Wikipedia’s page on securities fraud says, “Offers of risky investment opportunities to unsophisticated investors who are unable to evaluate risk adequately and cannot afford loss of capital is a central problem.”
Let’s go down the line:
Are Stock Options Risky?
Imagine you were given options with a strike price at 25 cents per share, and then suddenly, due to circumstances beyond your control, the company stumbles badly. Have your options lost value? Yes. If the company goes bankrupt, they’re worthless. If the company raises another round at anything less than 25 cents per share, your options are temporarily worthless, possibly for as long again as it took you to get to this point, possibly indefinitely.
Are Options an Investment Opportunity?
Not in dollars directly, but in time, yes they are. Most folks take options in lieu of full market salary. This means there’s a very real opportunity cost associated with working at a startup. If you’re an MBA at half market salary, we might be talking $50,000/yr plus interest.
Are Startup Employees Unsophisticated?
You don’t have to be accredited, which has a very specific legal definition, but you do need to be able to “evaluate the risks and merits of an investment” before you can be called “sophisticated.” So, how many skilled technicians can perform a discounted cash flow analysis? How many gifted programmers think in probabilities? How many of the potentially dozens of super-star employees who get stock options are also successful value investors, small business owners, accountants, or other money-savvy people?
Are They Unable to Evaluate the Risk?
Here comes my main point.
I was at a networking event recently where an attorney said, speaking to startup founders, “You want to have a lot of shares authorized and a big option pool so you can give eye-popping numbers of options to your employees.”
Someone said, “But it only matters what percent of the company they could get.”
To which the attorney said, “But most folks don’t think to ask.”
The standard form “employee incentive stock option agreement,” of which I’ve now seen a couple, doesn’t offer a cap table, doesn’t offer a fully diluted number of shares, and doesn’t offer anything that a sophisticated investor would need to properly value the incentive. So how can an unsophisticated investor value it?
It’s completely dishonest to withhold the relevant financial information from a would-be optionee.
You shouldn’t even have to ask. All this should come standard on the agreement with a link to somewhere that explains how to value it.
Finally, Can the Employee Afford a Loss?
According to CNN Money, a lot of folks are going to retire with too little cash. Nine out of ten startups fail to hit it big. Odds are good that your options package is going to fail to materialize, and then your years of hard work at that startup are going to impact your retirement plans.
So what do you think? Fraud or not? Use the comments below and let me know!
And follow me here on RSS or WordPress to watch for a future article on how to value options step-by-step.