How to Understand Your Startup’s Stock Option Plan

Many startups often use stock options as incentives to hire and retain talent. This is because young companies generally don’t have money to put toward high salaries and fat bonuses. Stock options allow these companies to attract and compensate dedicated employees with the potential of a big payday when the company is sold or goes public.

Options can be complicated for anyone without a finance background, but if you’re going to work for a startup you should have general knowledge about how stock options work. Here are some basic concepts from ValueChampion that you should know and questions you should ask to assess the value of your startup’s stock options.

How do stock options work?

Let’s say you go to work for a startup with a stock option plan that gives you the right to buy 60,000 shares of common stock in the company at a grant price of S$2 per share.

You won’t get these options all at once. You have to earn them incrementally through continued employment with the company. (That’s called vesting; more on that later.)

Once you are fully vested in your 60,000 options, you have the right to exercise your options; in other words, you can now buy 60,000 shares of the company’s common stock at S$2 per share, or $120,000.

If the common stock shares are worth more than S$2 per share — for example, S$10 per share when the startup goes public or is acquired by another firm — then you’re in for a big payday. You can sell the stock you purchased through exercising your options at a profit. In this example, you walk away with $480,000, before fees and taxes, of course.

What about vesting?

Vesting schedules are common with most employee stock option plans. Using our example above, let’s say this plan grants you 10,000 options after the first full year of employment.

This one-year waiting period is called cliff vesting and it’s common at many startup companies. But remember that you lose all rights to these options if you leave before the cliff vesting schedule kicks in.

Following your first year, you earn more options every month — 1,000 options per month, in this example — until you are fully vested in your 60,000 options at your fifth anniversary with the company.

Rights vs. obligations

An option gives you the right but not the obligation to purchase common stock shares. If the strike price is less than the grant price of your options — $1 per share instead of $10, for example — you won’t make any money. But you can wait to exercise your options until they are in the money.

But be aware of option expiration dates if you don’t exercise your options right away. You may decide to let your options expire without exercising them. In that case, your options would be worthless, but you also wouldn’t be out $120,000 to purchase stock that’s only worth $60,000.

You also don’t have to sell the common stock you purchase once you exercise your options. If you believe the startup has a viable long-term future, you can hold your common stock shares in the hope that the price appreciates even more — a strike price of $40 per share, for example. That would make you a millionaire when you sell your acquired shares.

What affects the value of my options?

The biggest influence on the value of your stock options is the total amount of equity available to investors, including other participants in the stock option plan. If the startup has issued a large amount of equity already to angel investors and venture capital firms, your 60,000 shares may not be worth much when the company goes public or is sold.

This is what’s known as share dilution. Every time new common stock is issued, the value of existing shares (and the related options) becomes more diluted.

A number of factors can affect share dilution. First, how much preferred stock has already been issued to the startup’s early investors? And how much more preferred stock will be issued in future rounds of financing?

Preferred stock owners are paid before common stock holders in the pecking order, so a large amount of outstanding preferred stock means less money for common stock owners when the company goes public.

Next, what kind of preferred stock has been issued? Straight preferred is the most common type at startup companies, which gives early investors priority payouts when the company is sold or goes public. But participating preferred is also used frequently, especially when investors feel there is a greater failure risk at the startup and want to be compensated for taking the early risks.

Then there’s the option pool, representing the amount of common stock the startup sets aside for its employee stock option plan. A startup can add to the option pool each year, which further dilutes the value of common stock, or start with a deep enough pool of common stock that would be available for future employees.

When you go to work for a startup with a stock option plan, you should ask how much capital has already been raised and how much additional funding will be anticipated. This can help you determine how diluted your common stock shares will be when you are eligible to exercise your options.

If the company is in the early stages of funding, it’s likely that shares have not been diluted so much. But as the company goes through multiple funding rounds, the possibility increases for further dilution of your common stock shares.