Startup stock options are a method of long-term incentive compensation meant to align employees with the ultimate monetization of their company via a strategic exit, investor recapitalization or initial public offering.
Over the years I’ve talked to countless startup employees who feel like they got burned because they didn’t know what questions to ask for early stock options. I’ve come to realize that most people just don’t understand how the equity component of their compensation package works and how it may or may not be realized some day.
Pros and Cons of Startup Stock Options
Clearly, the earlier you join a startup, the bigger the risk, but also the greater the potential reward. There tends to also be a big tradeoff for cash to stock at the earliest stages, so ensuring you know what you’re signing up for is imperative.
Startup stock options are granted at today’s fair market value, meaning they have a cost basis to them that someday will need to be paid before any upside gain is realized. It is an illiquid asset with no real value to you at its current state.
Below you will find common questions to ask for early stock options and the answers you should educate yourself on. Understand how to approach your illiquid net worth with eyes wide open!
What Are the Types of Stock Options for Employees?
The two different types of stock options for employees are non-qualified stock options (NSOs) and incentive stock options (ISOs).
NSOs and ISOs have nuanced differences in their tax treatments. If you are at this level of depth and seeing different types of stock options, as with all financials, please refer to your tax and financial advisors.
Many companies as they scale — more commonly, public companies — use restricted stock units (RSUs). RSUs are on a vesting schedule as well, but when they vest, they are yours, and their value is taxed as ordinary income.
What’s a Basis Point in Stocks?
Startup stock options are typically represented as basis points (BPs) in a job offer, commonly for senior management or early employees, which ends up outlined on the company’s capitalization table (cap table). For example, 50 BPs would be 0.5% in a fully diluted position.
It is important to understand the market for your role and stage as part of the holistic job offer (base salary, bonuses, commission, benefits, stock, etc.). As companies scale or for specific employees, typically just a number of shares will be represented. Dilution will most always play a role, but the absolute number of shares you have typically won’t change.
How Long Does It Take to Get Stock Options?
Stock options are attached to vesting schedules, generally with a cliff. In other words, you don’t get them all at once, but over time based on your employment with the company.
They usually vest over four years either monthly, quarterly or annually. (For board members or startup advisors, these vesting schedules can be as short as two years.) A cliff can be in place, meaning you don’t get the full vest until you hit it. The cliff can be 90 days, six months or even a year.
What Happens After Stock Option Vesting?
Startup stock options can only be exercised and become yours once they are vested. Most employees, if they remain gainfully employed, don’t exercise them until a liquidity event, as there isn’t always a need or opportunity to use cash flow to do so. There are tax benefits to doing so, however.
Many times when a company raises outside capital from institutional investors, even founders will be put on a stock option vesting schedule. This founder’s vesting schedule is done to protect a new investor from the chance that a founder who they are backing may think about leaving the company. It is typically done via some ratio split of the founder’s equity holdings.
If you were to leave a company and you have stock vested, there is a limited time window typically allowed to buy the shares at the exercise price – typically 60 to 90 days.
When Should I Exercise My Startup Stock Options?
The stock you hold in a private company typically doesn’t have an open market where you can actually redeem the value of the stock. Typically, you’re at the mercy of the startup’s monetization fate, which is directly tied to leadership, investors and the board of directors of the company.
If you do end up early exercising the stock options (writing a check to own them and turning your shares into real equity), it’s always best to hold them for one year for long-term capital gains tax. If sold sooner, you’ll pay ordinary income tax on the gain, which is not as favorable financially.
In essence, stock options are worth nothing until: a) they are exercised and you convert them to equity; and b) the company has a liquidity event. It’s important to track the value of the shares, but you shouldn’t spend the returns until they are truly monetized.
The horror stories you hear about startup stock options, where they end up having no value — or worse, negative value — happen when employees (current or past) exercise their options and the company ends up less valuable (having a worse valuation) at the time of exit.
This is something that York IE coaches entrepreneurs about, and it’s why we frown on vanity metrics, over-fundraising and inflated valuations. These only set companies up for potential failure during exit events, which should all be celebrated and rewarding.
What is Stock Option Dilution?
Your stock option percentage will get diluted every time the company issues new shares. This happens when it creates a larger stock option pool or raises more money. Every time a company brings on a new investor, it is selling a piece of the company, and the clock restarts on upside opportunity for all shareholders.
For all shareholders to win on the inevitable exit, the money raised must create accretive value while minimizing dilution. Team members must really believe in their incentives being aligned with leadership’s to realize the true potential value of their stock options.
What Other Stock Option Pitfalls Are There?
Typically, institutional investors have favorable terms written into investments. This can come in the forms of stock classes (preferred vs. common shares) and liquidation preferences (they get their money before you do).
The institutional investors tend to limit their downside risk, given the large amounts of capital on the line. It’s important you understand this and again have leadership that is fundraising responsibly and looking out for the interests of common shareholders.
There are exits where the stock preferences are so stacked against the common shareholders that investors make great returns on their capital, but employees are left with nothing or with shares under water.
What Stock Option Tax Implications Should I Be Aware Of?
In the most favorable of situations, companies qualify for Qualified Small Business Stock (QSBS). Under QSBS, fully vested and exercised shareholders who own and hold their stock for five years or more until exit pay no federal capital gains tax. QSBS qualifying is typically done early, at founding or maturity.
Align Your Incentives
When employees are betting on a startup, they’re also betting on themselves. Be prepared and educated. Know what questions to ask for early stock options — and what answers you should and shouldn’t be satisfied with. Negotiate well — not just about your startup stock options, but about all aspects of your compensation. And realize that when your motivation and incentives are aligned with those of company leadership and investors, you are most likely to see great success.
We wish you the best and hope to watch you create generational wealth and impact the world. The best and most healthy companies have all shareholders aligned, and our mission is to help ensure this happens more and more into the future!
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