Understanding Your Startup Stock Options

If you join a Startup, then you may be offered stock options in your compensation.  This is how you make the big bucks, right? Yea……. but it may not be all that it’s cracked up to be. Here’s somethings I wish I knew about startup stock options.

What are stock options?

A Stock Option is a option to buy a share of stock at a set strike price anytime within the exercise window.  The idea is the strike price is locked in at the price when you are offered your options and if the company does well and the value of the stock goes up, you can buy stock by exercising your options at the strike price.  Also you are generally granted your options over a vesting period, generally 4 years with a 1 year cliff.  That means you don’t earn any options until your 1 year anniversary to which you get 25% of your options.  The remaining 75% of your shares will be accrued monthly over the next 3 years.

How much my options worth?

When you get your contract is will generally have a Strike Price and number of options.  If you’re joining a really early startup, you may not even get a strike price! The strike price will be set by the board of directors at the fair market value at the time of the options are granted. This does not paint the whole picture though.  Basically how much is an option worth now?

Public Company vs Private Company (startup)

If you’re part of a public company, it’s very transparent.  You can just go to Google Finance and look up the share price.  You can read what analysts project for the company and you can witness the price go up and down. Also you can see how many shares there are.  So if you have 100K shares out of 20M, then you owe 0.5% of the company.

If you’re joining a Private Company then it’s not transparent at all.  You are granted 10k shares at a strike price of $1, but what does that mean? It means that you can potentially buy 10k shares at the $1 price, so it will cost you $10k to exercise all your options.  But in 5 years, your strike price is still $1, but how much are those shares really worth?  In general companies are valued as whole like $100M.  So in order to gauge how much your shares are worth, you need to know how many shares there are total. Most companies will not give this information out unsolicited, but it’s crucial that you ask!

Market Capitalization

If you’re offered a whopping 1M shares then that sounds like a lot! But if there are 100B shares, then you only own 0.001% of the company. If the company is worth a respectable $100M, then your 1M shares are worth $1000.  See how just knowing the number of options is worthless in the big picture?  You need to know how much the company is worth and how many shares they have.  The value of a public company is called Market Capitalization and is calculated by

MarketCap = SharePrice * TotalNumberShares

Startup Stock Expectations

When you join a startup, you can reach for the stars, but understand a successful company could have the company worth $100M and have a $1B (unicorn companies) is very rare.

So when signing on to a company you are granted 100k options with a strike price of $0.10.  You ask how many outstanding shares there are since this information was not given voluntarily.  They company response that there are 20M shares.  So you now you know you have 0.5% of the company!  You imaging that if you can grow the company to a $100M valuation, then your options are worth 0.5% ($500k).  What if your company can grow to $1B, then your 0.5% is worth $5M. Now that’s some real money!

The Pitfalls of Startup Stock Options

Depending on your industry, trajectory, demand, wishes you can make these kinds of predictions, but there is more to it then this one time calculation when dealing with a startup.

Dilution

If your company takes more investment money (Series A, Series B, etc) then your company is issuing more shares to give to the investors.  When more shares are issued, the total number of shares goes up and there fore you own less of the pie.  you had previously owned 100k / 20M shares, but now the company created another 5M shares and you now own 100k / 25M shares which is 0.4%. Everyone were just diluted 20%.  Depending on your company’s valuation and money needed, the dilution amount will vary.  Generally each round of funding you’re be diluted 10-30%.

Your boss may say something like that’s a good thing!  Your shares were worth $0.10 a piece, but after the fund raising(dilution event) they are worth $0.12 a piece.  Although this is true, in a startup, these incremental price increases towards a final value not worth tracking.  Your company’s price is valued as a whole and the percentage of your ownership is what truly matters if the company does eventually have a liquidity event.

Taxes

Although exercising options is not considered a taxable event, it does still does get factored into your tax calculations through the Alternative Minimum Tax.  Basically when you exercise your options, you are able to buy your stock at a discount.

Let’s say 5 years ago you were granted 100 shares at a strike price of $1 at a startup.  Now you’re leaving the company and want to exercise your shares, but the company is still private. The Fair Market Value (FMV) of a share is now $5. You get to buy your shares at $1, but because it’s valued at $5, you just made a $4 gain!  How you owe taxes on that gain!  This can be crippling depending on the FMV.

You worked hard to earn those options, so it’s hard to leave them on the table, especially when they appear to have value. You can’t generally sell some stock to pay the taxes either. Unfortunately you can’t extract that value until a liquidity event such as an IPO or a sale.

I personally was on track to receive a $10,000 tax refund one year, but due to stock options and AMT I ended up owing $10,000!  That’s a $20k swing!  Read about my option exercising for a full example.  Also there are former Uber employees putting themselves in debt trying to hold on to their stocks from all the taxes.

My Personal Opinion On Equity

Basically for an employee (particularly an early employee) it sucks!  Here’s my ranting list on why.  But all said and done, that’s how the game is played and it can make you a ton of wealth.

  • Employees get screwed over Investors.  Investors generally received preferred shares of the company have over employees who also own parts of the company.  Which means if the company tanks, then they can collect some money through the assets of the company.
  • Early employees get screwed the most.  They often will work just as hard as the founders but will maybe start at 1% while founders will start with the other 90%.
  • Transparency of the startup financials makes it difficult for employees to understand their stakes value.  Dilution on top of that is not transparent and killing your value.
  • Taxes can be crippling and it may end up being worth nothing even.
  • No liquidity end in sight.  There are private companies staying private longer.
  • If your options belong to an S corp, then you must report information every year on your personal taxes.  Really annoying.

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