Understanding Employee Stock Options

After reading a post on Hacker News the other day, I quickly remembered what it was like working for a startup where stock options make up a significant part of your overall compensation, only to realize that you have no idea what these options are or how they work. Not knowing how to exercise them or what kind of event would be required to make these options valuable at all. When you accept a job at a startup, there’s a good chance you may have taken a discounted salary to receive stock options in return, with the understanding that if the company IPOs or is acquired, there will be a tremendous upside to you.

Now, I’m no expert by any means, but I have held stock options in a few different companies and have spent a fair amount of time studying finance and venture capital in business school, giving me hope that I have a decent understanding of stock options from both sides of the table, and my hope is that this helps the average option holder understand what these mysterious, billion-dollar options they agreed to are. So, here goes…

What Are Stock Options?

Employee stock options, which you’ll also hear referred to as an ESOP (employee stock option plan) are a pool of shares that are set aside by the founders and investors of a company to incentivize employees. Basically, an employee will receive equity in a company so they have “skin in the game” and are motivated to do everything in their power to make the company a success in order to partake in a monetary upside. As the name infers, options give the shareholder the option to buy shares of common stock in the company at a specified price per share, known as a “strike price.” A strike price is specified at the time the options are initially granted and are based on the valuation of the current financing. It is common to see the strike price increase over time as more investors become involved and new financing rounds take place. The thing to keep in mind is that your strike price will remain constant regardless of whether future option prices have a higher or lower strike price. In a healthy startup, the earlier your shares are granted in the lifecycle of the firm, generally the better, since the strike price will be lower than future prices due to the valuation of future financing rounds.

Shares are usually distributed to employees at hiring and/or granted throughout employment for things like good performance. Options can be granted all at once, but tend to vest on what’s known as a vesting schedule. What that means is that let’s say you are granted 100,000 shares of stock upon hiring. If you are on a four-year vesting schedule, you would normally expect to see 1/48 of the shares granted, earned each month. Sometimes a schedule will include what’s known as a cliff. A cliff is like an upfront investment in time, say one-year, at which point no options will vest until one year has been achieved, at which point, 12 months worth of options will immediately vest and the remaining options will vest monthly at 1/48 per month until the remaining shares have vested.

Different Classes Are Not the Same

Earlier I referred to stock options as common stock, and that would be true depending on the shareholder exercising the option to convert the options to shares. Until that happens, your options are just that, an option. They are really nothing more than an offer to buy a security in a private company, at a set price, at a particular point in time, at which point the options convert to common stock.

Preferred Stock

Preferred stock is a special class of stock usually reserved for outside investors. What this means is that preferred shareholders, who are taking on the majority or all of the financial risk have specific terms written into an agreement that are designed to protect their investment. Some of these terms could be things like board seats, specific voting rights, liquidation preferences, conversion rights, dividends, and the list can go on and on. Employees will never receive preferred stock and for good reason. These shares are specifically created to give the investors leverage due to information asymmetries between them and the founders of the company. The preferred shareholders will never have as much insider knowledge as the founders, thus the need for investors to invest in a company and not just do the company themselves. Preferred shares, while defensive in their makeup, also incentivize founders to scale their company quickly to get the company to an exit event far above the initial investments made, so the investors get paid back and there are additional proceeds to be distributed amongst common shareholders.

Preferred shares do not transfer to public stock markets and are cashed out or converted to common because nobody would want to hold stock in a company where there are groups of people with special privilege.

Common Stock

Common stock, as the name suggests, is the most common type of stock in a company and what your stock options will convert to if you choose to exercise those options. Common stock is, basic stock. It’s the same kind of stock the founders of the company will have and are a real security in the company.

You can think of common stock like this: Investors are usually the only people that receive preferred stock, while everyone else, including the founders, receive common stock. The investors are putting cash into the company and use the preferred shares as a way to manage the risk and return of their investment. Also, options almost never come with voting or board rights. Something to keep in mind. Common shareholders will be the last in line to be paid. This means that preferred shareholders will receive their investment back, plus dividend payments and any special preferences, like a 2x liquidation preference, before common shareholders will be able to partake in proceeds. It also means that if the company goes bankrupt, the common shareholders will receive their percentage of whatever money is left over after all creditors, bondholders, and preferred shareholders have been paid in full.

Who Gets Paid, and When?

How the specific payouts happen will be outlined in the term sheet in detail and there are an infinite amount of ways the payouts can be structured. A cap table will tell you the percentage of payouts, but the missing components in the cap table are preferences before the common stock percentage-based payouts kick in. One important thing to keep in mind is that payouts will be different based on different milestones and timelines.

Cap Tables

Capitalization tables are important because they show the equity structure of a company, number of shares, percentage of ownership and outstanding option pool. What a cap table assumes is that all shareholders hold equal weight and that the percentage of ownership has essentially been converted to common shares. A cap table is laid out in a way that defines how the payouts will look if everything plays out as planned. Or, if the ideal scenario is realized. What is not defined in the cap table is what happens if things don’t go as planned and the company gets acquired on mediocre terms or liquidates in a fire sale. These scenarios are where things like liquidation preference, defined in the term sheet, come into play.

Here is a cap table example I put together to illustrate a Series A and Series B financing. You can play with the numbers to see how the investment and price per share modify the percentage of ownership.

Payout Scenarios

Now that you understand what stock options are and how they work, let’s work through a scenario to solidify the idea and help you gain a better understanding of your actual circumstance. Imagine this scenario: you are hired to work at a startup and have been granted 20,000 options, vesting over a four-year schedule with a strike price of $2.00 per share. What does that mean? Does that mean you will walk away with $10M, $50k, $0, or even owing money?! Let’s say your options were on 1% of a company valued at $4M (20,000 shares), but now because of a new investment (Series A) and dilution, you now have 0.67% of a company valued at $12M.

When the financing round closes, it’s a good idea not to think, “Now I own 1% of a $12M company!”, because that would be untrue. Think about the difference here. 1% of $4M is $40,000. 1% of $12M is $120,000. That would be great if that was how things were going to go down, but the reality is that your options have been diluted and you now hold options for 0.67% of a company valued at $12M, or $80,000. This scenario is still looking great for you. You just doubled the value of your options.

A very important thing to keep in mind though is how the payouts will actually play out if an exit event takes place. Let’s say your company is acquired for $50M. Congratulations! You just made 0.67% of that, or $335,000. Not so fast! Your 0.67% of the pie will be after the preferred shareholders are paid off, any creditors are paid off and after the preferred shareholder partake in their liquidation preferences. Let’s look at a scenario:

Acquisition price: $50M -(minus) Investment: $4M -(minus) Cumulative Dividend (4% per year * 5 years) = $866,611.61 Total Proceeds after preferred shareholders are paid off = $45,133,388.39

Now, everyone, including preferred shareholders, in this case, will convert to common shareholders and go in at their percentage. In your case, you will take 0.67% of $45,133,388.39, which will get you $302,393. Not bad at all, but there’s more! You own 20,000 shares with a current share price of $4 per share, but you still have to buy these options to convert them to common stock. Your strike price is $2 per share, so you’ll have to cough up $151,196 to purchase the shares, which you will resell for $4 per share, getting you $151,196 in cash.

$151,196 in cash isn’t anything to sneeze at, but it’s a far cry from $335,000, or $302,393. Your $151,196 isn’t fully in the clear yet, now you get to pay capital gains tax, which is currently 25%, so at the end of the day, you’ll take home $113,397. That’s a great payday and you can still buy a Tesla, a Macbook Pro and insurance on that Tesla for one year.

Keep in mind, this is only one scenario and each one will be vastly different from the next. I used a cumulative dividend as an expense to preferred shareholders, but this is not always common. Additionally, there may be other provisions that I left out.

Here’s a look at how the value of your shares change by taking new investment, with your percentage of ownership changing.

How you are impacted in this scenario by Series A

Sample cap table showing how your ESOP shares are diluted from a Series A financing.

You can download this cap table template as a Google Sheet here.

Are options even worth it?

With all this you might be asking yourself why anyone would finance their company with equity and complicate things by bringing additional shareholders into the mix. This is something that should be thoughtfully considered if you’re in a position to consider equity financing or influence your company in the decision-making process. The other side of that would be debt financing, which can be a great option, but also comes at a real cost. Debt is something most of us are familiar with, we use it to buy things like a house and we use a mortgage to finance it. Car loans and credit cards also fall under this umbrella. Someone loans us the money with the understanding that we pay them back over a schedule, with interest, and the rates are based on the risk the lender is taking on, the amount of time they have to wait for repayment and inflation. Debt can be a great option because you don’t have to give up any equity in your company, therefore no dilution, but you also assume all the risk, unlike equity, where the risk is shared. You are required to pay back your debts, just like in real life. Debt, similar to preferred shareholders, also cut to the front of the line during payouts from an exit event. Lenders will be the first in line to be paid, but unlike preferred shareholder, they will not be exercising conversion events to partake in additional proceeds derived from equity.

Options can be a great thing. In some cases, they can make you very wealthy, but the unfortunate truth is that in most cases, they wind up being worthless. That doesn’t mean they aren’t a lot of fun and a great motivator to try and do something great. Time and value of the options are incredibly important in determining what the end-value will mean for you. If you are a founding partner or very early employee in a startup, you are in a great position to get a lot of options at a low strike price that can fully vest. Not to mention that you will probably be granted additional options over the duration of your employment. Options this early are extremely risk though. Anything can happen to an early company. High risk could equal high reward.

Vice versa is when you join a late-stage, mature startup that has gone through a few rounds of funding. You may get a lot of options, but the strike price will be pretty high and the chances of an IPO, liquidation event or acquisition are much more likely to happen before your options fully vest. Low risk will probably mean low reward.

Questions you might want to ask

Like most legally-binding agreements that can affect your finances, the more info you can gather, the better. So, here are a few questions you may consider asking.

  1. Who are the investors and what kind of investors are they? How long have their investments been tied up in the company? These clues might hint at what the exit value will need to be.
  2. What are the company’s plans? Do they prefer to IPO, be acquired or keep on running? And when?
  3. Does this company seem likely to have an exit event and will it be a big enough exit event?
  4. Who are the founders and investors and do they have a track record of successful exits?
  5. What kind of salary discount are you taking in return for options, if any? If you are taking a discount, refer to questions 1–4 and determine the ROI vs getting market value somewhere else over the next few years.

In summary

  1. Employee stock options are an option to buy equity in a company at a specific price, known as the “strike price.”
  2. Options vest on a schedule, meaning you have the ability to exercise those options only after they have vested.
  3. The options are not actually stock that you own until you exercise the options, converting the options into common stock.
  4. Additional investment in a company generally dilutes the existing shareholders, including the employee option pool and the options that have been granted.
  5. Management and investors can create additional employee stock options without changing the overall value. New options are created and sit in the ESOP pool to be granted to employees. This would likely happen if your company is growing and hiring a lot of new people, or after a new round of financing.

Pay attention to what’s going on and stay classy.

If you like this madness, find me on Twitter at @iancorbin

Originally published at iancorbin.com on February 28, 2015.