The Golden Handcuffs? Silicon Valley Equity Compensation 101

Mar 4, 2024
I found that equity compensation in Silicon Valley is a really interesting topic to talk about on my blog. I think it's one of the main reasons people are drawn to Silicon Valley and it is embedded deep in the culture. It's behind all those amazing glory stories we hear about from the outside world. But at the same time, I can't ignore the negative impact it has been causing to tech workers. It's astonishing to see incredibly talented people who can handle world-class engineering challenges but struggle with understanding, navigating equity compensation. This is something that keeps happening, and it's something that's happened very recently and very close to me. Some of my friends have gone through it, and I figured I should write about this so my readers can learn and be cautious about it.

The Well-Known Bright Side

Equity compensation is a form of non-cash payment that companies use to incentivize and retain employees. It offers employees ownership interest or shares in the company, aligning the employees' financial interests with the company's success.
During the tech boom, numerous Silicon Valley companies popularized and expanded the use of equity compensation during the tech boom, making it a key component of Silicon Valley culture and compensation strategies.
People mostly talks about the bright side of the story such as:
Charlie Ayers, the chef who joined Google as its 56th employee, made a significant fortune from his stock options when Google went public. Originally skeptical about the value of his equity, Ayers' shares became worth millions as Google's revenue and value skyrocketed over the years. His story exemplifies the potential financial windfall associated with early employment at a successful tech startup.
David Choe, a graffiti artist, chose stock over cash for painting murals at Facebook's first offices, a decision that resulted in an estimated net worth of $300 million after Facebook went public. Despite initially doubting the potential of Facebook, Choe's choice to accept stock instead of a $60,000 payment reflected a remarkable intuition about the company's future success.
Steve Ballmer joined Microsoft in 1980, initially as Bill Gates' assistant, before rising through the ranks to become CEO. His wealth, now estimated at around $115 billion, largely comes from the equity stake he secured early on, making him one of the world's richest individuals, closely trailing Gates himself.
Many people are drawn to success stories, particularly those that involve achieving success with minimal effort. The appeal of such stories is straightforward, making the dream of prosperity a powerful magnet that draws numerous aspiring individuals to Silicon Valley from across the world.
Yet, the allure of these narratives diminished after the burst of the dot-com bubble. Many who had pursued their dreams in Silicon Valley found themselves trapped in a “golden handcuff”.
In fact, there seems to be a deliberate avoidance of discussing failures, and yet, people continue to fall into this trap even today.

The Ignored Dark Side

I find it intriguing to discover that there are numerous recent stories where things have gone awry. It seems that such stories recur with some regularity, and I anticipate this pattern will continue. It's astonishing to witness so many exceptional Silicon Valley talents, capable of solving world-class engineering challenges and complex mathematical and statistical problems, yet struggle to navigate equity compensation. Therefore I decided to list two stories for case study purpose.

2022 Bolt Stock Loans

Bolt is a payment company that focuses on simplifying ecommerce transactions, aiming to provide a more seamless checkout experience for users.
Ryan Breslow, founder of Bolt, gained attention for calling Stripe and Y Combinator "mob bosses" and alleging they were trying to undermine his company. At the time, Bolt was valued at $11 billion after a funding round.
At the peak of the valuation, Ryan introduced a controversial stock loan program for employees, where Bolt offers loans to any employee to exercise their options early. And he called it the most employee friendly plan and over half of Bolt’s employee chose it. (One of my college friend is one of them).
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He did this in a lecture way to the whole tech industry, disregarding the fact that it was an outdated strategy from Silicon Valley in the 1990s, known for its disastrous impact on workers. Such plans have historically led employees to spend years repaying loans on valueless stocks and dealing with hefty tax liabilities. This is precisely the predicament Bolt employees found themselves in.
Simultaneously, it has been verified that Ryan sold shares worth $10 million worth of shares  to investors during the Series E funding round in January, a time when Bolt's board had prohibited its employees from selling their shares.
I will cover the underlying reason in the later section for people who wants to know where is the issue. This happened mainly because the employees had to deal with taxes risks they didn't know enough about to make good choices. While employees suffering the tax obligations, Ryan remains active in various projects and defends his actions as increasing Bolt's visibility.

2023 Cruise Suspends Employee Share Program

“There will be layoffs, your equity is no longer worth anything, and here’s a huge tax bill.”
GM Cruise, often referred to simply as Cruise, is a subsidiary of General Motors that specializes in self-driving car technology. Established in 2013 and acquired by GM in 2016, Cruise is at the forefront of developing autonomous vehicle technology with the aim of deploying driverless cars for a range of uses, including ride-hailing and delivery services. The company is headquartered in San Francisco, California, and operates a fleet of self-driving vehicles that are being tested in urban environments to ensure safety, reliability, and efficiency in real-world conditions. Cruise's mission is to build safer, more accessible, and more environmentally friendly transportation options through the power of automation.
Last October, 2023, a Cruise self-driving car in San Francisco was involved in an accident where it ended up dragging a pedestrian after an initial collision caused by another vehicle. The incident led to investigations by regulatory bodies, as it was reported that Cruise did not fully disclose the extent of the accident initially. This lack of transparency resulted in the suspension of Cruise's permits to operate driverless taxis in California and may lead to fines and sanctions for the company. The situation has raised concerns about safety and regulatory compliance in the deployment of autonomous vehicles.
The following is from Cruise employee:
Leadership (Kyle Vogt) lied to us employees about the facts of the accident Cruise had last month and Cruise also lied to regulators.
Then, GM claimed our stock was still worth a lot, since they were still lying about the accident, sent us the Greek gift of vested stock, incurring a tax liability based on the large stock valuation, and just afterwards claimed the stock wasn’t worth what they said before and they cancelled the stock buyback program.
This is leaving most employees with a huge tax due next year for worthless shares. They’re either incompetent or Mary Barra is intentionally fucking us employees over since she had to compromise with the auto workers in the strike.
The misleading information led numerous employees astray, causing them to miss the crucial opportunity to liquidate their shares. In November 2023, Cruise halted its internal employee share program, which was the sole channel for employees to sell their shares. Kyle Vogt resigned from Cruise in the same month. For all the vested RSUs, Cruise employee are still obligated to pay tax, but without a method to liquidate these shares, it becomes a burden to pay off the tax bill.
On Feb 29, 2024, Cruise saw its internal share price cut by more than half from a quarter ago as the fallout from an October accident continues to weigh on the self-driving car company.

Where is the Catch?

For Bolt Employees

To understand what happened to Bolt employee, I need to explain Stock Options first, generally speaking, the reason option exists is to defer the tax obligation to future and if done right and waited enough time, you can lower your effective tax rate from somewhere 50% to around 20% (rough number). Instead of income tax, you can pay the long-term capital gains tax rate (may also subject to AMT) if you receive ISO.
Understanding the stock option can be quite complex for the normal employee. Moreover, the situation becomes at least 5x more intricate when you decide to take out a loan to exercise options or receive stock, as this can lead to a super complicated tax scenario.
  1. Using Loans to Exercise Options or Receive Stock: Employees might take out a loan to exercise their stock options (to pay the exercise price and possibly related taxes). Alternatively, they might receive stock as compensation with a loan arrangement from the company, where the value of the stock is essentially advanced as a loan that the employee is expected to pay back, often through the eventual sale of the stock.
  1. Company Underperformance and Worthless Shares: If the company does not perform well, and its stock becomes worthless, the employee is left holding shares that no longer have value. However, the loan taken to acquire these shares still needs to be repaid.
  1. Loan Repayment Issue: If the employee cannot sell the worthless shares to repay the loan, they may default on the loan.
  1. Loan Forgiveness and Tax Implications: If the loan is forgiven by the lender (which could be the employer in cases where the company provided the loan), the IRS generally considers the forgiven debt as taxable income. This means the employee would have to recognize the forgiven loan amount as ordinary income, despite the fact that the underlying asset (the company stock) has become worthless.
  1. Double Financial Loss: This situation leads to a double financial hit for the employee:
      • Loss of Investment: The shares they acquired are now worthless, so the money used to pay the exercise price (and any taxes paid if it was an early exercise intending to qualify for long-term capital gains treatment) is lost.
      • Tax Liability Without Corresponding Value: They must recognize the forgiven loan amount as income and pay taxes on it, despite not having actual income or value from the shares to cover this tax liability.
  1. Spread at Exercise: The term "spread" refers to the difference between the fair market value of the stock at the time of exercise and the exercise price of the options. In a thriving company, this spread can represent significant income (on paper) at the time of exercise. However, if the stock value then plummets to zero, the employee has incurred a tax liability based on a high paper value that no longer exists in reality.

For Cruise Employees

I would argue under this context, where leaders are concealing information and disseminating falsehoods, arriving at informed decisions becomes exceedingly challenging. This situation is further compounded by the unique circumstance in which the option to liquidate stocks has been eliminated by the leadership, leaving no alternative means for employees to cash out their shares.
Restricted Stock Units (RSUs) are a common form of employee compensation in tech and other industries, especially at private companies where traditional stock options may not offer immediate liquidity. RSUs typically vest over time, meaning employees earn the right to these shares gradually as part of their compensation package. The taxation of RSUs occurs when they vest, and if employees cannot sell shares to cover the taxes due, it can create financial strain. This issue is particularly acute in private companies where shares are not publicly traded and thus less liquid.
Under both cases, despite the distinct differences in their narratives and underlying causes, employees from the two companies find themselves in remarkably similar predicaments, burdened by immense pressure. The constant fear of job cuts looms over them, that fact that their valuable equity holdings effectively become worthless, and confronting substantial tax liabilities.


ISO (Incentive Stock Options)

  • Definition: ISOs are stock options that meet the criteria set by the IRS and offer favorable tax treatment. They are only available to employees (not consultants or board members), and there are specific conditions that must be met for the options to qualify as ISOs.
  • Tax Obligation:
    • At Exercise: Generally, there's no immediate tax due upon exercising ISOs, under the regular income tax system. However, the difference between the exercise price and the fair market value of the stock at the time of exercise (the "bargain element") may be subject to the Alternative Minimum Tax (AMT).
    • At Sale: If the shares are sold at least 2 years after the option grant date and 1 year after the options were exercised (known as the "qualifying disposition"), any profit is taxed at the long-term capital gains tax rate, which is lower than regular income tax rates. If these holding periods are not met, the sale is considered a "disqualifying disposition," and part of the gain is taxed as ordinary income, and the remainder is taxed as capital gains.

NSO (Non-Qualified Stock Options)

  • Definition: NSOs, also known as non-statutory stock options, do not qualify for special tax treatments like ISOs and can be granted to employees, directors, contractors, and others.
  • Tax Obligation:
    • At Exercise: The difference between the stock's fair market value at the time of exercise and the exercise price is treated as ordinary income and is subject to federal income tax, Social Security, and Medicare taxes.
    • At Sale: Any additional gain or loss upon the sale of the stock is treated as a capital gain or loss. If the stock is held for more than a year, it may qualify for the lower long-term capital gains tax rates.

Key Differences in Tax Treatment

  • Immediate Tax Implications: NSOs can lead to an immediate tax burden upon exercise due to the income recognition, while ISOs can potentially offer tax deferral until the stock is sold, but may trigger AMT.
  • Capital Gains vs. Ordinary Income: ISOs offer the possibility of paying taxes at the long-term capital gains rate, which is usually lower than the ordinary income tax rate, provided specific holding period conditions are met. NSOs, on the other hand, treat the bargain element at exercise as ordinary income.

Taxation of RSUs

  1. At Vesting: Unlike stock options, which a holder can choose when to exercise, RSUs are taxed at the time they vest, which is when the vesting conditions are met, and the stock becomes transferable to the employee. At this point, the RSUs are considered income, and their value is taxed as ordinary income. The value is determined by the fair market value of the stock at the time of vesting. This income is subject to federal, state, and local taxes, as well as Social Security and Medicare taxes.
  1. Tax Withholding: Employers usually withhold taxes at the time of vesting. This can be done in several ways, such as withholding an amount of the shares equivalent to the tax liability (i.e., "net settlement"), selling a portion of the vested shares to cover the tax (i.e., "sell to cover"), or requiring the employee to provide funds to cover the tax liability. The remaining shares after tax withholding are then deposited into the employee's brokerage account or provided in some other form.
  1. After Vesting: Once the RSUs have vested and taxes have been withheld, any subsequent sale of the shares will be subject to capital gains tax, not ordinary income tax. The capital gains tax rate depends on how long the shares are held after vesting:
      • Short-Term Capital Gains: If the shares are sold within a year of vesting, any gain is considered short-term and is taxed at the ordinary income tax rates.
      • Long-Term Capital Gains: If the shares are held for more than a year post-vesting and then sold, any gain is considered long-term and is taxed at the lower long-term capital gains rates.

© Daniel Zheng 2022 - 2024