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The Problem with startup Stock Options - YouTube
Channel: Slidebean
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if you've worked for a startup or
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founded one then you must have heard of
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employee stock options but i have
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actually found a lot of people both
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employees and founders that just don't
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get how they really work so much so that
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this is an actual number 55 of startup
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employees in the us never exercise their
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stock options which breaks my heart as a
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founder because they're a sacrifice that
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we founders make to
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give them this stock and we have to
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negotiate with investors and everything
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well just like any legal startup
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document it's it honestly sounds like
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it's made deliberately complicated just
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to mess with you but it's not it's just
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that dealing with company shares isn't
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easy from the legal standpoint but
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that's what our 101 series is here for
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okay so in case you're totally new to
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this world it is customary for startups
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at least in the us to offer a stock
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option pool to crucial employees and to
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crucial hires now many people think that
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these are actual company shares and
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they're not so let's start by clarifying
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that difference when founders establish
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the company they incorporate it they
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define a number of shares and they split
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it how many shares each founder gets
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determines the percentage of the company
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that they own to give you an example say
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a founder gets 500 000 shares and then
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the entire company was registered with a
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million shares they're of course getting
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50 of the company now the number of
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shares that they get rarely changes they
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rarely exchange hands when investors
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join what happens is that new shares get
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issued in the company so the 500 000
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shares of stock represent a smaller
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percentage of the entire company but
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that founder still has the same 500 000
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shares now when the company gets
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established when you register your
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corporation shares are worth nothing
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since the business doesn't really exist
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there's no revenue there's no ip then
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each share is probably worth fractions
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of a fractions of a cent of a dollar so
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there are no tax implications in you
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receiving those shares from this
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business but the moment a company raises
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capital shares acquire value let's say
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that this company raises a million
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dollars in a seat round in exchange for
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20 of the company that means that 250
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000 new shares are going to be issued to
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that investor and then the entire
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company is going to be officially worth
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five million dollars which means the new
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price per share is four dollars we have
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a whole
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much more thorough video on this
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breakdown i'm gonna link that in the
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description but the point here is
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that's two million dollars in value for
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those shares that the founder owns now
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when employee stock option pools are
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created then a new set of shares is
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going to get issued again shares are not
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exchanging hands the company just issues
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new shares that are going to be used for
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this pool but those shares have value if
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the company hired an employee and say
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offered them 10 000 shares of this
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company as part of their stock option
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plan the effective value of those shares
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is 40 000 at four dollars a share now in
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the u.s you just can't give somebody 40
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000 worth of anything and not have a tax
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implication if the company gave the
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employee those shares then that would
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become a taxable income moreover well
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this is an official investor verified
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valuation we all know that startups fail
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so you'd be paying taxes on those 40 000
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regardless of the company's fate and
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that's why employee stock options don't
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work like that instead they're given
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options they're not stock they're stuck
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options stock options are the option to
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purchase shares of stock at a fixed
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strike price so what the company does is
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offer the employee the option to buy 10
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000 shares at four dollars a share which
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is the current fair market value of that
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share according to the latest actual
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company valuation so the employee
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doesn't own these shares mind you they
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just have the option to purchase them at
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a fixed four dollar price regardless of
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what happens with the company so let's
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say that in the future the company gets
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acquired the buyer decides to acquire
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the company for 50 million dollars and
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that means that they're paying
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40 dollars per share i'm oversimplifying
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a huge journey of multiple rounds of
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funding etc but let's just keep it
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simple now this is where stock options
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are really exciting because this
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employee now has the possibility to buy
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10 000 shares at four dollars a share
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and then sell them to this acquirer for
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forty dollars a share which is what he's
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paying leaving them with a 36 dollar per
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share profit or in this case 360 000
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so this is the key about stock options
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they're only worth it if the company
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increases in value after you have
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received them and that's why they're
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such a fantastic incentive for employees
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and with a clever system that doesn't
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create an immediate tax liability now
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here's a challenge stock options can
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expire most plans have an expiration
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date of 10 years and also expire if the
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employee leaves the company employees
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usually have 30 to 90 days to decide if
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they want to exercise which means by
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purchase the stock options after they
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leave the company for most reasons so
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let me give you a very real world
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scenario in 2017 uber had become one of
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the most valuable private companies in
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existence estimations ran at around 120
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billion dollars based on their last
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actual investor evaluation so let's take
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a scenario of an employee that wanted to
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quit the company say they had received
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0.01 of the company in stock options and
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that they were issued a few years back
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when the company was valued at just one
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billion dollars which is still a massive
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increase so the strike price to purchase
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that stock option package was say a
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hundred thousand dollars with uber's
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massive fundraising rounds and valuation
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increase those shares are now worth 1.2
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million dollars so clearly you do not
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want to walk out of that kind of money
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stock options can genuinely be
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life-changing money for an employee as
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close as it can get to being a founder
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the problem was that uber wasn't
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planning on going public there was no
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visibility on this yet that meant that
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the employee would have to buy the stock
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and then hold it until the company was
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either sold or became traded publicly
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and honestly few people have a hundred
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thousand dollars flying around so cases
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like this one sparked companies like
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equity b to launch their financing
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service they essentially provide funding
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for employees looking to exercise stock
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options from private companies and they
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do it by raising funding from investors
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on their platform looking to benefit
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from the potential increase in the value
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of the stock and in return all the
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employee has to do is pay a percentage
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of the stock value in the event of an
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ipo or an acquisition if the company
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doesn't succeed or it doesn't increase
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in value the employee doesn't have to
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pay back anything so if you own stock
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options from a private company then
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equity b is i think is a fantastic
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option to fund your stock options so
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that you don't lose them again the fact
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that you only pay if the stock options
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actually increase in value is just a
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fantastic approach to doing this now
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while the uber story is very real it's
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quite an extreme case this happens often
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the employee has a good stock option
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ground they want to leave the company
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they help build but they just don't have
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the money to exercise these options now
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another rule i often get asked about is
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vesting founder shares as well as
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employee stock options often have a
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vesting period for stock options
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specifically vesting means that the
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employee will only acquire the right
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to a certain amount of shares in that
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pool after working for a certain amount
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of time for the company access to the
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purchase not access to the shares right
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so a common investing structure is four
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years say in this 10 000 share pool this
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means that each month the employee would
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get access to around 208 stock options
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this adds up to 10 000 stock options
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after 48 months another common rule
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investing is a cliff which requires a
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minimum amount of time working for that
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company for example the vesting
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agreement my co-founders and i used was
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exactly this one it was a one year cliff
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and then a four year investing using
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that 10 000 share example this means
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that by month 11 you will have earned
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zero shares that means if you quit you
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don't get any equity on month 12 you get
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your first batch of 2500 shares and
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after that you vest monthly 280 shares
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per month so investing is really
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important because it protects the
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company from an employee leaving early
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and
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getting back to stock options remember
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this one thing value is very much tied
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to the value that you manage to add to
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the business with your work if the
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business doesn't increase in value then
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stock options aren't really good for
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anything let us know in the comments if
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you have any questions i'm going to try
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to get to as many of them as i can
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thanks to the guys from equity b for
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sponsoring this video go check their
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website in the link below really
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exciting announcements later this month
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i'm going to be flying to bangalore to
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shoot a documentary on the local startup
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scene so you hit me up on twitter if you
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want to connect or if i if you know
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anybody that i should be connecting with
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thanks a lot for watching and we'll see
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you next week
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you
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