Simpler stock options with Matt Secrist

Jason Hi everyone and welcome to today's Startup Equity Matters. I have Matt Seacrest with me today. Hey Matt. Hey. Matt's an expert in many things relating to startup law and today we're going to cover stock options. The basics I suppose but also what we're going to do is not just do all the technical stuff we're definitely going to give you some technical insights because it's important but we're going to try and simplify and streamline that. Try and give you the answers as much as we can. Hey Matt. Hey. Look so welcome. Thanks for joining Startup Equity Matters is a podcast for founders and their teams to help them create more value from their equity. You need to use your equity for raising and building teams and I know as a founder myself I was just almost constantly reading a legal document or sending and signing something and you know it was a real headache. So this whole podcast is about really making your life a lot easier. So thanks Matt for joining us today. Would you mind just opening up telling us a little bit about yourself and your firm and

Matt what you're specializing in? Sure. Happy. Thanks for having me on today. Again my name is Matt Seacrest. I'm with TAF Law. We're a firm of a little over 800 attorneys. We represent startups through large publicly traded companies. I'm an employee benefits attorney. So what I focus on is basically how people get how employees get paid. So one aspect of my job is help companies with their equity incentive plans. I also help companies with their retirement programs and their health insurance programs that they offer to their employees. I've been working with Cake for say almost going on maybe going on three years now. It's been been a great relationship trying to help everyone understand just how option

Jason plans work and hopefully we can kind of again like Jason said simplify some things for folks. It's been great working with you. Your energy for startups and I guess simplifying streamlining things has been great for us and you've helped us learn a lot about the US over the years as we've been you know getting set up over there. So thanks for that. All right. Well look let's let's jump into what is a stock option and there's two main types that that sort of startups are using ISO and NSO. So let's dig into that a little bit and you know let's try and help people understand when they would use an ISO when they would use an NSO and I think we're going to have a little secret for everyone. What the best one is. If you're not going to say it I'm going to say it at some point along the way because

Matt I reckon there's a clear winner there for most startups. Yeah. So when I get a startup client that comes to me and say hey Matt I want to put an equity incentive plan in place and basically we're going to go over the types of options but generally one of my first questions is do you want do you want employees to own your shares. That's the one of the very first questions because the tax treatment of ISOs the incentive stock options the statutory the qualified options those require you to meet these holding period rules which means you've got an employee that actually has to become a shareholder and own the shares. If you have an employee that's not going to if you don't want your employee to own the For example say you have an equity plan that grants stock options and then basically everyone is all the people who own the hold the awards are essentially cashed out on an exit event when the company sold. Then an ISO really doesn't you don't really get the tax benefits of an ISO because you're actually not you're not you're not meeting the holding period employees aren't really holding the shares for that period. So there's really again two types I first start with do you want people do you want employees to be owners of the company. Do you want them on your capital.

Jason Because from my perspective Matt you know I don't know any founders thinking how really want the reason I'm giving you know options to my team is so that they own shares. I mean that's not really what people thinking in startup land it's all about high growth exits M&A IPO that kind of thing which is which is all about the exit the liquidity

Matt event so you're much more trying to align the ownership structure of the incentive plan to this this exit opportunity. Exactly so and that's why most startups use non qualified stock options the other one and it's a much more flexible so an NSO you can grant it to an employee an independent contractor so if you have someone coming in doing tech work you have an IT person coming in setting up your your your systems your firewall and you want to pay them with an option you can pay them with an with a not an ISO an ISO can only be granted to an employee so there's a that's like one restriction so an NSO is a lot more flexibility for especially startups when you know cash might not always be available to pay your bills so an NSO basically is an option it gives you a right to purchase the stock in the future for an exercise price in the US we have this internal revenue code section 409 a that will kind of mention that a few times here today I'm sure under 409 a the exercise price of an option has to be equal to or greater than the fair market value of a share on the on the data grant so if I grant you like one option to purchase one share and that share price at the time of the option is ten dollars per share that exercise price has to be ten dollars or more okay so as long as you do that you're going to comply with 409 a and

Jason then later on say that let me jump in quick back because like this is super technical and I was simplifying a lot I'm going to try and help simplify this I hope I'm actually helping but let's try so for me with in the life of an option that's got a four points there's the the granting point which is the point where hey the company's sending the offer letter and we're doing the agreement and you know we're granting the option to the employee or contractor or whoever it is and the next point is vesting the next point is exercising and then the next point after that you know will be exiting and they can all you know some of those things can happen at the same time but the sort of four main sort of moments in the life cycle of of the option and becoming chairs and getting the cash getting the liquidity so what we're talking about here is at the point of granting you must do the 409 a which establishes the exercise price which then gets paid at that third point which is the exercise point right so right it's like it's a little bit confusing so we're talking about the first bit and you have to do the 409 a so that you don't make a mistake on setting the wrong exercise price and if you do set the wrong exercise price you create like massive tax problems for both the company and the employee or is it mainly

Matt just the employee that has the problem so the trick the thing with 409 a is unlike a lot of us and other country tax co-provisions the penalty is actually on the employee the participant versus like most of the most of these penalties we talk about in the in the in the tax world are all in the company the employer but under 409 a if you if if you violate those rules it's actually a 20 percent excise tax penalty payable by the employee

Jason so they might have been so they might have been given for argument's sake you know $20,000 worth of equity as you know when they get it granted and the company gets audited before they've been paid any money the employee hasn't been paid any money yet they haven't had their exit and then they get found to be in breach of 409 a and then the employee then what gets a tax bill of 20 percent of whatever

Matt options they've been given whatever the value is and you do that every year it's it's it can it can add up really fast because there's also interest penalties that apply too because a lot of times when these options are granted people don't know they don't they don't think about that's one of the biggest issues for for for startups is getting a good valuation because if you don't get a good valuation that comes up in a couple different ways one is you know you have the risk of an IRS audit and people aren't filing their taxes right because the 49 a value that that violation is a yearly thing so each year you have to pay the tax and the penalties but then later on you also have your your exit events for the company so when you have someone doing due diligence like the mat for the buyer side he's going to look at okay did you get a good valuation and if not he's going to say did you company report this properly to the IRS and that could be additional headaches when you're

Jason actually going for the sale of the company later on so that's it's really it used to be that these 49a's are extremely expensive and complicated but most of the good cap table providers and law firms will have like a nice reasonably simple not mega simple but it's much simpler much more affordable you know including cake we have that you know built in and I'm sure you have partners for that so look it's not that hard anymore you've got to get the 49a let's make sure we massively put a big tick on that so like all right so we're doing our our grant we're getting our 49a we're making sure we're correctly setting the exercise price awesome thanks for highlighting that that's mega important so where were we so we're talking about NSOs and why they're great and why they're flexible and why they're probably the preference for for a lot of startups I suppose unless when when were we saying we would use an ISO I suppose you're saying it's like if you're working with employees and you want them to be shareholders down the track so you'd rather have them convert and become a shareholder and and stay with you over the medium term and it's not necessarily about like a liquidity event then you probably go for the ISO

Matt yeah so the main so the main difference is when so in both of them you have to have a good valuation for your data grain you have a good exercise price good 49a valuation okay and then there's the the event that as far as the tax treatment that's when you actually exercise the options okay the vesting is not a tax event it's nothing special it's just okay the people the individual award holder they get the they actually own something at that point they own the right to to exercise and receive shares for the payment of the exercise price yeah when that happens in an NSO say for example the the value of the shares are 20 dollars per share and you set your exercise price at five dollars in an NSO that 15 dollar difference for your employees is wages it's subject to income tax and employment taxes and then for your self-employed if you have paid you like your IT person with an option that self-employment income they have to

Jason report and pay taxes on so they're so they have to pay tax on that difference so that's an exercise all right so let's talk through this again so this is great stuff i'm going to try and simplify it or just talk it over so for both ISO and NSO when the company grants through the employee or contractor there's no tax payable under both as long as you get the right foreign INA and evaluation correctly with the exercise price similarly with vesting which is the next step there's no tax payable under both if you know there hasn't been an audit and you haven't had an issue with your valuation but with an NSO at exercise there is a taxable event which is the difference between the fair market value and the exercise price okay well this is super interesting and I think everybody should know this so I'm a huge advocate for having the longest possible exercise period when you grant an option but there are some rules around this and but it's different for ISO and NSO I think as well so it's probably worth us talking about this so from my understanding you know I've been doing this for years now and but yeah the country's a bit different but there's only really two reasons in my opinion or there's potentially three but two main ones why an employer or contractor would want to exercise their options the first one is that they want to participate in an exit event you know and you can only really participate in an exit event if you converted from an option to the stock or share and then you get your liquidity as part of that transaction the second one is you want to participate in dividends and option holders don't get dividends you have to be shareholder stockholders to get your dividend and the third one is if you want to vote because normally an option holder wouldn't have any voting rights but if you are a shareholder then you do get your voting rights and the third one I think is not that important because the amount of vote you have is normally so tiny you're not going to influence any vote anyway so it's really to get access to your cash which is what you want out of your stock option plan you need to exercise so my what I always say to founders is you want to exercise at the point of the exit or unless the dividend is significant because quite often you've got this big tax bill to pay to get your dividend and that may create like a pretty serious issue for you where the tax bill is larger than the dividend so what are your thoughts on all on that you know trying to align

Matt exercise to exit and the tax payments around ISO and NSO at that exercise point yeah most of most startups design their equity plan so that it's only it's only exercisable on it on a change control sale of the company and that kind of makes sense for the employee too because you think about it okay you've got if I'm an employee of a startup and I exercise this option okay now I'm a shareholder I own shares but it's in a liquid asset like I can't go and sell these shares on the open market it's not publicly traded stock and the stock that I receive is subject to transfer restrictions so I can't just go to my neighbors knock on the door and say hey I've got these shares of this ex-company will you pay me $20 for it you can't do that because these are non-publicly traded shares and you're going to be subject to a share restrict transfer restriction agreement when you exercise so you know you really you have this piece of paper that is worth something but you can never really recognize it until a good transfer event happens and in the startup world the real transfer event is a sale of the company you know so that's why most that's one of the probably the primary reason I would say most startups design these plans so that they're only the options only exercisable on a on a change of control and again it makes sense for both parties because you know you got your founders that don't want to have 50 different shareholders to kind of respond to invite to their annual meeting and everything and then you also saw in every single document they're going to go around the world yeah and then you got to worry about okay do I have to give financial disclosures to this shareholder that owns like one share out of the thousand shares or 10,000 shares you know it's just cleaner honestly to have it exercisable on a change of control and in NSO when you're talking about exercise periods you know you got to be mindful of state law and and you know your plan design but generally you can have a long of an exercise period as you want versus an ISO and an ISO it has a bunch of restrictions like for example you're you can't have longer than 10 years for an exercise period if someone quits and they're no longer an employee they have 90 days three months to exercise or they forfeit the options versus you know with an NSO you could have it that people keep their options and they just stay out there while they're not working for the company so there's a lot more flexibility than

Jason NSO. I think it's critical personally I mean everyone's going to have a different opinion and I'm still learning but you know you work for a company for several years and you earn options via vesting and that's part of your remuneration sometimes but then you get to the end and you have to pay your own cash out to exercise them and you know it's so hard to save cash and you might need it for house deposit or you know your kids college and then you have to take it and put it into the company that you just worked for and earned options I'm like I don't understand that from an asset allocation perspective and risk management perspective as a you know as a founder and anyway so I don't really get that I think it's tough on the employee to have to do that especially there's a big gap between you know there could be a reasonable size exercise payment and then plus there could be a tax component to that as well or to be said yeah there could be a tax component that's only on the NSO so at least in that case there is an intact component so

Matt yeah it's just the exercise payment that um yeah well the exercise payment here in the US we have this concept of a cashless exercise that happens that happens a lot in these sale transactions where basically we draft the purchase agreement that we're going to treat every option that's vested as exercise and we're just giving give the option hold our cash payment so there's no out the door as far as I have to get a loan to pay my exercise price so we have a cashless off exercise that's cool talk me through that a little bit so does the company fund that or how does that get funded then well it's it's it's usually funded out of basically you can fund out of the sales proceeds so the company when they sell they're getting this

Jason big chunk of money from the potential buyer okay it could be a balance sheet the company just pops on the balance sheet as like a second exit liability so it's almost probably not even on the balance sheet I don't know we're not accountancy I'm an accountant but you know like it could be yeah an off balance sheet liability like exit liability because I suppose it's not

Matt even required until exit interesting yeah and then there's so that gets into accounting rules which I'm not accounting to you generally like we have to like list vested options and stuff again there's a lot of accountants but okay we could do that way or it could be like a pre-closing liability where the company just uses cash off its balance sheet to cash out everybody and then what happens is with that cash payment that cash payment per share it's used to pay the exercise price and it's also used to pay any tax liability too so end of the day the employee net nets what the cash would be for those the cash value of those shares minus the exercise price and minus the taxes

Jason okay well that seems really fair you know you're an employee you have an iso you do your time you can exercise with the non-cash exercise and then you know the company just maintains that that liability you know through the exit yeah cool okay that's awesome and then with the nso similarly you know you'd be looking to have as long an exercise period as possible there's no rules around the exercise period there and have heard some founders you know wanting to have you know one two three year exercise periods oh lots of gone out for that you're going to be a bit more dynamic yeah it has like a motion thing in this room it does the same thing in my this isn't my office it says the same thing downstairs but we're going to be energy conscious so i think that's yeah i gotta i gotta be more energetic in these discussions to start jiving i'm gonna have a movement element now um you know so now let's put the nso on exercise so if people still getting it you've got the grant which is sort of a you get like there's even an earlier bit so you sign your remuneration and your remuneration sort of says hey i'm gonna get some cash every month or fortnight i'm gonna get some equity then you get a deployment contract which matt could handle you know and then but you still need to sign like an option grant which cake would handle or your cap table provider would handle so that's like you know separate documents you sign two documents to make sure you got your remuneration to get your cash and your equity that's kind of the granting element then you've got your vesting vesting's the bit where you kind of earn your options right matt so that's like 12 month cliff four year vesting everybody kind of gets that bit i think that's pretty straightforward you can have milestone based vesting as well which is kind of earning your options based on one particular outcome so that's your vesting that's stage two and then stage three is um stage three is the exercise and we've just been talking about that how it works for iso nso and then stage four is kind of like the exit where um there's the change of ownership as you sort of described it where you know is there anything we should talk to there that people should know about any differences between iso and nso we have talked a little bit about that already

Matt but yeah so i kind of hinted about the iso the incentive stock options that you have to meet these holding period rules so like how i said about every the benefit of an iso compared to an nso and nso the difference between your fair market value and exercise price is taxable wages okay but if you if you have an iso one exercise that difference is not taxable wages it's not subject to income tax or employment taxes on exercise and then if you sell it later on and you're within the holding period any difference between the difference between the ultimate sales price minus the exercise price you paid that's going to be long-term capital gain so long-term capital gain it has basically half the uh tax rate as an ordinary um as ordinary income what you'd have nso that's right but again you've got to be you've got to hold these shares so if you think about again you've you're exercising you don't have publicly traded stock so it doesn't always

Jason make sense and you're probably not going to get it like even though on paper that looks good let's pay half tax but in reality you're not going to exercise until it exits then you haven't held long enough to get the discount okay cool exactly so you're not going to get that tax benefit and okay typically in a startup one last thing i wanted to cover before we sort of move on a little bit to some some cool stuff that you've seen and just we're just sort of like jam on the space in general a little bit you get out of the technical elements but you do hear about people exercising their options earlier to minimize their tax bill and i suppose in this case we're probably talking nsos um my mind i'm thinking what people are probably doing is they're saying hey well if i've got say a three year exercise period which some plans would have we're probably not going to have a full exit in that three years so i'm going to have to exercise um before the exit and i want to exercise as soon as possible because you know i think that the fair market value of the company is as close to my exercise price as possible so i'm going to have the smallest taxable income and i don't want to exercise in one or two years time because if the company keeps going up in value when i exercise i'm going to have a bigger tax bill am i in the right space

Matt um to sort of explain how that how that might work yeah so you see that sometimes and those get like really complicated plans so it's really like a plan within a plan right so it's basically your extra you're doing an early exercise and you're getting what's called restricted stock so that's stock that's subject to a vesting schedule and you have to do different tax filings for that as well to kind of get the tax benefit it really i used to see that um sometimes here and there but i'm seeing less and less of that because it's just it just again it's like a plan within a plan so it's uh like a lot of times when you have a startup they they want to incentivize employees and and folks to think this is like real value and the more detail the more complications you add to it it becomes less of incentive even though it might be a lot of an incentive even though it might be better off it's just if you don't describe things in a way that people can

Jason understand it actually can be a disincentive oh i love that i think i said that all the time yeah it's so caught up in the legal technical financial element and and but when you explain it to a regular person they're just like what i don't understand anything you just said i just want to be i just want to know i'm part of this plan and if we all win together i'm going to get like a good outcome i want to be able to understand it i don't want to have a tax bill you know like the simpler is way better in this space it's so so cool to hear you say that well let's let's double down on that just to finish this section so what i got out of all this is that startups should use nso and have a long exercise period and give everyone the same thing and have a really nice simple plan so that people don't have a tax problem and that you know when we get down the track and we all win everybody gets a piece of the cake that's what i saw awesome look thanks um look everyone i hope we did enough technical stuff there because it is a very technical space we want you to understand enough but also kind of understand how to get this done well um not get too caught up in the jargon and solve this complicated problem simply and quickly for you but also for your team you know we want equity to be something that motivates your team and helps you build a great culture and you don't want you or your team constantly sitting in their accountant lawyer's office trying to work out what the hell is going on because that's very demotivating and thank you matt for bringing that up that's um that's amazing of you and a testament to why we partner so let's go now and dig into oh something cool that's happening at the moment well something not cool that's happening at the moment but something that's current is that unfortunately you know capital markets are much more difficult than they were in 2021 and what happens in these more difficult years is that valuation of companies come down but i think i'm you know breaking any news to anyone that unfortunately startup valuations have come down 50 to 70 percent in those later rounds seed stage looks to be pretty good but you know companies that raised at 20 50 100 times rev are having a really hard time matching those valuations in the current market and that actually creates big issues for ordinary stock and and stock options matt so let's dig into that a little bit try and help people understand that and how they can protect themselves how we can continue to create value from stock options through these difficult periods and you know because i think it's super interesting and it's the type of thing we

Matt want to help people understand you know yeah so in that situation say what we call them here in the u.s. is underwater stock options so these are stock options that have become worthless you set the exercise price that we talked about at one value and now things have kind of gone not the way we want them to go so like your ten dollar exercise price now your company is worth eight dollars so it's underwater the option is not really worth anything to employees i mean there's always the potential the company's going to grow and they're they're going to be able to exercise but again you want these things to be motivating to employees you want them to see the real value and get excited for what they're what they're doing at the company and the potential of this exit event later on so you know the simplest way that we kind of approach these things is we do a what's we basically do a cancellation and a grant of new option um basically what we do is um we get a new 490 valuation we look at how many options that we've granted an individual and we try to figure out okay you know this individual has been around for a long time we really want to motivate them and maybe if they've gotten like five options right now um because things haven't gone as well we'll give them a new option for eight we'll give them eight new options instead of to replace their five and the eight will be at the new valuation so that way they can kind of still see the the growth they don't feel like they're losing out on anything that's the typical way i kind of handle this it's the cleanest there used to be back in the there used to be back in the day people started looking at exchange programs and everything but that triggered all kind of 490 issues so just to keep things simple kind of our theme here typically what i recommend is you just cancel the option and then you grant a new option you just figure out some kind of ratio and and give them more options than

Jason they had before love it i love it every late stage founder should be looking at this right because you've got your team there they're getting distracted they think their equity is underwater that you potentially haven't even communicated to them what you think the current valuation is versus what it was and and where they're at you know like be communicating that keep them up to date be on the front foot potentially you know i think the average in the u.s. 18 of your stock is in your stock option plan so a huge amount of your company's stock is out there with these great people that have helped you build this company so take the time take the effort go through this process cancel renew it's much more likely you're going to have a motivated workforce and and you know in these tough times and coming out of these tough times you know companies with the best teams the most motivated teams are going to win you know on the bounce back so

Matt awesome thanks for covering that anything else on that one matt yeah i would just add on that like you hit the nail on the head it's like any employee benefit a stock option equity grants you got to keep stuff fresh you got to keep it top of mind of people so i see companies all the time where they grin and stock options in one year three five seven years past and no one's mentioned the stock

Jason option program at all and employees just forget about this think about the company the company's worth 20 million 50 million 100 million so 20 of that is just out there and not working for you it's such a huge cost to the company that just sort of goes unnoticed so for us it's always got to be the legal team the finance team and the people team connected to the leaderships it could have started at the top so the culture and strategy has to have this built in and then you know these three cross-functional teams need to work together to make sure that that this stuff's working it can't just be sitting in the finance manager spreadsheet or you know the legal council is sort of making sure the contracts are up to date you know i think when these things work well those

Matt three teams are working together and and it can be really wonderful drive company it should be part of your annual discussion with employees just say hey you know we've granted you these many options at exercise price give them a statement like go on cake and just print out a statement them and email to them you know just give them something to see to see in front of them that motivates them just don't like just don't reference their their stock option program let them see

Jason numbers people love numbers otherwise they're scarce worse than good it's scary for them you know so flip it around and we advocate talk talk to them in the all hands whether it's monthly or quarterly like they're investors you know like you give your investors updates like help your team understand they are investors in your company and then you can really make these discussions really positive so yeah thanks thanks matt um look let's um let's sort of wrap up um i think we've touched on something that you sort of see as the biggest fuck up already but let's just double down on that um we like to do you know like a little bit of a close segment so today we're going to do biggest fuck ups with matt um what's the biggest thing people do wrong um to cause themselves and their their team's problems matt oh there's a lot of stuff that could happen uh i think we i think we beat the 490 issue to death okay yeah we did we did but that's what you were gonna say right that's that's the biggest one well what's the next what's the next biggest

Matt issue there's so many ones so another one that you um that i see with startups sometimes um with your with your ex with your award agreement and your your exercise notice you don't um you don't have the employee the person exercising um agree to a share restriction agreement so you need to make sure those shares are actually restricted i've seen that happen where they don't have any kind of you know legends on their shares and they're just like people think these shares are transferable which as a private company you know that gets into securities laws issues and you're violating securities laws because you're you can't really freely exchange these in the in the public you can't go knock on your neighbor's door and sell them um so you want to make sure you have good restrictions on your um on your on your offer documents um another thing is you know people forget that you know security going back to securities laws there there's the federal securities laws in the u.s the securities and exchange commission that apply to publicly traded companies but um states have securities laws too that you have to worry about like california california is one of those states or california is a big state as far as employee protection individual citizen protection so yeah you need to make sure you comply with those

Jason state laws so even though you're saying probably delaware or you might be delaware so you think hey i'm abiding by the delaware laws where my company is domiciled if you're issuing stock options in say the state of california there could be some some additional obligations yeah really interesting

Matt insight yeah so like in california um there's um you have to have provisions as far as exercise ability of your options there's state laws for that there's state laws as far as access to records and stuff so you have to make sure you actually comply with these state laws so those are also on top of the four and i thought maybe i'd just add something else because i could say four and a

Jason all day long that's a cool one that's a cool one okay we're a big believer in trying to help our customers handle both sides because there's the stuff the company has to do wherever it's based and then there's also stuff you're going to do wherever your employees are based we've got a global product as well and you know that creates even more complexity and i know you're helping us on on that front too matt with taff so hey look everyone we better wrap it up um i don't i don't want to sort of keep matt too long i think we did a great job of simplifying things it is an incredibly complex area and our mission with startup equity matters is to simplify and streamline things it's obviously our mission at cake as well we love working with matt because he really is helping us go on this journey or seeing through all the complexity and trying to say hey look what's the best fit how do we help people stay out of the weeds on this stuff and actually just build our companies and have great relationships with our you know with our team so i think we did that today we definitely tried um thanks for joining us everyone thanks for joining us matt your founder knowledge i'm very grateful so yeah that's it for me for today thanks everyone thanks matt

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