Stock options are sexy. They represent the dreamy future of a startup, reinforced by envy-inspiring stories of early employees at rocketship companies that IPO. What you don’t hear are the stories of the many more employees at companies that shut down or languished or simply evolved into privately held lifestyle businesses. These are two ends on a spectrum, though, and in the middle are employees at companies for whom their stock options may be wise—if not billionaire-making—investment opportunities.
Founders know that stock options are an attractive aspect of compensation. Stock options say, “Yeah, we’re betting on a future payout, and we want you to be in on it too.” So, that’s a sexy prospect. However, options are much more speculative and complicated than this. Sadly, many employees do not understand their options and either over-value their potential or don’t take full advantage of their opportunity.
Your plan to understand
As I’ve talked with startup employees, I’ve found a fair number don’t understand that options are not shares, but are simply an opportunity to buy shares at what could be an advantageous price. As with any major investment—say a new car or a house—you’ll want to do some research to be sure you’re buying wisely. You can and should spend anywhere from an hour to a half-day getting a cursory understanding of how options work and the parameters around your particular situation.
There are a handful of resources to start with. On Startup Decoder, we’ve offered guidance on the basics of stock options. Packy McCormick recently wrote an excellent, in-depth breakdown of everything you need to know about options in his newsletter. (While McCormick’s is a sponsored article, it nevertheless gives a very factual and easy-to-understand summary of the most important points to know.) Carta also offers some basic content that can serve as a primer. Almost all the specifics of your own options are contained in a document you most likely signed upon employment called a stock option agreement or option grant. Now, to understand its details….
Your timeline
The agreement will spell out some important dates, including a vesting schedule. To incent employees to stick around, options are generally doled out in increments as your length of tenure expands. Often, you don’t begin to vest until you’ve been with the company a year, known as “the cliff.” Then you begin to earn options in batches over time. A common vesting schedule is over four years.
Another important date is the length of time you have after leaving the company to buy the shares. It’s commonly 90 days, but there’s a trend towards lengthening this. Finally, if an IPO is on the horizon, you should take that into account in timing the purchase of your shares—you don’t need to leave a company to exercise your options.
Your cash outlay
To state the obvious (but sometimes overlooked): Buying stock shares requires cash. And it can be a lot. You will pay the “strike price,” which should be spelled out in your grant document. Depending on the maturity of the company when you joined, the discount this provides over the current price can be substantial. The company’s valuation and current stock price should be spelled out in a document called a 409a, which the company has.
Tax implications are extremely important, and tricky. Some types of options require paying tax when you exercise them. On others, you will pay tax when you sell the stock in the future. It’s advised to consult your tax attorney before exercising, to fully understand your current and future tax obligations.
Stock options have remained an important aspect of startup compensation because they’re incentive to buy into the company’s future. It’s up to the employee, though, to understand how best to maximize those options. Taking the time to do that is a valuable exercise, one certainly worth your time.