Diving head first into a startup is an excellent way to accelerate your career and to get involved early with a company whose potential success could translate into big financial reward for you. The latter is made possible through Stock Option Programs.
Based on my experiences in startups, I’ve seen that new employees too often have a limited understanding of Stock Options, particularly those folks joining a startup for the first time. I’ve participated in many conversations where team members express confusion with Stock Option Plans, which can be intimidating legal documents.
If you are a first timer to the startup world, then this primer is here to demystify employee stock options and to equip you with a few basic tools to get the most of out stock option opportunities.
First, what is a stock option and how is different from shares of stock/equity?
It is very important to know that an option is NOT equity or stock in the company!
An option is simply the right for you to buy shares of stock in the company at a predetermined price in the future. Or put another way, options are the way in which you purchase shares of stock in the startup. If your company is able to grow and be successful, then your stock options can become very valuable for you.
What are some common terms I need to know?
- Stock Option: Stock option is the legal right to buy shares of stock in a company at a predetermined price in the future (the strike price).
- Shares: Your ownership in a fraction of a percent a company’s overall stock or equity after you buy your vested options.
- Issue date: The date the stock option is given to you.
- Strike price: The purchase price that you are offered to exercise each option. Essentially, this is the per option price that you will pay to convert the options into shares. The strike price offered in your options agreement is locked-in and should not change — even as the value of the company’s shares increases — this locked-in ‘strike’ is one of the major benefits to Stock Option Plans.
- Vesting: The pre-designated timeframe and rules for when you will have access to the full stock options offered to you. In short, this means that you won’t have the ability to exercise all or a portion of your stock options until a certain time period has elapsed.
- Exercise: The moment you buy your vested options at the pre-determined Strike Price. Upon purchasing your options, they are converted to shares in the company. You don’t get to purchase your options immediately! Instead you need to go through a vesting period.
- Vesting Cliff: The time period in which you are not allowed to exercise any of your stock options — typically one year. Your employer uses a vesting cliffs to ensure that you put in at least a year of work before having the ability to exercise your options and gain shares.
Can you give a step-by-step example of how options might work for me?
- Venture Startup Inc. hires you — congrats! As part of your hiring package, Venture Startup Inc. has a Stock Option Plan that grants you options to acquire 10,000 shares of Venture Startup Inc.’s common stock at $1 per option (For reference, $1 is the fair market share value at the time you are provided options).
- You see from the Stock Option Agreement that your options are subject to a four-year vesting period, with a one year vesting cliff. This means that you have to work at Venture Startup Inc. for one year before you have any right to exercise 2,500 options (25% of your total 10,000 options granted).
- The remaining 7,500 options you were granted will then vest over the next 36 months. Each month 1/36 (or 208 options) of the remaining options will vest until all of the 7,500 remaining options are fully vested.
- If you leave Venture Startup Inc. or are fired before the end of your first year, you don’t get any of the Options because of your one-year vesting cliff (with some variations usually laid out in the agreement, for example ‘for cause’ versus ‘not for cause’ terminations).
- After your options are “vested” (whether it’s immediately after the vesting cliff is over or each month following the vesting cliff) you have the right to exercise the options at the guaranteed strike price of $1 per option — even if the share value of the company has gone up dramatically (which is what you hope for!). You don’t have to do this immediately though. You now have the right, but you don’t have to exercise until you want to (usually when the company is acquired or when you leave)
- After all four years, all 10,000 of your option shares are vested if you have remained employed by Venture Startup Inc.
- Venture Startup Inc. becomes so successful that it is acquired or goes public. Venture Startup Inc.’s stock becomes valued at $25 per share.
- You exercise your stock options and buy 10,000 shares for $10,000 (10,000 x $1).
- You turn around and sell all 10,000 shares for $250,000 (10,000 x $25 per share publicly traded price), making a nice profit of $240,000. Congrats!
Why would I would want stock options?
When working at a high potential startup, stock options can be an amazing pathway for you to purchase shares of stock at an affordable rate. Ideally, as the company becomes more successful, the company’s stock value will rise, while the strike price of your options remains the same. In other words, you can get a bargain deal on increasingly valuable shares of stock!
OK, how do I get stock options?
Not all employees are provided Stock Options. However, in the startup environment, it is common to offer stock options more widely to employees. Startups provide stock options via a Stock Option Plan, which is a legal document that details your stock option rights.
Each company will have its own version of a Stock Option Plan, but the plan follows the same terminology and processes outlined previously in this article. You will want to review this plan carefully and if possible, consulting legal advice or outside opinion on the matter can be very helpful.
If there are any issues you see with your company’s Stock Option Plan or if you just have questions, please be sure to bring them to your employer’s attention! Of course, you want to believe that your startup employer has written the terms of the Stock Option Plan in favor of its employees, but it is not always the case. By understanding standard stock option terms and practices, you can be better prepared to recognize the nuances in your company’s specific Stock Option Plan and negotiate any points that you’re unhappy with. Consult your own counsel if you have questions. (Remember the companies counsel does not represent YOU they represent the COMPANY)
Finally, when you sign the agreement for your Stock Option Plan (whether it’s on paper or digitally using a service such as Carta), there is very little that you can do to turn back or change. That agreement is a legal contract between you and the company, so be sure that you are fully comfortable and informed before finally signing!
What are common things I should consider discussing stock options with my company?
- Stock options as sweetener to lower wages: Working for a startup often means that you are going to have a wage that is below market rate. Your employer will likely provide you options to balance out the lower salary because they believe that if you can contribute to the success of the company, then you can purchase the options and benefit from the upside of actually owning shares. Be careful with this kind of thinking. Remember, if the company tanks, then the stock options and subsequent shares have no value!
- Understand percentage of ownership. As part of your hiring, your new company might say you get 10,000 stock options. However, the number 10,000 alone has no meaning. In other words, 10,000 may seem like a high number, but how many stocks have been created? For example, the opportunity for 10,000 stocks is dramatically different if it 10,000 of 100,000 stocks (10%) verses 10,000 of 10,000,000 stocks (0.1%). It is very important to find out what your specific percentage of ownership will be. Conversely, you need to know the current market value or the last round valuation of the stocks (this might be different than the strike price for a variety of complex reasons) but knowing that will help you understand what a financially savvy and informed investor has paid for the same slice of the company.
- Paying to exercise your stock options. Be sure to review your Stock Option Plan and agreement very closely to determine the ways in which you can pay to exercise your stock options. In contract terms, this is typically described as ‘consideration.’ Payment or consideration can take the form of cash or deferred payment. Whatever the case, be sure that you understand the method for exercising your stock options. Especially consider what happens if you leave the company prior to either fully vesting or an acquisition. Life happens and you might move on. Usually the vested shares will need to be exercised within some time period following your departure, which means you will need to pony up the cash to exercise your options and convert them into shares of stock (remember shares of stock don’t have a time limit!).
- Success events and triggers. A Success Event is typically a sale or Initial Public Offering of a company. Be sure to review your stock option agreement for clauses that discuss accelerated vesting at the time of a success event. For example, if you have stock options with a 4-year vesting period, but after 2 years of being with the company it is acquired, then your options could be accelerated so that you could purchase them before the 4-year vesting period is complete. If your agreement stipulates that your remaining stock options are accelerated automatically at the occurrence of a success event, then it is called a trigger. Note that some stock option agreements actually leave such acceleration up to the discretion of the board of directors. Acceleration can be in full (meaning all the remaining unvested options become vested) or partially (only a portion of unvested become vested). You certainly want to have your stock options accelerated and you want them to be accelerated in full — you contributed to the company’s accelerated success, so you should benefit from having the opportunity to purchase all that stock included in your option plan!
- Single vs double trigger: One final note on acceleration is that there are two kinds of triggers. The most typical trigger is the single trigger, which means that either the full or partial acceleration of your unvested stock options occurs at a single success event (e.g. sale of the company). The less common double trigger is often reserved for cofounders or executive employees. In a double trigger, two events are needed to accelerate vesting. The first event is typically the sale of the company and the second is the termination of the employee without cause. In this case each trigger accelerates a partial amount of unvested stock options. Double triggers are typically used to protect founders and executive staff that might be terminated during an acquisition or merger of the company. Definitely be sure you understand what triggers (if any) are associated with your specific stock option agreement!
Is there anything else I should keep in mind about Stock Options?
- Be comfortable with the terms and values surrounding the stock option agreement. The company should be forthright in ensuring that you understanding the values and valuations, number of shares outstanding, etc.
- The amount of stock options granted varies greatly based upon when you join the company as well as your specific role. Typically earlier employees are given larger stock option plans because in the early days a company is worth less and it is riskier to join. Also, management generally receive bigger stock option packages because of greater responsibility to impact the company’s value.
- Stock options and shares of stock are not cold hard cash. Remember that options have no value until they are exercised and converted into shares of stock in the company. Even shares of stock are not liquid cash like a bonus or wage increase.
- Stock options are lottery tickets, not something to rely on. Working towards vested stock options and exercising those options is a gamble. Regardless how many stock options you exercise and ultimately how many shares of stock you eventually own, if the company fizzles out, then the value of the shares of stock becomes zero as well. It’s important to realize that it is not a replacement for your salary.
Hopefully this guide offered some helpful tools to navigate the ‘stock option conversation’ with your startup team. Good luck!