Now, quick qualify it here. There’s something called the alternative minimum tax that affects some but not everyone, and it’s created a lot of problems for employees even just exercising their options. So this is why it’s still always a good idea to just quickly run your situation by a CPA before you exercise your options. In theory, it should be as simple as you exercise and you don’t taxes on ISOs until you actually sell the underlying shares.

Michael Mizrahi (21:31):

Got it. But I’ve heard about something else… Which is probably a familiar phrase to people listening to this. I’ve heard about an 83(b) election with the IRS.

Zac Henderson (21:38):

Mm-hmm (affirmative).

Michael Mizrahi (21:39):

And so people say, as soon as you get your shares or as soon as you exercise your shares… Let’s figure out which one it is there… You should file an 83(b) election. What is an 83(b) election? What am I electing to do here and why does the timing of it matter?

Zac Henderson (21:53):

Yeah. So the 83(b) election is… The way I like to think of it is it’s kind of a cool deal that the IRS is making with people who own shares. And so the idea is this, once you have exercised your option, now, you own some shares. What happens if the value of those shares increases from here before you sell them? Because remember a second ago, I said, hey, you’re on the clear. You don’t owe taxes until you actually sell. Well, what happens if that $10 a share stock two years from now, when you’re running to sell, goes up to a 100 dollars a share? So now, you have a 1,000 shares at a 100 dollars a share. One good for you but two, you really are going to have a tax burden when you sell. So what the 83(b) election enables you to do is you basically declare to the IRS, hey, IRS. I would actually really like to go ahead and pay my taxes right now on my 1000 shares, $10 a share. Why would you want to do that?

Zac Henderson (22:56):

Well, maybe you really believe this company is going to keep growing. It is going to be worth a 100 dollars a share down the road and the IRS basically makes you a deal. They say, cool. You can elect to go ahead and pay your taxes up front. What does the IRS going to out of that? They get guaranteed tax dollars. But in exchange, if instead of going up to a 100 dollars, your 1000 shares goes down in value… Let’s say it goes down to a dollar a share. The company just completely goes under. The IRS says, not so fast. I know you pay taxes on that already, but we’re going to keep it. We let you gamble a little bit and you gamble by paying your taxes up front, but if it doesn’t work out, that’s on you. So that’s an 83(b) election. It’s a usually great tool to let us pay taxes now instead of later, when they might be higher. But if you don’t believe in the company, you don’t want to exercise your options and you probably don’t want to do an 83(b).

Michael Mizrahi (23:47):

Yeah. So you have some calculations to make here on where your tolerance is, what your financial situation is, what you believe about the company and its future prospects. And I think it’s also worth mentioning, there’s a phrase here that’s thrown in often around early exercising. So that plays a role into 83(b)s. And so to break that down a little bit, we spoke about earlier how if you’re granted a 1,000 shares and they vest on a four year schedule with a one year cliff. So you don’t own any of those, or even the option to own any of those until your one year cliff, but the company may allow you to early exercise those options generally around the six month mark, but it depends on the company specific.

Michael Mizrahi (24:27):

At that six month mark, you can essentially exercise the options that you don’t yet own and pay taxes on them as well as part of the 83(b) election. So it’s understandable why that’s confusing, you’re paying taxes and something you don’t own that haven’t vested, but you’re locking in some of that early money to the IRS and benefit for you, hopefully. Did I get that right?

Zac Henderson (24:48):

Yeah. You did. And to break that down just a little bit, remember when we were talking about vesting? Here we are talking about exercising your options, but the whole point to vesting with options is you’re not actually allowed to exercise your options until they vested. Right? So go back to that example you gave earlier where we have four years vesting with a one year cliff and let’s say you received options. In that world you’d have to wait until 12 months before you could exercise at all. So early exercises where the company basically says, we recognize there are advantages to you to let you exercise early. There’s still not yours. You still have to wait for the full vesting period to go through, but because we see the value in early exercising so that you can do this 83(b) thing, we will let you exercise early, but the vesting clock still continues as normal. And that’s a little confusing. Miz, this might be a good time to just distinguish ISOs from a restricted stock awards, which are sort of just shares themselves,

Michael Mizrahi (25:51):

Which are not restricted stock units, RSUs. These are restricted stock awards. Sure. So what is an RSA? What is a stock award? And why does it exist and why is it discreet from a stock option?

Zac Henderson (26:02):

Yeah, for sure. So you usually will see restricted stock awards in the very earliest time within a company, and frankly, it’s often only the founders and maybe a few key employees who are granted RSAs. The simple way to think of a restricted stock award is it’s just actual ownership. It’s just actual shares with some restrictions, and those restrictions are typically restrictions on how you can sell those shares. They’re restricted. You’re not allowed to sell them to just anyone. Usually, the company reserves some right to buy them back, that kind of thing. So if you are granted a restricted stock award, then chances are you’re filing an 83(b) right away, just like you would if you’re granted options and you exercise those options. One way to think about it is when you exercise your options, in most cases, you’re functionally turning your option into an RSA or into a restricted share. That’s a sort of a practical way to think…

Michael Mizrahi (27:01):

Got it. So the awards of skips the step where I actually have to buy the option. Why don’t all companies do this? That seems much more straightforward. Why is it restricted to early employees or founders?

Zac Henderson (27:13):

Yeah, it’s a great question. And as with all of these things, most of it comes down to the taxes get complicated and expensive. So think of it this way, a restricted stock… We’ll just call them RSAs has an actual value and very early in the company, the value is probably extremely low. So if you’re a couple of founders and you have an idea and you found your company, the value of your shares will be absolutely negligible, think .000001 dollars. Right? So if you issue yourself one million shares at .000001 dollars, that still probably is like 10 bucks or something like that. Tax implications, very minimum. So early on you see a lot of RSAs. On the other hand, let’s go to a world where maybe a company’s stock has a fair market value of even just $1 a share. If someone receives 10,000 RSAs at $1 a share, then you have functionally received a $100,000 bonus that they have to pay taxes on.

Zac Henderson (28:18):

And remember, these are restricted shares. You probably can’t sell them. So you might think, oh great. I got my shares and I’ll just sell some of them to pay the taxes. That might actually not be possible. So it’s very common that someone receiving RSAs has to come up with cold, hard cash to pay what amounts to a tax box. So that’s why we don’t see RSAs too much in the startup context.

Michael Mizrahi (28:42):

Got it. Something that’s helpful that I think confused me earlier on that might be confusing for other folks is there’s a few different points at which you pay taxes and it’s best just to think of this as like a physical item. And so you pay sales tax when you buy the thing. And then, [crosstalk 00:28:59] you were to sell the thing, legally, you would also pay sales tax when you sell the shares. And so you’re taxed at both ends on every transaction when you acquire something and when you sell something. The point at which we’re talking about tax implications exist on both sides, both when… We’re more specifically talking about the acquisition side of the asset in this case, but it also applies when you sell those shares in the future when you can even sell those shares.

Michael Mizrahi (29:24):

And most of the cases we’re talking about here, these are restricted. These are private companies. You can’t just sell them, even if they are vested. There’s a lot of terms around that. So maybe [crosstalk 00:29:33] fast forward and roll the tape to a point where you could sell these shares. What are the conditions where I would be able to sell shares that I own in a private company?

Zac Henderson (29:42):

So your options for selling shares that you own in a private company are frankly generally pretty limited. And the company itself is going to have a fair bit of control over that. So the most common way that you can experience liquidity… And liquidity is just the ability to sell your shares in exchange for money. The most common ways to experience liquidity as an owner of shares in a private company is when the company undergoes maybe an acquisition, so some other company purchases it, or when the company goes public. And you can see why going public might create liquidity, because at that point, your shares are going to transition from being companies in a privately held company to companies in a publicly held company. So at some point you’re just going to be an owner of shares in a publicly held company. And so you can sell and buy and trade on the general market, just like anyone else.

Zac Henderson (30:38):

Without those options, you’re pretty limited. It’s possible that the company will do something like a secondary sale, which is basically a way for the company to either enable employees, for example, to sell some percentage or amount of their shares to private investors, to sell to other people. Or very commonly, maybe the company actually is interested in buying back some of its shares. So instead of saying, hey, you all can sell up to 20 percent or whatever of your ownership to these interested private investors, maybe the company says, hey, we’re actually looking to buy back some of our shares. So we’ll buy back 20,000 of your shares or something like that. Those are the ways that you could experience liquidity as an owner of private shares.

Michael Mizrahi (31:24):

Got it. And some other terms that I think are worth throwing out here that go into this bucket, you might hear the term buyback, you might hear the term a tender offer. The company’s holding a tender offer to transfer those shares to another owner. And so those are some of the terms that get mixed in here. Yeah. If you wanted to liquidate some of your share in this company, donate it to a charity, buy a Ferrari, there has to be a liquidity event or an opening where you can actually sell what you own there, but until then, a private company it’s restricted. And even worth mentioning if a company IPOs and goes public, there’s still limits and blackout periods during which you can’t, as an employee, sell your shares, just to stabilize the market and to put other controls in there. So these kinds of shares, these class of shares that you get as an employee are distinct from the ones that you might buy on the public market. At least in the early stages of the share and the ownership and the IPO process.

Zac Henderson (32:19):

Yup. That’s exactly right.

Michael Mizrahi (32:21):

I’ve heard of crowdfunding. And until now what we’ve spoken about is basically the employee equity world, where employees can own a part of the company and they’re given that as part of their employment offer, as part of a bonus, as whatever it might be. And then the other people that own the company are the founders who started it. And then the early investors, whether they’re independent investors, big investment firms, venture capital firms, VCs, that invest in the company. But there’s a world where some companies on the private market open up an investment opportunity for public consumption, basically, for members, for community, for supporters. There are a few different companies that do this. Levels recently experimented with one of them. I shouldn’t say experimented. Recently ran a program with one of them. What is this and how does this work? I thought this is a private company, why can anyone just buy a share in a private company?

Zac Henderson (33:15):

Yeah. Great questions. So remember that public companies are permitted by the SEC to put their shares out on the public market, mainly because the SEC feels comfortable. They have forced those companies to be very, very, very transparent, but the SEC doesn’t force private companies to go through all of that rigmarole and produce documents all of the time and make all of these filings and disclosures. And so because private companies are able to keep their information pretty close to their chest, the SEC’s put limits on what they can do. If a private company wants to raise money, then they have to turn to the SEC and one of the SEC’s investment exceptions. So traditionally, the main ways that investors have invested in private companies is through what’s called Regulation D and basically, this is an exception that the SEC has created to let really high net worth people who ostensibly have a lot of financial savvy to invest in private companies.

Zac Henderson (34:19):

The thought is… From SEC, the thought might be something like, well, these particular investors really know what they’re doing so if they want to risk their money, they’ll be okay. They have lots of money. They have financial experience. Like contrast normal people who might want to invest in the company, maybe they haven’t done this a lot. Maybe they’re not financial experts. So the SEC tries to limit how much everyday people can invest in private companies that after all, they’re not disclosing all of their financial details. Pretty recently, the SEC has decided that it wants to open things up a little bit more, and so it has allowed something called regulation crowdfunding, which has a bit around for a while, they’ve allowed it to expand. So now private companies can raise up to about five million dollars from everyday people, regardless, whether they’re an accredited investor or not, so long as there are just some income tiers in place. So if you make a certain amount of money, you can invest up to a certain amount of money.

Zac Henderson (35:21):

And so Levels did recently work with a company called Wefunder. And we actually raised five million dollars from our members in something like five and a half hours. So we had a whole lot of interest and it was pretty exciting, but basically this is a really neat development, especially through a company that is so transparent by its nature, like Levels. It’s a pretty cool way for us to confidently get our members involved in just a really good faith way. So hats off to the SEC.

Michael Mizrahi (35:48):

Yeah. It’s nice that that’s opening up. I think it’s been locked down for a while. Yeah. The Wefunder activity was definitely interesting to watch and really encouraging and worth noting, like the average check size there is relatively small, we’re talking a few 100 dollars, not massive investments. So in aggregate this does really add up and there’s a lot of appetite for that. So how is that share that you might buy through, Wefunder different in price, characteristics, whatever it might be, from a share that you get as an employee, when you sign an employee agreement and get a grant? Are those the same price? Are they different? How is one priced versus the other?

Zac Henderson (36:23):

So the way to think about the shares underlying all of these terms is there are roughly two different buckets. There are common stock shares or common shares, and then there are preferred shares. The common shares are the ownership itself without any bells and whistles. So what are the bells and whistles? Things like voting rights. Things like liquidation preferences, which I’ll chat about in just a second. Basically, there’s a suite of extra perks that preferred shares get. And preferred shares are thing that companies reserved for their investors. You can imagine that if you are an investor and you’re investing in a startup company, you might want some additional rights and some additional assurances. So maybe you’ve put in as an investor… I don’t know, 20 million in the company and you really want to know that if things go bad, the company’s going to try and get you back at least a good chunk of your investment or maybe if the company… Things don’t go bad necessarily, but the company sells just not as much as everyone thought it would sell for.

Zac Henderson (37:28):

You still want to have some additional rights maybe ahead of the employees and common stockholders. So that’s what that preferred shares basically means. It’s some extra rights that help protect investors, either in case things go wrong or to give them a little bit more power when it comes to things like voting when the board makes big company decisions. Common stockholders, which are usually employees don’t get those extra rights.

Michael Mizrahi (37:55):

Got it. So we spoke about prices early on when we were talking about exercise price or strike price on the shares. Are folks that are buying shares through… Let’s say Wefunder, through a crowdfund, are they paying the strike price or are they paying some other amount?

Zac Henderson (38:09):

Yeah. This is a great question. And something that took me a while to get my head wrapped around. So there’s a concept in economics generally, and it certainly purveys the startup world called the fair market value, right? And the fair market value is… In many context, it’s kind of like a range. It’s a number that’s if a thing sold for that price, a reasonable person would agree, hey, that was roughly a fair price. It might be $3. It might be $10, but if it’s $3 or $10, it’s certainly not a 1,000 dollars. That wouldn’t be fair if three and 10 are also fair. If that makes sense. So when we think about the strike price, that relates to our common stock, right? And as you can imagine, common stock is going to be less valuable than preferred stock because preferred stock has these extra bells and whistles, right? So the fair market value for your common stock is going to be your strike price.

Zac Henderson (39:00):

And that’s something that company, and oftentimes an outside auditor, has said, hey, this is a reasonable fair market value for your shares. Contrast that with maybe the valuation of the company that an investor is thinking about. The fair market value is something that’s true today, but an investor isn’t really interested in what the company is worth today, right? They want to know what the company’s going to be worth a year from now, two years from now, five years from now. So when we think about the fair market value on the one hand, versus a company’s valuation on the other hand, fair market value that’s today, and it’s this squishy concept of what would be a fair price to pay just for this common share. But the company’s valuation is mostly, what do these investors think the company’s going to be worth years from now, that’s obviously going to be a much bigger number. If you’re getting investors to invest in your company, then they’re probably counting on your company growing by five, 10, 100 X.

Michael Mizrahi (40:04):

So is anyone buying at that fair market value, that FMV?

Zac Henderson (40:08):

Potentially. And what I mean by that is what we go back to… We mentioned restricted shares earlier. There are two ways that you could get your hands on restricted shares. One way, is for them to be given to you, in which case you’d pay taxes on the grant. Another way, is for you to actually buy them from the company at that fair market value price. So that’s the narrow situation in which you’d be paying fair market value. And Miz, as you pointed out, the strike price is going to be the fair market value at the time you were granted those options. So that’s another context in which you would be paying that fair market value. But again, that’s going to change over time because whatever the fair market value is today is probably different than what it’ll be a year from now or what it was a year ago.

Michael Mizrahi (40:57):

That makes sense. I think that draws out the distinction between the 409A value and then the fair market value of the company, two different things. Did I get that right?

Zac Henderson (41:06):

So when we talk about fair market value, we’re often talking about the 409A fair market value, that’s really what we mean there. Contrast that with the valuation for investment purposes, right? When we talk about… so you like hear terms like a 100,000,000 dollar valuation, what does that mean? That means that some investor has determined that your company has the potential to become a 100 million dollar company in some short period of time, right? Such that it makes sense to invest now, because they believe your value is going to exceed a 100,000,000. It’s a lot. It’s a lot.

Michael Mizrahi (41:43):

Let me just throw some other terms out there and you just [crosstalk 00:41:46] a fire around that folks might have heard. So cap table or capitalization table. What’s a cap table?

Zac Henderson (41:50):

Yeah. You’re going to hear this term a lot. Don’t be intimidated by it. This is literally just a table. It could be as simple as an Excel document. Nowadays it’s usually something managed by a company like Carta. It’s basically just a very clear, well kept record of who owns what and in what percentages. So this keeps track of a company’s equity who owns it. Et cetera, et cetera.

Michael Mizrahi (42:14):

So it’s just the record of who owns the company, who’s on the cap table, or these are the owners of the company?

Zac Henderson (42:20):

That’s exactly right. Yup. From founders to investors, to employees. Yeah. A good cap table will include every single owner. So as you imagine, it’s pretty important to keep your cap table up to date or things could get messy quickly.

Michael Mizrahi (42:31):

Seems pretty basic, so that make sense.

Zac Henderson (42:33):

Yup.

Michael Mizrahi (42:34):

We’ve covered a bunch of these. What about dilution? Where does that matter? And that might be opening up a little bit of a rabbit hole. But at a high level, what is dilution? Why should I care about it or not care about it?

Zac Henderson (42:44):

Yeah. Miz, I’m really glad you asked about this. We won’t go too far down the rabbit hole, but I think dilution is one concept that is really easy to misunderstand. When you hear people talking about dilution in startups, many people hear dilution and they think, oh, that’s a bad thing. Dilution is bad. It can be bad, but it’s not inherently bad. The way to think of it is this… I’ll make this real really simple. Let’s say, Miz, you and I start a company and we decide to issue a total of four shares. That’s it. We have four shares. You own one. I own one and our outside investor owns two shares, right? So that outside investor, what percentage of the company they own right now?

Michael Mizrahi (43:30):

They’ve got 50 percent.

Zac Henderson (43:30):

50 percent. They own two out of our four shares. Cool. We decide it’s time to raise… Oh. And I should say, by the way, right now our company is worth a 100 dollars. The investor put in a little bit of money. Our company’s worth a 100 dollars. Great. We’ve grown and we’ve decided to bring in a new investor. And we’ve convinced this investor that our company is now worth a 100,000 dollars. We’ve done some really good work here, right? We went from a 100 dollars to a 1,000 dollars. And so we want to bring this investor in and we’ve agreed to issue new shares. We’re going to issue six new shares to this investor. So this investor now has six shares. You still have one. I have one and first investor has two shares, right? So there’s 10 shares issued in total. Our company went from a 100 dollars in value to a 100,000 dollars in value. So let’s just break this down. Before this new investment, our investor holding 50 percent of the company in a $100 company had $50 in value.

Michael Mizrahi (44:28):

Mm-hmm (affirmative).

Zac Henderson (44:30):

Now, that investor still has his two shares, and it’s two out of 10 so his percentage ownership went way down. Now he’s down to 20 percent, right? We have diluted his ownership. His ownership was 50 percent. He’s experienced so much dilution that he’s down to 20 percent, but this guy now owns $20,000 in the company because the companies worth a 100,000 dollars. So the way to think about dilution is dilution happens when you add more shares, but dilution is only bad if you’re adding shares and the value of the company is staying the same or going down. More commonly, the reason why you’re adding shares is because you got through a new investment round and hopefully that new investment round is on a higher valuation. So even if your percentage ownership may have been diluted, there’s a really good chance that the value of the underlying shares you own has gone up. So dilution can be bad. Oftentimes though, if you experience dilution, it means you had a successful round. You got people to invest. That’s a pretty good bit.

Michael Mizrahi (45:27):

So it’s just like that scene in The Social Network where Eduardo is pulled of the room and he signs this agreement, signs the paperwork, and afterwards finds out, he’s been diluted. He gets really angry and… It’s a great movie. Yeah. Certainly a ton of value there. There are cases that’s worth noting where someone will want to maintain their percentage ownership in the company, understanding that the value’s going up, that they’re making out better, but they have certain rights to say, if our outside investor owns 50 percent of the company, he can continue to own 50 percent of the company if we raise more money. What is that called?

Zac Henderson (46:01):

Yeah. That’s an anti-delusion term. Specifically, that’s a pro rata right. It’s a right that certain, usually, very prominent or your investors negotiate where in the event that there’s a new fundraising round of some sort, they’re really interested in keeping their percentage ownership. And so they ask for a contractual right to basically be a part of that next round, such that they can buy up to their current percentage. So if they own 20 percent right now, and new round comes along, they want to be able to make sure that they keep that 20 percent. And they do that by being permitted to buy shares in the new round to maintain that. And this makes sense, usually, this is going to occur for major investors that want to maintain voting rights or a sort of a prominent position on the cap table. Because you can imagine maybe you have voting rights today, but if you don’t maintain your percentage ownership, maybe you don’t have voting rights tomorrow. So pro rata can be pretty valuable for major investors.

Michael Mizrahi (47:05):

Got it. One last term that I’ve heard thrown around, not for pro rata, but pro forma. In our context, when we give out offers to employees, we send them a spreadsheet with a bunch of the options on it. So we give them the cash salary offer, the shares that we wish to offer them, the 409A valuation of those shares, the current approximate values of the shares. So we give them the spreadsheet in a pro forma format.. So we’ll talk about what that means. And then we also give them two other options in addition, right? And so there’s a higher salary, but lower equity value and then there’s a lower salary and higher equity value. And so the employee or the perspective employee can choose between the offers on the table, and make the choice that’s right for them.

Michael Mizrahi (47:48):

They might need to optimize for more cash in the short term and make a trade off on the potential future value of the equity, or they might make the opposite call and say they’re okay on a certain cash salary and want to take a bet on the equity, really increasing in value over time. And so these offers can look the same early on, but over time play out very differently, depending on how the company is valued. So just a few shares can make a big difference over time. Did I get that right? Is there anything you’d add there or context that’s important to the pro forma that we share?

Zac Henderson (48:17):

That’s exactly right. The only two things that I would flag is the pro forma is a tentative document. And what I mean by that is we can’t… Even if our 409A price is X today, we really can’t say that it’s going to definitely be X when your shares are granted. A pro forma is always a tentative document. It basically says, so long as things are exactly this way when you accept your offer, here are the terms, but when it comes to actually putting the offer letter together and accepting, the funny thing is companies can’t actually promise that the shared price is going to be this. They can only promise that it’s going to be the fair market value, so small legal tweak, but the pro forma is basically a great way for someone to see what their likely total package is going to be depending upon how successful the company ultimately is.

Michael Mizrahi (49:11):

Fair enough. So it’s just for illustration purposes only, and obviously there’s work to do to make that a reality, which is part of the offer to come join and make it happen.

Zac Henderson (49:19):

Yeah, that’s exactly it.

Michael Mizrahi (49:20):

Awesome. Well, thanks Zac. I think this was a good overview. A little bit all over the place, but we answered a lot of our questions, covered some of these topics in depth, and I think it’ll be a helpful resource for folks so I appreciate you chatting with me totally unplanned and off the agenda. No clear outline, but I think we did it justice.

Zac Henderson (49:37):

Nothing like a fun off the cuff conversation. Miz, this was a pleasure and see you soon.