Kickigai Weekly
Posts
The ultimate guide to stock options for employees - Part II

The ultimate guide to stock options for employees - Part II

Exercise dynamics, taxes and non-trivial questions you should ask

Giammarco Pacifico
October 04, 2023

Last week we covered the basics of stock options, how they work, how much they are worth and some red flags that you should watch out for.

If you need a refresher, you can read it here:

The ultimate guide to stock options for employees - Part I

Stock options basics, how much they are worth and red flags

kickigai.beehiiv.com/p/guide-stock-options-part1

Now, let’s dive into some more advanced topics and by the end of this post you’ll know everything you need to accept a life-changing stock option offer!

Sweat Equity

In most situations, stock options are a complement to a cash salary but that’s not always the case.

If you are joining a pre-seed startup where money is tight and they have not raised a founding round yet, you can decide to work part-time or full-time only in exchange for “Sweat Equity”.

This means you won’t get a salary at all but you’ll be adequately compensated in equity based on your hourly/daily rate and the company stage.

Here is a simple yet effective way to calculate sweat equity:

If we consider a € 500-day rate for 90 days with a risk coefficient of 2 and a nominal valuation of €2M = 4.5% of the company.

It’s up to the company to offer straight-up equity in the business by giving away shares or offering stock options for the same value. Both can work based on the situation and if the person is joining as a de facto co-founder or a specialized employee working on a specific set of topics.

Exercising rules

During a liquidity event, you will get the right to buy shares in the company.

This is referred to as “exercising”

If your shares are fully vested, then you can exercise them immediately but this is rarely the case. Even if your initial vesting period has passed (after you’ve been at the company for 3-4 years), the company has probably offered you more stock options a few years back and it’s very common to have multiple stock options grants vesting at the same time.

Un-vested stocks are usually “accelerated”, or immediately vest so employees can purchase them before the full vesting period is complete.

This is usually referred to as a “single trigger”.

Founders and executives usually have an additional clause (“double-trigger”) related to their termination without cause, which protects leaders from being fired during an acquisition.

If you leave the company, there are three cases:

Bad leavers: the employee is terminated for cause. In this case, you don’t get any of your vested or unvested options. This usually happens in cases of gross misconduct, intentional mistakes, fraud and rarely when failing to meet targets
Good leavers: the employee resigns for personal reasons, illness or desire to move on. Or the company terminates the contract for reasons other not in the employee’s control. In this situation, an employee can exercise their vested shares based on the exercise window
Layoffs: these are usually treated on a case-by-case basis and stock options are part of the severance compensation package. On the generous side, companies might remove the vesting cliff or offer an acceleration scheme to laid-off employees. Other companies might consider everyone who is terminated as a bad leaver and prevent them from exercising any options

When you leave the company as a good leaver or you get the right to exercise your options as part of a severance package, you’ll have a specific timeframe to use that right, called the “exercise window”.

In Europe, 50% of companies ask their leavers to exercise their options in the 90 days following their last employment day. This might be prohibitive for some employees who don’t have the required cash or who are not entirely sure about the future company’s success.

The other 50% allows leavers to retain their vested options until a liquidity event, without incurring any financial cost.

Differences among European Countries

Europe is very fragmented. We all know it.

And this is even more clear when it comes to stock options.

Let’s take the same example as above: a medtech seed-stage company that is raising €2M at a €10M valuation with an expected valuation of $2B at exit after Series D (dilution of around 50%).

At the expected liquidity event, a mid-level tech person who received 0.7% of the company in stock options makes €7.3M pre-tax and €6.5M post-tax in the UK, only paying 11% in taxes.

The same exact person in Germany makes €7.2M pre-tax and €3M post-tax, paying 58% in taxes.

In the exact same situation, a German employee earns less than half of his UK counterpart.

If this doesn’t shock you, I don’t know what does!

Even accountants are speechless

Going into more details, there are 3 main types of stock options in Europe:

ESOs (Employee Stock Options)

Commonly used in the UK, Ireland and Sweden
This is the easiest framework and they are fairly tax-efficient

VS (Virtual Shares)

Commonly used in Germany
Provide a contractual right to the employee that mimics an ESO without the real option
They have similar dynamics but do not provide employees with voting rights or the other rights of traditional shareholders upon exercise
Usually preferred for legal reasons linked to the burden of having a high number of shareholders (even if there are cases to prefer ESO)

Warrants

Commonly used in France and Sweden
Very similar to ESOs in terms of benefits but in some regions, they have more favourable tax treatments than ESOs

Country-by-Country overview

If you’re interested in learning more about the differences between Countries, check out the full review from Index Ventures.

Non-trivial questions you should ask before accepting an offer

How did you determine the strike price?
In some countries, companies have to get a third party to establish a “fair market value” for stock options whereas in other places, it’s up to the board's discretion or the previous funding round. Keep in mind that during a liquidity event, if the strike price is deemed unfair, employees might get additional tax
What are the exit scenarios you have presented or discussed with your latest investors?
Modelling exit scenarios in the early days is not a guarantee of success but it’s a useful exercise investors do before committing any capital. They need a large exit and so do you. Understanding expectations can help you map a few scenarios, from a small acquisition to an IPO
What is the stock incentive plan for current employees?
Every startup that offers stock options to attract great talent has a scheme to reward high performers and incentivize them to stay. You should look for a plan where the top 10-20% of employees are given meaningful incentives every 2 years
How will my shares be taxed upon exercising them?
You are not a legal expert, nor you should become one. The founder or company lawyer should provide you with all the information based on the Country of jurisdiction and your tax situation
How is the option pool generated?
This is a more nuanced topic but it can help understand long-term incentives. In most companies, option pools are created by issuing new shares (usually before a new financing round) while in others, the founders allocate a part of their shares to employees. In the case of unallocated shares, in the former case they would be redistributed to all shareholders while in the latter, they’d go back to the founders

Finally, let’s not forget that stock options are lottery tickets and you are gambling that the company will be successful by giving away today’s salary for a higher payout in the future.

On the other hand, one way to build wealth in a few years is to become owners and share the upside in the success of what we work on, so don’t be afraid to negotiate fair compensation in a company you believe in.

If you enjoyed this issue, share it with a friend or two

This week's top scientific reads

Losing weight, not knowing why (Nature Medicine)
Bad diet causes depression (JAMA Network)
How many cells are in your body? (PNAS)
The protein that rejects implants (Nature Biomedical Engineering)
The cell’s waste system (Nature Communications)

Read my comments on these articles here.

Latest funding rounds in health & bio

Ready to turn this news into your next career opportunity? Here is how

Tolremo Therapeutics raised $39M to further their non-genetic drug resistance approach in cancer and get to a first-in-human study 🇨🇭
Opterion raised CHF 6.5M to advance their peritoneal dialysis solution through the late pre-clinical stages and prepare for Phase I 🇨🇭
CNS Therapy raised CHF 1M to complete the regulatory steps for their drug-free non-invasive chronic pain treatment 🇨🇭
Resolve Stroke closed €2.2M for their High-Resolution Ultrasound Imaging platform and the collection of clinical trial data 🇫🇷
Everimmune raised €3.5M for clinical trials on a cancer drug candidate, based on microbiota oncology 🇫🇷
Notify Therapeutics raised €5M to develop a novel first-in-class treatment for female infertility 🇩🇰