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Are Startup Stock Options a Form of Fraud?

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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.”

That’s terrible.

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.


3 Comments

  1. 0jc says:

    I think part of the problem is that people tend to treat these two situations differently:
    1. Get Paid $100,000. Buy $20,000 of options.
    2. Get Paid $80,000 and $20,000 worth of options.

    These are, of course, identical, but in one case you actually had to part with $20,000 and in the other case you never actually saw the $20,000. If you actually had to pay $20,000 for the options a lot of people would be a lot more careful about making sure they got value for money. This bias is also used to make taxation seem less oppressive by removing it from your paycheck before you ever see it.

    There’s also a potentially large information asymmetry at work here. The company is going to have a much, much better idea of what the options are worth than even the most savvy of new employees.

    Also, because startups are SO risky, it’s unlikely that you’re being adequately compensated for the risk you’re taking relative to alternative investments you could make if you were just paid cash. The options are unlikely to be on the efficient frontier of your possible investment choices.

    Like in all economic transactions: caveat emptor. If you’re buying options with your labor, you should make sure you’re happy with your deal.

  2. dougjq says:

    Great points! If you had the $20,000, would you invest it in the company?

    Regarding information asymmetry, “Why can’t the startup pay market salary?” The answer might be because they want to create an incentive to work hard. More probably it’s because they can’t afford it. That’s not something they’re likely to share, so be careful.

  3. […] about setting the strike price of stock options given to employees.  (See my previous article here.)  They also experiment with panels and roundtable discussions, which are helpful for giving […]

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