So, you joined a start up! Do you really understand your stock options?

You just joined a start-up and you were lucky enough to get offered stock options. Good for you! How much do you know about stock options? Knowing the ins-and-outs of stock options in private companies can make the difference to your dreams of driving away in the Ferrari you’ve been eyeballing, or dreaming of what might have been.

Before you make any decisions about your stock offer, you should have a decent understanding of what’s going to happen at all stages of the option buying process — from grant to sale.

The number of options granted

That depends on many factors. The important thing to find out is the number outstanding common shares in the company. If there are 100,000 outstanding shares and you are being granted 1,000 of them, you are getting 1% of the options in the company. Typically, most employees are only granted a very small fraction of a single percentage. There’s no default number to the amount of shares you are entitled to. Negotiate for a number that feels good to you.

The vesting schedule

The vesting schedule refers to how long it takes for the options to become available — or “vested” — for you to purchase. A typical vesting schedule is 4 years. Let’s say you are granted 1,000 options, that means 250 are available for you to buy each year, until the 4th year when all 1,000 have vested.

The strike price

This is the price at which you are allowed to buy the options at. It’s set when you are granted the stock. As an example, you are granted 1,000 options at a strike price of $1. That means that you will need to spend $1,000 in total to buy all of your options once they have vested.

The fair market value (FMV)

This is the price that the market values the options at. Let’s say you are granted 1,000 options at a strike price of $1, and they have a FMV of $5. That means the you’re effectively getting a $4 discount per option — buying all your options will cost you only $1,000 when they are really worth $5,000, so you made a $4,000 profit.

The monetary difference between the strike price and the FMV is important because you will pay tax on this amount. In the scenario above, you will pay tax on your $4,000 profit.

The ideal time to purchase your options is when the strike price is the same as the FMV because there is $0 difference between what you paid per option and what the market value is. Therefore there is no tax liability to pay on exercise (you will still need to talk to the tax man when you sell).

Early exercise

In some companies, it’s possible to early exercise your options. This is where you buy options before they have vested — ideally when FMV is equal to strike price. This is beneficial to keeping the tax low on exercise but there are a few risks involved: If the company fails, you may lose some (or all) of your investment. It’s important to realize that the vesting schedule still applies. If you leave the company before the stock has vested, even if you early exercised, you must relinquish the stock. Usually the company will buy your options back from you, but its worth checking in each individual case.

The exit

It’s important to remember: the majority of start-ups fail. Make sure you pick one that has a solid chance of achieving one of two outcomes: IPO or acquisition. There is often a black-out period where employees are restrained from selling any stock for 6 months after going public.

Acquisition of the company will convert your existing shares into the parent company stock, or in some cases it can immediately become liquid (cash).

Wow that’s a lot of information, right!? Yes, there are lots of details to understand when it comes to your stock. Read your stock plan carefully — ask questions if you are unsure of anything, and make sure you get tax advice from a professional.

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