How Employee Stock Options Can Influence the Value of Ordinary Shares
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Stock options are a big part of the startup dream but they are often not well understood, even by senior execs who derive much of their income from stock options. There is a small but necessary catch: This means that if you leave the company the week after you join, you lose your stock options.
So, how long do you have to stay to keep your options? In most companies, they vest over four years. Details vary from company to company; some companies vest options over 5 years and some over other periods of time, and not all employers have the cliff.
Why should you care about whether that guy who got fired after six months walked away with any options or not? Remember each share represents a piece of ownership of the company. The more shares there are, the less value each one represents. Lets say when you join the startup and get 5, shares, there are 25, total shares outstanding.
You now make half as much for the same company value. That said, dilution is not necessarily bad. The reason the board approves any dilutive transaction raising money, buying a company, giving out stock options is that they believe it will make the shares worth more.
If your company raises a lot of money, you may own a smaller percentage, but the hope is that the presence of that cash allows the company to execute a strategy which enhances the value of the enterprise enough to more than compensate for the dilution and the price per share goes up. This brings us to the number which is much more important though it is less impressive sounding than the number of shares — what portion of the company do you own.
Regardless of units, this is the number that matters. Long ago Albert went to work at company A and Bob went to work at company B. Bob was very happy — he was granted 50, options at only 20 cents each. Who got the better deal? Lets say company A had 25, shares outstanding, and company B had , shares outstanding. So while Bob had more options at a lower strike price, he made less money when his company achieved the same outcome.
This becomes clear when you look at ownership percentage. Albert had 2 basis points, Bob had one. Even though it was less shares, Albert had more stock in the only way that matters. At some level the number is totally arbitrary, but many VC funded companies tend to stay in a similar range which varies based on stage. As a company goes through more rounds of funding and hires more employees, it will tend to issue more shares.
A normal mid-stage significant revenue and multiple funding rounds, lots of employees with a full exec team in place might have million shares outstanding. Late stage companies that are ready to IPO often have over million shares outstanding. I talked briefly about exercising options above. One important thing to keep in mind is that exercising your options costs money. Depending on the strike price and the number of options you have, it might cost quite a bit of money.
In most private companies, there is no simple way to do the equivalent. The other really important thing to consider in exercising stock options are taxes, which I will discuss later. Why is the IRS involved and what is going on? One of the factors that the IRS uses to determine this is how the strike price compares to the fair market value. Options granted at below the fair market value cause taxable income, with a penalty, on vesting.
Companies often prefer lower strike prices for the options — this makes the options more attractive to potential employees. In the case of startup stock options, they specify that a reasonable valuation method must be used which takes into account all available material information. The types of information they look at are asset values, cash flows, the readily determinable value of comparable entities, and discounts for lack of marketability of the shares.
Most startups have both common and preferred shares. The common shares are generally the shares that are owned by the founders and employees and the preferred shares are the shares that are owned by the investors. There are often three major differences: What do these mean and why are they commonly included?
The biggest difference in practice is the liquidation preference, which usually means that the first thing that happens with any proceeds from a sale of the company is that the investors get their money back.
In some financing deals the investors get a 2x or 3x return before anyone else gets paid. Personally I try to avoid those, but they can make the investors willing to do the deal for less shares, so in some situations they can make sense. Investors often ask for a dividend similar to interest on their investment, and there are usually some provisions requiring investor consent to sell the company in certain situations. Employees typically get options on common stock without the dividends or liquidation preference.
The shares are therefore not worth quite as much as the preferred shares the investors are buying. That is, of course, the big question. If your company has raised money recently, the price that the investors paid for the preferred shares can be an interesting reference point.
The more likely that the company will be sold at a price low enough that the investors benefit from their preference the greater the difference between the value of the preferred shares and the common shares. So in effect, a smart investor is indirectly buying your common shares for around the price the VCs pay for preferred. Options typically expire after 10 years, which means that at that time they need to be exercised or they become worthless. Options also typically terminate 90 days after you leave your job.
Even if they are vested, you need to exercise them or lose them at that point. The requirement to exercise within 90 days of termination is a very important point to consider in making financial and career plans.
This is an area of asymmetry where senior executives have these provisions much more frequently than rank-and-file employees.
There are three main types of acceleration: In this second case, I think a partial acceleration, double trigger is fair.
In the first case, full acceleration may be called for, single trigger. In most other cases, I think executives should get paid when and how everyone else gets paid. Some executives think it is important to get some acceleration on termination.
How many stock options you should get is largely determined by the market and varies quite a bit from position to position. This is based on my experience at two startups and one large company reviewing around a thousand options grants total, as well as talking to VCs and other executives and reviewing compensation surveys. I strongly believe that the most sensible way to think about grant sizes is by dollar value.
While percent of company is better it varies enormously based on stage so it is hard to give broadly applicable advice: Dollar value helps account for all of this. What I would then look at is the value of the shares you are vesting each year, and how much they are worth if the stock does what the investors would like it to do — increases in value times. This is not a guaranteed outcome, nor is it a wild fantasy.
What should these amounts be? This varies by job level:. Key early employees often wind up in this range as the company grows. For those reading this from afar and dreaming of silicon valley riches, this may sound disappointing. Remember, however, that most people will have roughly 10 jobs in a 40 year career in technology. Over the course of that career, 4 successes less than half at increasing levels of seniority will pay off your student loans, provide your downpayment, put a kid through college, and eventually pay off your mortgage.
Your employer should be willing to answer this question. I would place no value on the stock options of an employer who would not answer this clearly and unambiguously. You should ask how much money the company has in the bank, how fast it is burning cash, and the next time they expect to fundraise.
This will influence both how much dilution you should expect and your assessment of the risk of joining the company. You should ask what the strike price has been for recent grants. Nobody will be able to tell you the strike price for a future grant because that is based on the fair market value at the time of the grant after you start and when the board approves it ; I had a friend join a hot gaming company and the strike price increased 3x from the time he accepted the offer to the time he started.
Changes are common, though 3x is somewhat unusual. You should ask if they have a notion of how the company would be valued today, but you might not get an answer.
There are three reasons you might not get an answer: If you can get a sense of valuation for the company, you can use that to assess the value of your stock options as I described above. One feature some stock plans offer is early exercise. With early exercise, you can exercise options before they are vested. The downside of this is that it costs money to exercise them, and there may be tax due upon exercise.
The upside is that if the company does well, you may pay far less taxes. If you do early exercise, you should carefully evaluate the tax consequences.
By default, the IRS will consider you to have earned taxable income on the difference between the fair market value and the strike price as the stock vests. This can be disastrous if the stock does very well. In this case the taxes are calculated immediately, and they are based on the difference between the fair market value and the strike price at the time of exercise. If, for example, you exercise immediately after the stock is granted, that difference is probably zero and, provided you file the paperwork properly, no tax is due until you sell some of the shares.
Be warned that the IRS is unforgiving about this paperwork. You have 30 days from when you exercise your options to file the paperwork, and the IRS is very clear that no exceptions are granted under any circumstances.
I am a fan of early exercise programs, but be warned: What if you leave?