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May 16 2019 - San Francisco, CA

Stock Options: Michael Tannenbaum

Chris Read:
Hi, welcome to brex in the black, where we talk about finance for operators. We've got our CFO here, Michael - Michael, thanks so much for joining us.
Michael Tannenbaum:
Thank you, Chris.
Chris Read:
So today we're going to talk about stock options. Stock options are obviously very relevant for all startup companies.
Michael Tannenbaum:
Super relevant - that’s the money, Chris.
Chris Read:
Yes. So why don't we talk about stock options and how to do that?
Michael Tannenbaum:
Sure. So stock options are a feature of the compensation package. And for many people they are a huge part of why employees work for startups. Stock options are a financial security, they're a form of a financial instrument that basically give employees and others that are granted them the right to buy - to exercise - a right in the future to purchase a share at a specific price.
Chris Read:
And why do most startups do stock options as opposed to stock grants?
Michael Tannenbaum:
So there's two reasons. One has to do with taxes, and the other has to do with compliance. The tax reason is that when you are given a share - so if you're just given a share of stock - that is taxable upon receipt. And so if you're given a share of stock, and it's taxable, it's non-cash income, because as a private company, you [as an employee] cannot go turn around and sell that share. So imagine, let's just say Company A gives you 100 shares, at $1, you get $100 of compensation - in the US the IRS would deem that net taxable income - so you'd have to pay taxes on that hundred dollars, but you don't have any cash income to offset that because you can't sell your shares. So that's the problem. Now, let’s take options, which you only pay taxes on when you exercise. So the sort of historical view and most popular thing to do would be you hold on to your options, and then exercise them when you have liquidity.

There's a second piece, which is the compliance piece, which is after you have a certain number of shareholders that are people that actually own stock options - option holders are not shareholders, they have the right to buy shares, but they don't actually they can't vote those shares until their exercise. So the government will say that once you have a certain number of shareholders and a certain dollar amount of shares of common shareholders, that are not what they call accredited investor - so people who make $200,000 or have over a million dollars of non-primary residence net worth, those people - once you have a certain number of them, you have to file certain disclosures, and it's almost like being a public company, because you have to file all these documents. Does that make sense?
Chris Read :
Yes - can you explain that just a little more?
Michael Tannenbaum:
Sure. So point one is that if you give people shares, they have to pay taxes on their shares. Point two is that the government is trying to protect shareholders from people who are not considered accredited investors. So, I'm not making a comment about these people, but unsophisticated people, just random employees of startups, once there's a lot of those out there that are shareholders, the government says - it's really the SEC - after you have a certain number of these people, you need to start filing reporting. So things that look like an annual report showing your financials, disclosures about your company, you need to start telling people, or at least give the shareholders more information. Many companies don't want to do that, because they don't have the infrastructure or they want to keep their numbers private. And they don't want to start telling, for example, former employees that could be shareholders, and have the right to receive that disclosure, could then be turning around and sending it to the Wall Street Journal, a story you and I have seen before. Yes, so that's the point.

And then one other minor point without getting into, you know, I don't view myself as a personal finance advisor, but one of the other things options allow people to do is they allow you to start slowly exercising your options. And then you can take advantage of long term capital gains - meaning, you could hold those shares, you could exercise them before an IPO, pay a little bit of taxes on that gain, and then because you're really only paying then you could pay less tax.

There's different structures within options that we can get into ISOs versus NSOs and these things, but there are different ways that employees can have tax advantaged shares. More generally, there are RSUs - or restricted stock units - which is kind of just the standard for giving people options. I'm sorry, for giving people shares. If you just give people shares that's usually considered RSUs. That's what Google and Facebook do. They just give them the shares. Those shares are perfectly liquid. They're taxable upon receipt, and they sell.
Chris Read:
So going back to point number two really quick. I’m also curious what the tax implications are for point three.

So for point two, the triggering with the SEC only happens for shareholders, which is only for people who actually have the shares, correct?
Michael Tannenbaum:
Correct. It’s called rule 701. Okay, so for those in the know, rule 701 is the way to find out more information about this.
Chris Read:
So there's just like a percentage trigger?
Michael Tannenbaum:
It's more of dollar threshold of securities that you issue as a company, so that are going to non-accredited investors. So there's a song and dance that you do - more of a dance. And the dance is as you issue the shares, and as people start to redeem them, you're always trying to prove that the majority of the people that are shareholders are in fact accredited investors. So I spend a lot of my time - not a lot, but I spend 30 minutes of my time a quarter when we issue shares to make sure that we're showing that a lot of the recipients of these shares are, in fact, accredited investors, because that continues to make it so that Brex does not have to disclose this information.
Chris Read:
If you have options worth more than $200,000. And you exercise them, does that make you an accredited investor for that year?
Michael Tannenbaum:
No - if you were to sell shares worth more than a million it would, or if you were to receive income of more than 200,000.

But I think rule 701 is the definition if you want to know more.

But that gets into a few other points for vesting schedules. So let's talk first about vesting schedules. The Silicon Valley standard is a 48 month vesting schedule with a one year or 12 month cliff. What does this mean? This means that the standard deal is that you receive options for that vest over a four year period, starting on the vesting day. Starting on the vesting day means you are earning the shares. So they begin vesting - that date is up to a conversation between you and your employer.

Then there's also the grant date. So the grant date can come after the vesting date. The grant date is typically the date the board approves the shares, usually the board has to this year. So you could start you start vesting on July 1, the board doesn't meet until September. That's when the board approves. And the board approves the price at that point, but you've already started vesting, that's fine. If you started July 1st 2019, July 1 2020, you then earn one fourth 25% of all the shares at once. That's the cliff.

Okay, one thing about pricing. And this is important. You can never backdate options. That's a major no-no. Back dating means putting the price at the options lower than the prevailing price at that time at which it's approved. Going back to this July 1 example, so you start on July 1 share price, your price is $3. It goes up to six by the time the board meets in August even though you vested, you started on July 1. By the time the board approves the shares, it has to be at the current price - you cannot backdate an option. It just sounds like the kind of thing people go to jail for. You don't do it.

Okay. So what you have to do in that instance, you can always make somebody economically whole by issuing more shares. So if that happens, there's ways to deal with it that are legal, but you can never backed into an option and say oh, no, when they started. And so the point is, is that you can set the vesting date, and work with it to be when the person actually started performing services to the company. But on the date of approval and the grant date, you have to issue them at the prevailing price.

So more on the structure. So options have what is known as the strike price. The strike price is the price that you agree - it’s the price that you have the right to buy the shares at in the future. So after the cliff, at the end of month 12 you could buy 25% of the shares of your grant, and you can buy those at the exercise price - and that exercise price at that point is hopefully lower than the prevailing market price.

What determines the prevailing market price, and the exercise price, you ask? Good question. So what determines that is what's known as the 490a valuation. This is part of the Internal Revenue Code. And basically this is a way that private companies use to price their common shares. Preferred shares in venture land usually are at the price that’s obvious as there's been a recent round at which they were priced. Common shares, you usually use some third party valuation service, whether it's software or a person. But third party valuation services will determine what the price of the common is. And it's implied based on the preferred and other factors, like how far along the company is because, remember, in standard Silicon Valley style capital structures and documents, once a company goes public, common shares and preferred shares have the same price. And so what these valuation firms are trying to say is, what is the appropriate discount on common shares for a factor of things like liquidity, how far you are from an IPO, but also things like governance. Preferred shares have certain protections, for example, they have often liquidation preference rights in the time of bankruptcy, and all these things are getting priced. We cover that on a different podcasts. But the point is, the third party valuation service determines the common stock price. That is the strike price. And your strike price is what the options are issued at. This third party service tells you this is the common price that you're going to issue your shares at IC. When you have a new valuation, you have a new implied common valuation. Remember, it's implied because you're typically not having shares traded. So what happens is, when you raise a new round, say you were series A, you raise Series B, now you have a new preferred prevailing price, which means you have to go out and get a new valuation and then your options change.

And so back to the scenario we discussed, that's where the differences between investing versus grant date start to matter. Because theoretically, you could have started on before the board approves your options, they could go up in price. There's a lot of drama around this topic, typically. So there's a lot of back and forth about this. People are always worried what's the price of my options. And it's hard for companies because you can't really guarantee them because the winds of fundraising will blow as they blow, as we know. There's always, you know, a company that's growing, always hiring people then someone's always going to be kind of in this interim area. How you handle it as a company is sort of up to you. But as I mentioned, one of the things people often do is they will issue more shares to make the person economically whole.
Chris Read:
Do you think that that is the best way to do it?
Michael Tannenbaum:
So part of me is like, let the vagaries of the market be as they will. Because, when I went to my first startup, I sort of had this happened to me. And I felt like - well, let me rephrase. Think about if you're going to work at Google. When you do that, you realize that the share price will be as it will be. If you take a job at Google, you know that the day you start, you start investing shares - the share price, consumer share price varies, and you are sort of taking that risk as an employee. So in startup land, you go to a company, you are sort of aware of this risk. But the problem is is that it's such a big piece of comp that I do think the best way that the company should handle it is to make the employee whole. And the way Brex does it sort of interesting. What we do is once a raise has become public, we say as soon as we've announced this round, you are now accepting this job assuming this is the value. If you happen to be caught on the wrong end of it, because you started and then they raised but your options were approved, we will make you whole. And I think that's the right way.
Chris Read:
I think so.

So before we mentioned ISOs, and NSOs - what are those? And the difference between them?
Michael Tannenbaum:
Yes, yes, yes, yes. An ISO, or incentive stock options, and NSO, or non qualifying stock stock option, the main difference is the tax treatment. NSOs are kind of the most standard form of option. They're typically given to employees and to advisors - so people performing services to the company. So think of NSOs as the standard, and an ISO is our special type of option that have a special tax refund. They're generally used for executives. There is a limit, there's an annual limitation that has a dollar amount that a person can receive of ISO options. I believe that that amount is $100,000. So the exercise price times the number of shares that person is you cannot receive more than $100,000 annually of ISOs.

The way it works is as follows. When you exercise those options, that is considered a taxable event, according to the IRS. So if you exercise options, and you exercise them at $1, and the prevailing price now is $2, you owe $1 of taxes - you have made $1 of income for every share that you exercise. And then that dollar of income is taxed like ordinary income - the same as your salary. So if your tax rate is 30%, you're paying 30 cents of taxes on every dollar you exercise. Now if you exercise an ISO, you do not owe taxes on the portion of the difference between the strike price and the prevailing 409a at that point. It's an incentive stock option, you have a limitation on how many of those you can receive, and you are subject to what's called the alternative minimum tax. Meaning if you have too much of that income, you're likely to pay taxes anyway. But it is a tax advantaged structure. So those are typically good for people that are earning lots - a lot of times they are used for executives, because they're getting lots of shares.
Chris Read:
I see - I would have thought to be used for employees, because there's a $100,000 cap.
Michael Tannenbaum:
I mean, so it depends on the company. But in general, my opinion is ISOs are good to get and so you should give them.

One thing about early exercising, though, and this is important. And this is a little bit of a nuance. This is a tricky, tricky topic, but NSOs are typically what you offer employees the chance to early exercise. What is early exercise? Early exercise means you buy and exercise all your options up front. A lot of people want to do this. So you basically pay for them - all four years of them - day one. And what that means is that when you're exercising them, they are initially at the same price as the prevailing price. But you haven't even vested them. So if you leave early or you get terminated, God bless you, whatever, what happens is, let's just say you pay $1,000 up front and you only work three years, the company pays you back $250, because you're not investing into the last 25% of the shares. And you have to take the deal. But what you've done is when you early exercised the shares at the same time you were granted them, there's no delta between the exercise price and the prevailing 409a, so there’s taxable income. In that circumstance, you'd rather have NSO than ISO, because the magical tax treatment of ISO only works if you hold them for two years.

So you have two limitations on ISOs. One, we already talked about was the $100,000 limit. The second is that you have to have a qualifying disposition, meaning to get the benefits of this you can't sell ISO shares for at least 24 months after they were granted. And so because of that - because ISO has extra limits - if you're going to not benefit from the tax piece, which your not if you early exercise, you might as well not have those restrictions. And because the one favorable thing about ISOs is not relevant to you anymore, take NSOs.

People do not understand this. So just replay this podcast until you do. The point is is that ISOs are good, but NSOs are the standard options. If you're going to early exercise, you basically don't benefit from the main benefit of an ISO, so you shouldn't take the extra limitations.

I know this seems pedantic but this an important topic and nobody will tell you the truth on it. People will give you legal jargon and they'll tell you oh, I don't know why. It's taken me a long time - many years as someone in finance. It's very hard to get to this level of truth. So I hope this is helpful.
Chris Read:
Michael, thank you so much for coming on to talk about stock options.
Michael Tannenbaum:
Thank you.
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