[Author’s Note: I don’t have an MBA or finance background. Half of this knowledge comes from my personal experience and half comes from numerous blog posts I’ve read over the years. I’ve tried to distill all the information down into writing that is digestible for all to understand. Opinions and suggestions are my own, research your stock options further before entering negotiations. If I’ve made any errors, feel free to correct me in the comments or send me angry tweets.]
Have you ever heard of Charlie Ayers? How about David Choe? In Silicon Valley folklore, they are legends. Charlie is a chef and Google employee #56. David is a graffiti artist that created murals for Facebook at its original Palo Alto office. Both received stock options as part of their compensation and a result, both are millionaires many times over.
Stock options. They are the lifeblood of so many startups. Startups are cash poor, equity rich. So when a founder is recruiting talent to her company, it’s common to pay a minimal salary and offer stock options as compensation. Founders routinely dangle the hope of a lottery-like payday down the line for a massive amount of work at below-market pay. Potential startup employees have to weigh the opportunity cost of valuing cash now for stock options’ future upside. It’s easy to choose stock options when you focus on the stories of Charlie Ayers and David Choe. But stock options are complicated and many don’t truly understand what their stock options mean.
There are many things that engineers, marketers, and other early startup employees often miss when considering stock options. What’s the vesting period? Is there a cliff? What liquidation preferences do the investors have? These are just a few of the questions that are often overlooked by employees receiving stock options. It’s not a decision you should make ill-informed. To help, here is our definitive guide to understanding your stock options.
Let’s start with the basics. Companies typically set aside an “options pool” for employees. This is can range from anywhere from 10-25%. There is no cap, but most option pools fall within that percent range. This pool is divided among the employees. A single employee’s equity share depends on her role, timing of hire, and possibly her negotiation ability.
For what it’s worth, venture capitalist Fred Wilson has a blog post with a formula for employee equity distribution. Social media company Buffer also has an open formula. You can learn about their formula and see an actual distribution of equity among their team.
Typically, stock options vest over a four year period with a one year cliff. So after the first year of employment, you’ve earned 25% of your stock options. Each subsequent year, you earn another 25%. If you leave before a full year accrues, your vested options will be pro-rated, usually on a quarterly basis.
Once you’ve become fully vested, meaning you fully own the rights to all your stock options, you have the option to sell your stock or hold onto it and let the value increase. In the case of startups and private companies, you might not be able to sell. There would need to be a liquidation event (acquisition or public offering) for you to be able to sell your shares for cash. In some instances, likely with company approval, you can sell your stock on the secondary market. But for the most part, startup employees have to hold onto their stock, hope it appreciates, and wait for a liquidation event.
Stock option related taxes are complicated. When you eventually exercise your stock, you are subject to taxes. The law isn’t auspicious for employees either.
If you become fully vested at a company and stay there, you don’t have to exercise your options immediately. You have the luxury of waiting for a liquidation event. But what happens if you leave early? For example, if you work at a startup for 2 years and 4 months, then you’ve only vested a portion of your total stock options allocation. You have the the option to buy your vested shares from the company, usually 90 days after your last day (Pinterest recently announced they’ll allow employees of at least two years to retain their vested options for seven years after they’ve left without having to exercise them.)
This poses a big problem for many employees. Most employees don’t have the capital to exercise their options. And if they do, they’re also hit with a large tax bill on top of that. So let’s say your options are worth $50,000 and you’re 50% vested. You would need to spend $25,000 to own your stock. Plus taxes.
Remember, this is for private stock, so there is no guarantee that these shares will have any value a few years from now. If this were public stock, it’s much easier for an employee to sell their shares at the strike price. Should the value of the stock increase from the strike price, then an employee could easily sell enough to cover the exercise price and still have cash/shares left over.
Questions to Ask
If you are looking to join a startup and want to have stock options as part of your compensation package, be sure to have this conversation upfront. Vague promises of stock usually don’t materialize and people get burned. As a company gets more successful, it’s easy for anyone to fall victim to greed and not turn over stock options to an employee after the fact. Don’t let someone tell you “they’ll take care of you.” Make them “show you the money.”
When you do have this conversation, make sure you ask the right questions. Below is a glossary of pertinent terms regarding stock options. You should definitely be aware of these terms, a few in particular. They will help you understand the following seven questions you should be asking while negotiating your stock options.
- What is the total percentage of my stock option plan? (As opposed to just knowing the number of shares).
- What is the vesting period? Is there a one year cliff?
- What is the exercise price?
- How long do I have to exercise my options after I leave the company?
- Is there an accelerator clause in the event of a liquidation event?
- What is the investor liquidation preference?
- Do investors have participating preferred stock?
Understanding your startup stock options is crucial to every employee. There are many people who don’t understand their options and get burned in the process. I know many friends who have fallen prey to this. Even I have lost out on options because I didn’t understand them. Use this post as your guide to help you navigate the tricky world of employee stock options. It’s fun to dream of a Charlie Ayers or David Choe windfall, but tread carefully. Stock options can be fools gold if you don’t understand them.
Startup Stock Options Glossary
Employee Stock Option (ESO): ESOs are a type of stock option that can be granted to employees. This gives employees the right to buy shares after a vesting period, but does not obligate employees to do so.
Restricted Stock Units (RSU): RSUs are a form of common stock. They always hold value and when they vest, they are turned into stock at a fair market value.
Liquidity: When a stock or asset can be exercised for cash.
Vesting Period (aka Lock-In Period): The time period employee must wait until they’ve earned their options and are able to exercise stock options.
One-Year Cliff: A one-year cliff means that none of your stock options will vest until the one-year anniversary of the stock issuance.
Full Accelerated Vesting: In the event of a company sale, vested options become liquid while the unvested shares transfer to new owner stock options plan. But an accelerated vesting schedule will result in all your stock vesting in the event there is change in control over stock.
Double Trigger Accelerated Vesting: Double trigger is similar to full accelerated vesting, except that an extra action has to occur for the shares to vest. Change of control is the first trigger and then termination or proposed role demotion at new company (resulting in leaving company) is the second trigger.
Exercise Options: The action shareholders take when they want to convert their stock options into shares or cash. There are three types of exercises a shareholder can engage in. Cash, stock swap, or cashless exercise.
Option Price: The amount per share an option buyer has to pay the seller.
Strike/Exercise Price: The price that a stock can be exercised.
Common Stock vs. Preferred Stock: These are two different classes of stocks. Preferred stockholders are paid out before anyone else. Common stock shareholders are not paid until preferred stock holders are paid.
Liquidation Preference: Usually a liquidation preference is insurance to investor if there is a liquidation event at a price lower than initial investment. For example, if you raised $10 million and gave up 30% to an investor and sold your company for $25 million. The investor would be entitled to its original $10 million investment instead of the $7.5 million stake it has in the $25 million liquidation event. (Never agree to a liquidation preference greater than 1.)
Participating Preferred Stock: Participating preferred stock enables an investor to get its original investment back, before other payouts, and then continue to get paid from remaining common stock proceeds based on ownership percentage.
Feel free to leave any questions or comments you may have in the comments below.