How Employee Stock Options Can Influence the Value of Ordinary Shares

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Stock options are a big part of the startup dream but they are often not well understood, even by senior execs who derive much of their income from stock options. There is a small but necessary catch: This means that if you leave the company the week after you join, you lose your stock options.

So, how long do you have to stay to keep your options? In most companies, they vest over four years. Details vary from company to company; some companies vest options over 5 years and some over other periods of time, and not all employers have the cliff.

Why should you care about whether that guy who got fired after six months walked away with any options or not? Remember each share represents a piece of ownership of the company. The more shares there are, the less value each one represents.

Lets say when you join the startup and get 5, shares, there are 25, total shares outstanding. You now make half as much for the same company value. That said, dilution is not necessarily bad. The reason the board approves any dilutive transaction raising money, buying a company, giving out stock options is that they believe it will make the shares worth more.

If your company raises a lot of money, you may own a smaller percentage, but the hope is that the presence of that cash allows the company to execute a strategy which enhances the value of the enterprise enough to more than compensate for the dilution and the price per share goes up. This brings us to the number which is much more important though it is less impressive sounding than the number of shares — what portion of the company do you own.

Regardless of units, this is the number that matters. Long ago Albert went to work at company A and Bob went to work at company B. Bob was very happy — he was granted 50, options at only 20 cents each. Who got the better deal? Lets say company A had 25, shares outstanding, and company B had , shares outstanding. So while Bob had more options at a lower strike price, he made less money when his company achieved the same outcome.

This becomes clear when you look at ownership percentage. Albert had 2 basis points, Bob had one. Even though it was less shares, Albert had more stock in the only way that matters.

At some level the number is totally arbitrary, but many VC funded companies tend to stay in a similar range which varies based on stage. As a company goes through more rounds of funding and hires more employees, it will tend to issue more shares.

A normal mid-stage significant revenue and multiple funding rounds, lots of employees with a full exec team in place might have million shares outstanding. Late stage companies that are ready to IPO often have over million shares outstanding. I talked briefly about exercising options above. One important thing to keep in mind is that exercising your options costs money. Depending on the strike price and the number of options you have, it might cost quite a bit of money. In most private companies, there is no simple way to do the equivalent.

The other really important thing to consider in exercising stock options are taxes, which I will discuss later.

Why is the IRS involved and what is going on? One of the factors that the IRS uses to determine this is how the strike price compares to the fair market value.

Options granted at below the fair market value cause taxable income, with a penalty, on vesting. Companies often prefer lower strike prices for the options — this makes the options more attractive to potential employees. In the case of startup stock options, they specify that a reasonable valuation method must be used which takes into account all available material information. The types of information they look at are asset values, cash flows, the readily determinable value of comparable entities, and discounts for lack of marketability of the shares.

Most startups have both common and preferred shares. The common shares are generally the shares that are owned by the founders and employees and the preferred shares are the shares that are owned by the investors. There are often three major differences: What do these mean and why are they commonly included? The biggest difference in practice is the liquidation preference, which usually means that the first thing that happens with any proceeds from a sale of the company is that the investors get their money back.

In some financing deals the investors get a 2x or 3x return before anyone else gets paid. Personally I try to avoid those, but they can make the investors willing to do the deal for less shares, so in some situations they can make sense.

Investors often ask for a dividend similar to interest on their investment, and there are usually some provisions requiring investor consent to sell the company in certain situations.

Employees typically get options on common stock without the dividends or liquidation preference. The shares are therefore not worth quite as much as the preferred shares the investors are buying.

That is, of course, the big question. If your company has raised money recently, the price that the investors paid for the preferred shares can be an interesting reference point. The more likely that the company will be sold at a price low enough that the investors benefit from their preference the greater the difference between the value of the preferred shares and the common shares.

So in effect, a smart investor is indirectly buying your common shares for around the price the VCs pay for preferred. Options typically expire after 10 years, which means that at that time they need to be exercised or they become worthless. Options also typically terminate 90 days after you leave your job.

Even if they are vested, you need to exercise them or lose them at that point. The requirement to exercise within 90 days of termination is a very important point to consider in making financial and career plans. This is an area of asymmetry where senior executives have these provisions much more frequently than rank-and-file employees. There are three main types of acceleration: In this second case, I think a partial acceleration, double trigger is fair.

In the first case, full acceleration may be called for, single trigger. In most other cases, I think executives should get paid when and how everyone else gets paid. Some executives think it is important to get some acceleration on termination. How many stock options you should get is largely determined by the market and varies quite a bit from position to position. This is based on my experience at two startups and one large company reviewing around a thousand options grants total, as well as talking to VCs and other executives and reviewing compensation surveys.

I strongly believe that the most sensible way to think about grant sizes is by dollar value. While percent of company is better it varies enormously based on stage so it is hard to give broadly applicable advice: Dollar value helps account for all of this.

What I would then look at is the value of the shares you are vesting each year, and how much they are worth if the stock does what the investors would like it to do — increases in value times. This is not a guaranteed outcome, nor is it a wild fantasy. What should these amounts be?

This varies by job level:. Key early employees often wind up in this range as the company grows. For those reading this from afar and dreaming of silicon valley riches, this may sound disappointing. Remember, however, that most people will have roughly 10 jobs in a 40 year career in technology. Over the course of that career, 4 successes less than half at increasing levels of seniority will pay off your student loans, provide your downpayment, put a kid through college, and eventually pay off your mortgage.

Your employer should be willing to answer this question. I would place no value on the stock options of an employer who would not answer this clearly and unambiguously. You should ask how much money the company has in the bank, how fast it is burning cash, and the next time they expect to fundraise. This will influence both how much dilution you should expect and your assessment of the risk of joining the company.

You should ask what the strike price has been for recent grants. Nobody will be able to tell you the strike price for a future grant because that is based on the fair market value at the time of the grant after you start and when the board approves it ; I had a friend join a hot gaming company and the strike price increased 3x from the time he accepted the offer to the time he started.

Changes are common, though 3x is somewhat unusual. You should ask if they have a notion of how the company would be valued today, but you might not get an answer.

There are three reasons you might not get an answer: If you can get a sense of valuation for the company, you can use that to assess the value of your stock options as I described above. One feature some stock plans offer is early exercise. With early exercise, you can exercise options before they are vested.

The downside of this is that it costs money to exercise them, and there may be tax due upon exercise. The upside is that if the company does well, you may pay far less taxes. If you do early exercise, you should carefully evaluate the tax consequences. By default, the IRS will consider you to have earned taxable income on the difference between the fair market value and the strike price as the stock vests. This can be disastrous if the stock does very well.

In this case the taxes are calculated immediately, and they are based on the difference between the fair market value and the strike price at the time of exercise. If, for example, you exercise immediately after the stock is granted, that difference is probably zero and, provided you file the paperwork properly, no tax is due until you sell some of the shares. Be warned that the IRS is unforgiving about this paperwork.

You have 30 days from when you exercise your options to file the paperwork, and the IRS is very clear that no exceptions are granted under any circumstances. I am a fan of early exercise programs, but be warned: What if you leave?

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Part of the problem is the sheer amount and complexity of information required to understand equity and ownership in the first place. For most people to understand how much of a company they actually own, all they really need is the fully diluted share count, the broader breakout of ownership among different classes of shareholders, and a couple other details.

There are lots of things that can increase the fully diluted share count over time — more options issued, acquisitions, subsequent financing terms, and so on — which in turn could decrease the ownership percentage. Of course, people may also benefit from increases in options over time through refresher or performance grants, but changes in the numerator will always mean corresponding changes in the denominator.

The exercise price of employee options — the price per share needed to actually own the shares — is often less than the original issue price paid by the most recent investor, who holds preferred stock. Dilution is a loaded word and tricky concept. On the other hand, raising more money helps the company execute on its potential, which could mean that everyone owns slightly less, but of a higher-valued asset. After all, owning 0.

But… the value of that ownership has increased significantly: While not all dilution is equal, there are cases where dilution is dilution — and it involves the anti-dilution protections that many investors may have. The basic idea here is that if the company were to raise money in a future round at a price less than the current round in which that investor is participating, the investor may be protected against the lower future price by being issued more shares.

The amount of additional shares varies depending on a formula. It also means the fully diluted share count goes up by an additional 10 million shares; all non-protected shareholders including employees are now truly diluted. We saw the effects of such a full ratchet in the Square IPO , where the Series E investors were issued additional shares because the IPO price was half the price at which those investors had originally purchased their shares.

Some investors may also have liquidation preferences that attach to their shares. Simply put, a liquidation preference says that an investor gets its invested dollars back first — before other stockholders including most employees with options — in the case of a liquidity event such as the sale of the company. Given the high sale price for the company in this example, the liquidation preference never came into play.

It would, however, come into play under the following scenarios:. When a company goes through several rounds of financing, each round includes a liquidation preference. There are various flavors of liquidation preference that can come into play depending on the structure of the terms.

But some investors do more than 1x — for instance, a 2x multiple would mean that the investor now gets 2x of their invested dollars off the top. The impact of this on other stockholders can be significant. The common and option holders are no worse off than they were when our investor had only a 1x liquidation preference:. This is the language that determines who gets to approve an IPO.

In most cases, the preferred stockholders, voting as a single class of stock, get to approve an IPO: Add up all the preferred stockholders together and the majority wins. Sometimes, however, different investors can exercise control disproportionate to their actual economic ownership. This typically comes into play when a later-stage investor is concerned that the company might go public too soon for them to earn the type of financial return they need having entered late.

In such cases, that investor may require that the company get its approval specifically for an IPO, or if the price of the IPO is less than some desired return multiple like x on its investment.

How would they do this? By asking for more shares or lowering the conversion price at which its existing preferred shares convert into common. This increases the denominator in the fully diluted share count. To be clear, none of this is to suggest nefarious behavior on the part of later-stage investors. Besides the financing and governance factors that could impact option value, there are also specific types of options that could affect the economic outcomes. In general, the most favorable type of options are incentive stock options ISOs.

Basically, ISOs mean that startup employees can defer those taxes until they sell the underlying stock and, if they hold it for 1 year from the exercise date and 2 years from the grant date , can qualify for capital gains tax treatment.

Non-qualified options NQOs are less favorable in that someone must pay taxes at the time of exercise, regardless of whether they choose to hold the stock longer term. Since the amount of those taxes is calculated on the exercise date, employees would still owe taxes based on the historic, higher price of the stock — even if the stock price were to later fall in value.

One of the most frequently asked questions about options is what happens to them if a startup is acquired. Below are some possible scenarios, assuming four years to fully vest but the company decides to sell itself to another company at year two:. This means that, if someone is given the option to stay with the acquirer and choose to stay on, their options continue to vest on the same schedule though now as part of the equity of the acquirer.

Unvested options get cancelled by the acquirer and employees get a new set of options with new terms assuming they decide to stay with the acquirer.

Unvested options get accelerated — they automatically become vested as if the employee already satisfied her remaining two years of service. There are two flavors of acceleration to be aware of here, single-trigger acceleration and double-trigger acceleration:.

Note, these are just general definitions. There are specific variations on the above triggers: And double triggers give the acquirer a chance to hold on to strong talent. But how the money ultimately gets divided across these various buckets can sometimes diverge from what the initial option plan documents dictate as acquisition discussions evolve.

Rule , the exemption for issuing employee stock options. But times have changed, and the requirements that were put into effect April have failed to keep pace. Companies are now staying private longer and are therefore raising more capital , often from new entrants to venture investing with more complicated terms.

Rule should be updated to better reflect the information people need to understand options. Startup outcomes are, by definition, unpredictable. Every startup is unique, every situation has unknown variables, and new data will always change the economic outcomes. Working at a startup means getting in early for something that has yet to be proven, which means it could have great risks … and potentially, great rewards. The original issue price is just what it says: This price tells us what various financial investors believe the value of the company was at various points in time.

The conversion price is the price per share at which the preferred stock will convert into common stock. Dilution Dilution is a loaded word and tricky concept. Liquidation Preferences Some investors may also have liquidation preferences that attach to their shares. It would, however, come into play under the following scenarios: The common and option holders are no worse off than they were when our investor had only a 1x liquidation preference: ISOs vs non-quals and exercise periods Besides the financing and governance factors that could impact option value, there are also specific types of options that could affect the economic outcomes.

Below are some possible scenarios, assuming four years to fully vest but the company decides to sell itself to another company at year two: Unvested options get assumed by the acquirer.

There are two flavors of acceleration to be aware of here, single-trigger acceleration and double-trigger acceleration: So people would get the benefit of full vesting whether or not they choose to stay with the new employer. In double trigger , the occurrence of the acquisition alone is not sufficient to accelerate vesting. Related Stories Raising Capital: