The Startup Employee's Guide to Stock Options

By Steven Moseley

HOW TO EVALUATE AND MANAGE YOUR OPTIONS LIKE AN INVESTOR

April 15, 2020

Employe stock option certificate

So you're thinking about working at a startup, because you want the upside opportunity provided by owning options in the company. Well, before you jump into the wonderful world of startup craziness, let me give you a little background on how stock options work, why they're a great benefit, what the risks are, how you should evaluate them, and more.

Thinking about your stock options like an investor is going to give you the ability to evaluate them rationally, exercise them at the right time, potentially save yourself a lot of money in taxes, limit your exposure to risk, and give you the best options (pun intended) in your career path.

Let's get started.

Part I: What are stock options?

In plain English, stock options give you (the "option holder") the right to buy (or sometimes sell) shares of stock in a company at a later date, at a preset fixed price (called the "exercise price" or "strike price"), even if the value of the company goes up (or down).

In the case of an private company's option incentive plan like the one you're considering, options are often granted to the employee over a period of time called a "vesting period", with portions of the total grant "vesting" (becoming available for exercise) at predefined intervals.  A typical option plan will have a vesting period of 4 years, which means 25% of your options package will vest each year. So if you had a grant of 100,000 shares, you could exercise 25,000 of them each year you stay with the company. Usually, you'll have a window before those vested options expire, often 10 years from the vesting date, which gets cut to only 90 days or so after you leave the company (aka the "golden handcuffs" clause).

In public markets, options to purchase ("call options") or sell ("put options") shares of public companies are bought and sold every day in trading activity. Options investors employ multiple strategies that don't really apply to startup employees, but a key takeaway from this activity is that options in their most basic form have a calculable intrinsic value. That value, for 100% of companies, is somewhere between $0 and [the current market value of the shares - the exercise price set in the options]. In other words, the right to buy shares is never worth more than the market value of the shares themselves.

In public markets, the value of options is easy to figure out - it's set by the millions of traders buying and selling them every day. In a private company with virtually no trading activity, it's a much harder process. I'll give you a framework you can use to try to get to a dollars-and-cents valuation below.

Part II: How to evaluate an options grant

Stock options in a private company are a tricky thing to evaluate. But here are some important rules to help you think about them rationally:

1. A share in Company A is not the same as a share in Company B

So Company A's option offer is for 10,000 shares, and Company B offered 100,000 shares. Do you think Company B offered you the better options plan? Not necessarily. There are a few factors you need to take into account:

  • Divide your options by total shares. Your count of shares of a company are relative to the total count of outstanding, or issued, shares in that company. No two companies have the same count of outstanding shares. If you're offered 100,000 shares of a Company B, which has 10 million outstanding shares, for example, that equates to a 1% equity stake. Whereas if you're offered 10,000 shares of Company A, which has only 100,000 outstanding shares, that's a 10% equity stake. It's important to know the size of the total pool to know what your full-vested stake will be.
  • Make sure common shares aren't underprivileged. Most companies will have different classes of stock for employees (typically "common") and for investors (typically "preferred"). Preferred stock holders usually have better voting rights, some kind of liquidation preference on exit, and sometimes dilution protection or other benefits. It's important to ensure 1) your options are in a class of stock that is protected against manipulation by your investors, 2) that the preferred stock has a healthy split between "participating preferred" and "non-participating preferred" classes, and 3) that the liquidation preference to participating preferred shareholders isn't excessive, as these can all impact your common stock's value. Another red flag to look for is if employee stock options are a different class of shares than the founders' equity.
  • Ask an expert. You should consult with a lawyer, accountant, or someone who is exceptionally savvy about options agreements to determine if your options grant is particularly disadvantageous to you. Read the story of how Eduardo Saverin was ousted from Facebook to get an idea of how bad an underprivileged class of stock can be for the holder.

2. How to calculate the value of your options grant

The key takeaway you may have missed from the intro is: "the right to buy shares is never worth more than the market value of the shares themselves". For this reason, you have to consider recent investment activity for your startup to define the ceiling of your options' market value.

Simply demonstrated, if a qualified investor can buy your company's stock for $1 per share, an option to buy one share of the same stock is worth less than $1. If the option gives one the right to buy each share for $0.20, it's worth no more than $0.80 ($1 - $0.20), because it costs $0.20 for something ostensibly valued at $1. Even if the exercise price is only $0.01, the option is still worth at most $0.01 less than the $1 share itself.

In reality, when considering additional factors, your options are worth even less than that. Here is a step-by-step guide to calculating the value of your options as precisely as possible:

  1. Use the last investment round as a baseline. What was the amount raised in the last round, for what % of the company, and how many outstanding shares are tehre? This will give you an idea of what the market thinks the company's value is.If the company got $2M for 20% of the company, that implies a pre-money value of $8M. If there are 10M outstanding shares after the raise, that imputes a value of $1 per share. 
  2. Discount invested funds spent.  Assume the last round was intended to last 18 months. If it's been 6 months since that money was raised, you can assume 1/3 ($0.67M) of it is gone. Subtracting that from the per-share value yields $1 - ($0.67M/10M) = $0.93 per share present market value for preferred stock.
  3. Discount that amount for your class of stock. If you're being offered an underprivileged common stock class, where a significant participating-preferred class gets a 1x or more liquidation preference, you should probably value your shares at ~50% that of preferred stock. Otherwise, go with ~75%, to account for the slight increased risk of common stock going to $0. So in the example above, your options might worth anywhere from $0.47 to $0.70 per share, based on these factors.
  4. Subtract the exercise price. As in the exercise above, if the exercise price is $0.20 per share, subtract that from the intrinsic value of your options relative to the share value. That gives your options a fair value of no more than $0.50 per share
  5. Do the Math. Taking the most aggressive $0.50 per-share value, $0.50 x 100,000 = $50,000, or $12,500 per year of value to you as a benefit.
  6. Other considerations. Consider things like future dilution vs growth prospects of the company. More than likely, the company will have to raise 1-2 more rounds before all your options vest. That could dilute your stake by 33% or more, depending on the terms of those capital raises.  Also consider risk of illiquidity for at least 4 years. If your options and shares aren't transferable, you run the risk of sitting on a highly volatile asset that may go to $0 before you can exit it. Some investors would discount the options for this reason.

3. The exercise price impacts your ability to exercise the options

The exercise price not only impacts the value of your options, as I explained in the last section. It can also impede your options' liquidity by making you unable to freely exercise your options.

As an example, let's use the previous numbers of a recent investment at $1 per share, and an exercise price of $0.20 per share. If you have 100,000 options, it will then cost you $20,000 to exercise, or $5,000 per year over 4 years. If the exercise price were $1 per share, it would cost you $25,000 per year ($100k total). The exercise cost can represent a material investment you'll be required to make in the company, which may impact your ability to purchase your options as they vest.

Your employer will likely tell you "your vested options will automatically exercise on acquisition, so it doesn't matter." I'll discuss why you shouldn't count on that, and why it actually does matter in the next section.

5. Final Thought: How do startup options stack up vs pubco RSUs?

If you were to join a big public company instead of a startup, you'd potentially receive an annual grant of RSUs (restricted stock units) instead of options. Often times, these RSUs are offered as a benefit over and above your market-rate salary, whereas at a startup, options are often granted in exchange for a pay cut.

Furthermore, RSUs in a public company are very easily liquidated and converted into cash or other stocks, so you can easily diversify out of the stock of the company you work for. That's important because holding stock in your employer imposes a double-risk to you: if the company goes to $0, you lose your job AND your investment. When weighed vs the riskier, illiquid options you are offered from a startup, the RSUs can be an attractive alternative.

For example, if your market rate is $100k:

  • A large public company may offer you $100k + 1,000 RSUs / year with a $20 market-price, totaling $120k in package value.
  • A startup may offer you $85-90k + 100,000 options worth $50k (based on the above), totaling $97.5-102.5k in package value.

You should consider in your decision to work at a startup your personal risk tolerance. But you should also heavily consider how strongly you believe in the startup and its potential for growth. If you're not all-in on it, you're probably better off going for the big-company option.

Also consider you can also take that extra ~$20k per year from the public company and later invest it in startups as an angel investor buying preferred stock, once you have enough savings to be a qualified investor. Being a part of the early team is not the only way to get into a startup.

Part III: How to manage vested options

So you weighed the risk and took the startup job... Now you have options vesting, and need to know what to do with them. Here's an outline of how to create a plan for that in a way that will balance your risk with your job-flexibility and ultimate reward.

1. Think like an investor

The best way to manage your vested options is to think like an investor. Most companies will tell you that the best thing to do is to sit on the options until the company exits. This is only true in some cases, but is always best for a company that is growing quickly, as it can force good employees to stay longer, and prevent bad employees from exercising their full grant of options.

The company's value will change over time. As an investor holding the option to purchase a given amount of stock, you should always evaluate the relative risk-reward ratio and determine whether you want to exercise your stock.

Part of this means treating your employment there as an investor would.  You're taking a salary cut for the right to purchase the company's options. That salary cut is real dollars and cents. You should at all times determine whether you believe that salary cut is worth the options you're getting. If not, you may want to consider moving to a new company, to diversify your startup-option-portfolio's risk.

But what about exercising options? If you have an exceptionally low strike price, and the 409a valuation isn't too high (explained more in the AMT details section - #3 below), it may make sense to exercise 100% of your options as they vest, to avoid future tax implications (as I explain further below).

If you have a higher strike price, you may want to wait until the company is on the path to derisking from its present situation. That may mean that the company is beginning to raise a big round of funding, providing the capitalization necessary to continue growing. Let's delve into that situation, and I'll explain why you should always exercise before a capital raise.

2. Exercise 100% of your vested options ahead of any big raise

Assuming you still work at your startup because you still believe in the company (see point #1) you should consider exercising 100% of your vested options (or at least, as many as you can afford) before any capital raise that significantly increases the company's market value per share.

Why? As with everything else in this article, it's complicated. But keeping it short, after the capital raise, the company will be forced to file a new 409a valuation, which states the market value per share of the company's stock. The IRS will determine your AMT liability (explained more in the #3 below) based on the delta between the market value and your exercise price, which if you wait until after the raise, can increase by an order of magnitude, and may cause you to have a 5- or 6- figure AMT liability, preventing you from being able to exercise your options.

This AMT lockout is extremely important to consider in combination with short-term capital gains liability (explained in point #4), as you don't want be locked you into holding your shares, then later be forced to pay an extra $100k+ in capital gains taxes, if you can exercise your options today for only a couple thousand dollars. It's all about the risk vs. the reward here. I'd suggest you discuss some of these scenarios with an accountant and figure out what makes sense for you.

Another point: If you're an early employee, and the cost to exercise your options is very small (e.g. < $0.02 per share), you may also want to simply exercise 100% of your options as they vest, until the implied AMT becomes too much to handle, which usually doesn't occur until after a large (7- or 8-figure) capital raise.

Now for the nitty gritty on AMT and Capital Gains considerations.

3. How AMT can become handcuffs for an option holder

AMT, or Alternative Minimum Tax, is a type of tax you may have to pay when you exercise options. AMT is designed to prevent abuse of loopholes around stock options grants to high-paid CEOs, but winds up impacting startup employees, as well. The good news is when you trigger AMT taxes, you also typically trigger an AMT credit, which means the excess AMT taxes you pay in a given year can be applied as a credit toward tax liabilities in future years. After 3 years, if you have any long-term AMT credit with the IRS, you can simply cash it out.

All that being said, AMT is real money of yours that will be held by the IRS when you exercise options, so if it's money that you need in liquid form, consider you won't be able to touch it for at least 12 months. If you're not careful, the amount of AMT you might owe on exercised options can become so large it can virtually handcuff you to your employer indefinitely. I'll try to explain how below.

Let's say you hypothetically have a grant of 100,000 options at a $0.20 exercise price and $1 market price at the time you were hired. 18 months later, the company raises $20M at a $100M post-money valuation, and files a 409a valuation showing a new $10 per share market value, where the previous 409a filing showed a market value of $1 per share. What does that mean to you?

Well, if you had exercised all of your available options in that first year prior to the $20M round, you would have gotten those in at a $0.80 realized value to you per share. Since you're vesting at 25,000 shares annually, that means $20,000 of value in your pocket in the eyes of the IRS. Depending on your total income, the added AMT liability on that exercise could add anywhere from $0 to $5,000 to your tax liability.

If you wait until after that round closes, with a $10 per share valuation, your shares are now worth $9.80 more than the exercise price, so your AMT penalty would add on the order of $9.8 x 25,000 x 28% = $70,000 to your taxes that year!  If you're a startup employee, $70k is likely more cash than you can afford to leave in an IRS credit for several years.

So what? So you can just sit on the options until the company exits, right?

Probably not (see #4), but now you have no other choice.

4.  Why you don't want to hold your options until exit

In one sentence: Short-term capital gains taxes are more than double Long-term capital gains.

Your options aren't actually equity until you exercise them. If you wait for them to auto-exercise on the day of acquisition or exit, you've held them 0 days prior to selling them. That means they count as short-term capital gains in the eyes of the IRS.

If, instead, you've been exercising those options as you go, many or all of them could have been converted to equity more than 1 year before the exit event. Those shares are taxed as long-term capital gains.

What does it mean in dollars and cents?

Let's say your company sold for $200M, and your options equate to a 0.5% equity stake.

Case 1) 0.5% of a $200M exit at short-term cap gains, $20k exercise price. You get paid out $980k, of which Uncle Sam takes 37% avg (per 2019 tax rate), leaving you with $620k

Case 2) 0.5% of a $200M exit at long-term cap gains, $20k exercise price. You net $980k again, of which Uncle Sam takes 18% avg (per 2019 tax rate), leaving you with $806k

That's an extra $186k in your pocket if you acted early.

5. Other reasons you don't want to hold vested options

Consider the optionality around your career path. If you hold your shares until they're 100% vested, and you're now sitting on 100,000 shares of equity with a potential $200-300k AMT liability, you may put yourself into the situation of choosing between a) not leaving the company until it exits (or fails), or b) leaving the company and only being able to exercise a small fraction of your vested options.

Either way, you're leaving money on the table here, and forcing yourself into an undivsersified stock holding concentrated in a single startup. You took a pay cut for those options. Not exercising them is the same as giving that money back to the company you busted your butt for over the last four years.

Sticking around in a company that may not be the optimal career path for you is also leaving money (and happiness) on the table. Even if you believe in the business you've built, 4+ years is a long time to spend with a single employer. What is it costing you emotionally to lock yourself in to this financial situation?

As a final thought, there's risk of total loss. Most options agreements include a clause saying that your vested, unexercised options are forfeit if you are terminated with cause. While you shouldn't plan as an employee on doing something to warrant getting fired, you should plan for that possibility as an investor. Exercising your options eliminates the risk of the company taking away your vested options if they decide to fire you. Again, this should be a low-likelihood, which is why I put it last, but it should play some small factor into your overall strategy.

What should you do next?

Hopefully, I've given you a lot to think about in terms of how to value your options, how to manage them as they vest, and even possibly other alternatives that may better suit your risk profile. I've personally had multiple startup option packages go to $0, a couple that exited with a decent little windfall, and one in a company that is still going strong and may wind up being a nice retirement for me. I am also currently a partner in a startup, which provides stock options to our employees as a benefit.

What I've learned through the years is that working at startups is a lot like investing in startups - it's very high volatility, and could yield a huge payday or a whole lot of nothing, but one big payday is enough to make all the effort worth it, and potentially even do better than working at a big company for decades and cashing in your RSUs.

What you should do next is entirely based on your personal risk tolerance. The key thing to remember is that there's an actual dollars-and-cents risk involved - by joining a startup and taking an options grant, you're essentially investing in that company. Your options will more likely go to $0 than millions, so factor that in to your risk assessment, and be sure you are willing to place that real-money bet on the company before taking the job.

If you decide to go for it, win or lose, you're in for a wild ride. Enjoy!