For early-stage startups, offering employee stock options can be a key part of attracting and keeping key talent. A stock option is an agreement that gives an employee the right to buy shares in the company at a discounted rate.
For the employee on the receiving end, making sense of a complex, jargon-heavy stock option offer can be daunting. Given that such shares can carry significant risk – with startups often having poor survival ratings – it is very important to properly evaluate your stock option offer.
Here is a guide to making sense of your stock option offer.
First, do a basic assessment of the company
The first step is to conduct a basic assessment of the company. This is key to understanding the risk involved with any stock option plan.
At what stage of investment is the company at? Is the company a pre-seed investment? If yes, you need to understand that this is the highest-risk stage of a company lifecycle. 90% of new companies never get to VC funding and founders can be delusional about their prospects for investment. So take any claims that a company has a large, interested investor with a grain of salt.
How much should you get?
You will need to have a clear understanding of the size of your offer before you will be in a position to judge whether it is big enough.
First, figure out what your percentage ownership will be. Know how many shares have been set aside for the founders and for the company’s stock option pool. Also find out how many shares have been issued or promised to investors (i.e. convertible notes). Ask for the company’s capitalization table (i.e. table of all of the outstanding shares). What is the current value of the company? If they don’t have a current valuation, ask them what amount of investment they would require for 10% of the company. Wrapping your head around these figures will enable you to calculate your percentage ownership and give you a baseline against which you can measure your offer.
Your offer should match the stage the company is at. Established companies will have set standard tiers for different levels of seniority. A pre-seed company, however may not yet have established tiers. Joining a company in its early stages, you should anticipate higher risk and a higher reward in your share package.
As a guide, an offer of 2% ownership for an employee of an early-stage company is reasonable and you might even push for a higher amount, given the shares may carry substantial risk. Assess how much value you are bringing into the company. If you’re going to be responsible for 20% of the the future value of the company, then your equity should reflect that.
Given the high risk of startup failure, you should also find out what liquidation preferences sit on top of your equity. If investors are given liquidation preferences, the amount of liquidation proceeds that are available to common shares may be reduced – significantly.
What is the vesting schedule?
If you accept your stock option package, it is important to understand that your options won’t be granted straight away, but will vest over time according to a vesting schedule. This means that you will have to be with the company for a period of time before you can earn your shares.
The standard “Silicon Valley” vesting is monthly vesting over a period of 4 years with a 1 year cliff. This means that you earn 1/4 of the shares after one year, and 1/48 of the shares every month after that.
If you are joining a startup as an advisor or a consultant, you may want to attempt to negotiate a lower cliff and vesting – as your role will likely be shorter in term. Some companies may be open to vesting upon completion of a project.
Mechanics of exercising your option
Exercising your stock options does come at a cost, and a potentially significant one at that.
In order to get the cash value of the stock options, you are going to need to exercise them by investing the exercise price (i.e. purchase price) upfront. The exercise price will not be negotiable, and should be at least equal to the fair market value of the stock at the time you originally signed up for the grant. The earlier you join the company, the lower the exercise price will be.
Some stock agreements allow you to exercise your options early. When you exercise your options early, you purchase some/all of your unvested options up front and then receive the shares at vesting time. Depending on the circumstances, this may have tax benefits.
Reading the fine print
Generally, if you are fired you will have 90 days from the date of termination to exercise your options. However, if your stock option agreement contains a claw-back provision, it may be possible for the company to force you to sell back your vested shares to it when you leave.
The stock option agreement may also contain restrictions on transfers, which will impact on your ability to sell the shares to outside investors.
Look out for clauses detailing what will happen if the company is acquired. If the company is acquired prior to your vesting period coming to term, you don’t get compensation (or receive reduced compensation) for your unvested shares. Depending on how early you join the company, and how much room there is for negotiation, you may push for the inclusion of protection clauses in your stock option agreement. For example, double trigger acceleration means that your options are fully vested automatically if the following conditions are met:
1. An acquisition occurs prior to stock being fully vested, and
2. Your role is terminated. This is to prevent companies from sacking you prior to a sale.
Other ways of getting compensated
One option is to receive phantom stock. This is when you receive a cash payout tied to the company’s stock value, which is paid out at a specific date or event (such as the next financing, or upon the sale of the company). For example, if the company is sold, the phantom stockholder might receive an amount equal to what they would receive if they owned the same percentage of the corporation’s stock. Structuring employee packages in this way may potentially remove the need for the employee to invest cash or have their stock options taxed as income.
Seek Expert Advice
Get in touch if you have received a stock option offer from a company and would like advice.
While outside the scope of this post, stock options can raise significant tax considerations and it is important that you speak with a qualified tax specialist.