Who pays when startup employees keep their equity?

This seems crazy to me as I have watched many close friends cash out options from companies including Google, Yelp, Apple and Pandora and buy houses (some with cash), start companies, become investors and/or take long sabbaticals with the proceeds from their options. With salary there is a clear upper bound and the tax on W2 income is simply the worst. I would say that at least in the Bay Area, options are a good bet and much better bet based on what I've seen.

Startups are always a gamble for everyone involved. But outside of the financial industry, where 6 and 7 figure cash bonuses are common, I think options are superior to other forms of compensation if you're trying to optimize for gaining a "life changing amount of money" in less than say 10 years. High salary could only compare if you are very good at minimizing tax and maximizing the money making potential of your salary though investments (requiring additional work). But if you're going to have to invest anyway, why not work for a company you believe in and have a chance at influencing the company's success as well as your own?

I had stock options (not RSUs) at BigCo where I worked for 2 years. At one point, had I been fully vested, I was sitting on about $240k worth of stock. After a 3x1 split and the company going back down to almost the strike price I was granted stock (and most of it was worthless because was given it as part of a raise at a high strike), after I parted ways with the company and sold my options (had to as part of the severance agreement), I walked away with $2000. Basically a $1k/yr bonus. I would have gladly taken extra salary instead of stock. Lesson learned.

I do work for a startup now, with options (and have in the past as well). I object to options in the sense that it takes a lot of luck for them to ever be worth anything. It's easy for companies to talk up their potential value (once we get our billion dollar valuation, your 0.05% is $500k!), but in order for the options to be worth the paper they're printed on, a lot of things have to happen in a specific order. One bump in the road, and your shares are wiped out.

Appetite for risk is a tricky way of putting it. I don't think the risk is that the company will fail and the options won't be worth anything; I think the real risk is that something will happen to cause the options to be worth less (or perhaps worthless). That's the sort of risk I'm not interesting in sacrificing much salary for, especially if the company isn't bootstrapping.

When the sum of the options pool allocated for employees is 5% or 10%, the risk/reward ratio is all out of whack. The risk of being diluted/preferenced/strong-armed out of your shares is fairly high. All it takes is one investor with preference to completely wreck the cap table.

As an employee, you need to know that you're absolutely last in line. Standing in front of you are: banks (loans generally come off the top), investors with preference, investors, founders (who will be fine, even if it means their shares are worth $0, but they get an incentive to stay worth $5m), C-level employees who might have preferred shares, and then finally, common stock holders.

So assuming everything to there goes really well, the shares convert to common and everything is looking up. You haven't been diluted into the ground, your company isn't Zynga and demanded your shares back and your company is now public. Congratulations! There are still more obstacles: you can't sell your shares for a certain lockup period, during which the share price could very well dive. If the stock is going up, you don't care, but if it dips, it's a race to your strike price. If the stock dips under your strike price, you have no reason to exercise your options, so you're left hoping that Wall Street likes your company.

And even then, let's say you exercise your options, sell the shares and make $500k. After taxes, you're going to walk away with a good chunk less than that. After taxes, let's say you have $330k. Say you worked at the company for 5 years before they went public, that's roughly $60k/year that your stock was worth.

So the real question then is how much salary is it worth deferring on the very long shot that you make $60k/year off of your stock? $330k isn't exactly life-changing money for most people: it's not enough to retire on, it's a nice down payment on a house someplace in reasonably high demand.

I think the presumption is that all parties act in their own self-interest. For some founders that means compensating employees with equity, for others that means keeping equity to themselves and relying on cash compensation for employees. Without talking about specific situations I don't think you can ascribe malice to either choice.