A Guide to Employee Equity
Joshua Reeves, CEO of Gusto (YC W12), discusses Gusto’s new guide to employee equity.
Craig : Why did you guys create this?
Josh : This guide was derived from a doc I created and shared inside our company. Many employees don’t understand the value and financial implications of stock options. This stuff can be confusing, so I felt like the right thing to do was to empower our employees with the knowledge to gain the most upside of our success. The concepts in the guide are basically the things I went through when I made employee offers and then realized it would help other entrepreneurs as well.
Whenever we’ve done financing, or whenever I’ve made offers here for candidates to join and I dove into a lot of the detail, I didn’t agree with a lot of the “standard terms.” So we created our own equity structure that makes sense for our future, and pulled together central guidelines and questions to help other founders as they navigate these same decisions.
Craig : Gotcha. Ok, so what are the main points of contention for you?
Josh : There are a lot but three jump out most.
I think the first one is around the actual offer process. A lot of times people don’t know the details of their equity, so there are really three things that need to be communicated in every offer. People need to know the number of shares they’re being offered, they need to know the price of their shares, and they also need to know the valuation of the company or the number of shares outstanding in the company – once you have one of those, you can calculate the other ones.
A lot of people who get offers know they have a number but they don’t know what it represents. So just those basic details should always be communicated and I find companies don’t always do that.
Craig : Makes sense. What’s the second point?
Josh : The second point, which is a bigger one, is around exercising. With vesting schedules there’s a cliff attached. At Gusto, we do five years because we’re building for the long term, so we give more equity and it’s a longer vesting cycle. But companies can choose.
Exercising means the ability to exercise options – to spend money to purchase options and turn them into actual equity. Most companies don’t allow their employees to early exercise. It’s always the choice of the employee. There is no guidance that companies should give here, but in my opinion, companies should always give their employees the choice to early exercise because early exercise has, if a person chooses to do it, some very clear tax benefits. I can summarize quickly if it’s helpful.
Craig : Yeah, definitely.
Josh : Sure. So there are roughly three phases when someone joins a company. When they first join, call it the first several months to a year, they get these options. If they can early exercise, that means they can take money out of their pocket, purchase those options, get the stock and in that year, if the value of the stock equals the value of the options, they basically pay no taxes at the point of exercise. They would just have to pay taxes when selling their shares.
So that has the best tax treatment, but it also has the highest risk, to be clear. It’s basically acting as an investor and that money can be lost if the company’s not successful.
The middle period is kind of a no man’s land because two years in, you can exercise and the stock value has gone up if the company’s growing, but you don’t get paid yet. However, there might be taxes due that year and the company is illiquid, so now you may have to pay taxes out of pocket. It has to be money they’re willing to not think about because it can’t be something that they depend on for living.
Then there’s the IPO timeframe where someone can exercise and then the stock value has gone up quite a bit, but they can sell right away and have the money to pay taxes that year because there are taxes based on the difference between the option price they paid and the stock value at present. That one has the most conservative approach because the company’s already liquid, but it has the highest tax rate because you’re now paying income tax, whereas in the first scenario, you pay long-term capital gains (which is a good thing) – assuming that the time delay between exercising the options and the liquidity event is more than a year.
The main point is, people should have the choice to figure out the difference. Certain paths, like paying out of pocket cash before any form of liquidity, can literally mean half the taxes. If someone is choosing to join a startup, it feels fair to them to give them that information.
From an options standpoint, exercising early creates more work for the company. If someone leaves the company, they don’t get all their options if they haven’t vested. So, if they are on a four-year grant and they leave after two years, the company basically gets back the options for the two years they haven’t vested.
To me, all the paperwork and overhead is just the right thing to do if the employee chooses that this is important to them. And a company, to be clear, can never give guidance on this because it’s a personal decision. This equity guide is just about surfacing the pros and cons and letting people make the choice.
Craig : Okay. Let’s jump to the next one.
Josh : So, this other one is around something called “golden handcuffs,” which is something that’s changing. It’s becoming more a part of the conversation but it’s still not very standard. The main point is that if someone decides to not exercise and/or is not able to exercise and they leave the company, their options typically have a three-month expiration. So, unless the person exercises them within three months after leaving, they lose those options, which is kind of crazy to think about because the person has already invested time, already contributed to the company, already meaningfully helped the business. Just because they don’t have the cash in time to pay the option price or the AMT they would have to pay on the gain, they lose their options. It doesn’t seem very fair.
They’re called golden handcuffs because a lot of times people will stay around the company simply to not lose their stock. I think that’s a whole other problem – “rest and vest,” you might say. People should be at a company because they really care about the work, they believe in the product, and they enjoy the company of their colleagues. They shouldn’t stay only because of their financial motivation.
So what I believe is important there is to give people flexibility. I don’t think it’s across the board, I think someone has to earn it. So at Gusto, for example, everyone that has stayed here at least three years, their expiration changes from three months to ten years.
The thought process is that if hypothetically, an employee has to move home to live with their family or they’re getting married to a childhood sweetheart across the country, these are all things that are great decisions that should not be punished. People should have the ability to still be honored by the business, maintain the option to point of liquidity, then exercise and not lose the stock they worked for.
Craig : Cool. Yeah, Ben Horowitz is pretty vocal on this stuff.
Josh : Yeah, definitely. People should feel appreciated for their work. They should be treated like owners in a business. We get asked a lot to give advice on this. I’m happy to give my advice, but a lot of it is also just knowledge that is not rocket science. People should spend time understanding and learning, too.
And again, it has huge implications. For example, on the early exercise piece. These are first world problems in the grand scheme of things, but if someone has early employee equity and it becomes worth $10 million, long-term capital gains versus income tax is 20% versus 40%. So, it’s $2 million difference in taxes that could have been mitigated if they had spent maybe $20,000 exercising options early on. Again, people should know the pros and cons. I’ve talked to people who said, “I didn’t even know what early exercise was. My company definitely didn’t let me do that.”
The main point I emphasize when I make offers is that this isn’t just about the transactional side. It’s also how you treat someone once they’re an owner in the company – the information your share and the respect you give them.