Stock options allow staff to buy shares in the company and are an extremely popular method for attracting, motivating and retaining employees, especially at startup stage when the company is unable to pay high salaries.
Thousands of employees have become millionaires through stock options, and the success seen in Silicon Valley companies has made it a powerful motivator for employees’ long-term commitment to a business. The story of the part-time masseuse who joined Google in its infancy and ended up a millionaire, has now been played out thousands of times in many startups.
It might be worth mentioning that stock options aren’t actual shares of stock – they’re the right to buy a set number of company shares at a fixed price, usually called a grant price, strike price, or exercise price. If the value of the stock goes up, your purchase price stays the same, and you make money on the difference.
Sounds great. But what does this all mean for you and your prospective job offer?
One thing to keep in mind in the early stages of the recruitment process is that interviewing with a tech company is sometimes very different to interviewing with tech startups. With established tech businesses, it could seem like you’re getting a better deal and a higher salary, whereas startups might offer a slightly lower salary, with stock options as an extra.
It’s important for you to know exactly what to ask to make sure you’re assessing your options thoroughly. Here are some questions you should ask the hiring manager…
1. What percentage of the company do my options represent?
What’s important is not the number of options, but what the number represents as a percentage of the fully diluted number of shares outstanding. For example, if you are awarded 100,000 options, but there are 100 million shares outstanding, that only represents 1/10 of 1% of the company. But if you are awarded 100,000 options and there are only 1 million shares outstanding, then that represents 10% of the company (Forbes 2016).
2. How does my proposed option grant compare to the market?
Once you know what’s on offer, make sure you go away and research what other startups are offering. This will make it easier to negotiate your options and make an informed decision.
3. How long will my options need to vest for? When will I be able to exercise them?
Vesting means you have to earn your employee stock options over time. Most companies provide a vesting schedule, where the employee has to continue to work for the company for a set period of time before they can buy shares at the agreed price.
4. How much will you have to pay for the stock when you exercise your option?
Typically, the price is set at the stock’s fair market value at the time the option is granted, but double check. If the stock’s value goes up, the option becomes profitable because you have the right to buy the stock at the cheaper price.
5. Is there any acceleration of my vesting if the company is acquired?
Until the company goes public or is acquired, the options might not be the equivalent of cash benefits, so it’s always better to keep a long-term mindset and stay informed in the event of acquisition.
6. Will I have the opportunity to receive additional options, for example bonuses?
Some startups might offer additional options as a bonus scheme for a further incentive – check.
7. What happens to my shares if I leave before my entire vesting period has completed?
Usually, if you leave the company, your shares will stop vesting immediately and you can only buy shares that have vested as of that date. You’ll only maintain this right for a set window of time, called a post-termination exercise (PTE) period.
To give you an idea, the below example from Forbes (2016) shows how a stock option plan could work and also make a nice profit over a 4 year period.
- ABC Pty Ltd., hires employee John Smith
- As part of his employment package, ABC grants John options to acquire 40,000 shares of ABC’s common stock at 25 cents per share (the fair market value of a share of ABC common stock at the time of grant)
- The options are subject to a four-year vesting with one year cliff vesting, which means that John has to stay employed with ABC for one year before he gets the right to exercise 10,000 of the options and then he vests the remaining 30,000 options at the rate of 1/36 a month over the next 36 months of employment
- If John leaves ABC or is fired before the end of his first year, he doesn’t get any of the options
- After his options are “vested” (become exercisable), he has the option to buy the stock at 25 cents per share, even if the share value has gone up dramatically
- After four years, all 40,000 of his option shares are vested if he has continued to work for ABC
- ABC becomes successful and goes public. Its stock trades at $20 per share
- John exercises his options and buys 40,000 shares for $10,000 (40,000 x 25 cents)
- John turns around and sells all 40,000 shares for $800,000 (40,000 x the $20 per share publicly traded price), making a nice profit of $790,000
It’s clear there’s a lot to consider for startup employees when faced with a stock option plan. But you need to know exactly how much your options are worth if you’re going to make the investment. Do your due diligence and ask the above questions so you know exactly how it works for the long run.
Let’s hope Australia continues to produce inspiring tech startups that we can be proud of. They can’t do it without you, so reach out to discuss your next career move and a potential future with a startup.
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