I regularly hear people getting excited about having been awarded stock options in their companies, but not having any idea what the value of those options actually are. As a startup CEO, I wanted to write a quick guide for our current and future employees on how stock options work, and give some rules of thumb about how to assign a financial value to your options grants.
[Disclaimer: I’m not an attorney, and stock option plans can have slight differences that result in huge changes of value. I’ve assumed “vanilla” stock options here, but you should read your options paperwork to understand how your situation may be different. Also, this assumes options in a venture-backed kind of company; options in publicly traded companies are a totally different beast.]
Salary + Equity
If you’ve ever been offered a job at a startup, you may have heard the hiring manager say something like “We can’t match a big company salary, but we’re going to give you X thousand stock options, so you have huge upside!”. Options in a startup company do a great job of aligning investor, manager, and employee incentives. They can also return life-changing sums of money for employees when things go well. However, people frequently over-value their stock options, leading to disappointment when (and if) their company is acquired, or goes public.
What’s An Option?
A Stock Option gives you the ability to purchase shares of a company at a pre-defined price (the “strike price”). If your option plan lets you buy shares at $0.10 per share, and the company sells for $1.00 per share, you make a profit of $0.90 per share. Nice!
Mistake #1: Not Knowing Your Ownership Percentage
An employee might know that they have options to buy 10,000 shares at $0.10. But privately-held companies don’t really have an advertised share price, so knowing how much your shares will be worth is tricky. You need to know both the number of shares you have options to buy, as well as the total number of shares that have been issued for the company. Many private companies won’t tell you the total number of shares that have been issued. If a company does this, assume your options are worthless. You have no way of assessing the value of the shares without this information. At MedCrypt, we have about 5.3 million shares outstanding. So an employee with options for 10,000 shares could own approximately 0.19% of the company.
To find your ownership percentage, divide your number of shares by the total shares outstanding. Here is a table showing the relative ownership percentage for an employee with 10,000 options in a few different scenarios.
Mistake #2: Using a VC’s Valuation Of Your Company
People will hear that a Venture Capitalist (VC) has valued their company at $1B, and simply multiply their ownership percentage by $1B. This can lead to huge disappointment.
When VCs invest in companies, they almost always get “preferred shares”, which come with a few extra features. One of these features is a “liquidation preference”. This means that, if the company is acquired, the preferred share holders each get their initial investment back before any other share holders get a dollar.
Let’s look at someone who has options for 10,000 shares, at a company that was just acquired for $100M. They may think their options are worth $100k.
If that company has raised $50M in VC funding, there is actually only $50M left after the liquidation preference to split between shareholders. Therefore, this employee’s 10,000 options are actually worth $50k.
It’s even worse if that company has raised $70M.
An Equation For Valuing Your Stock Options
Your Money = (Your Shares / Total Shares) * (Exit Value — Money Raised)
Here is a table showing the options value for an employee with 0.1% ownership in a company, with various different liquidation preferences and exit values.
It’s not a coincidence that the whole bottom left corner of the chart shows $0. If a company doesn’t sell for more money than it has raised from investors, common stock is basically worthless.
Employee options almost always have some “vesting period”. This means that you actually have to work for the company for some period of time in order to earn the options. A common vesting period is 3 years for employees.
What if the company sells before your options have vested? Unless your company offers “accelerated vesting”, you’re out of luck.
Exercising Your Options
In order for your “options” to become “shares”, you need to “exercise” your options. That means you need to write a check. If you have 10,000 options, and the strike price is $0.10, you’ll be writing a check for $1,000 to your company to get those shares.
If you decide to leave the company, you normally only have 90 days to exercise your options. That means you’ll be quitting, and writing your boss a big fat check on the way out the door. Lots of employees don’t exercise their options upon leaving the company, which means those options were essentially worth $0 to the employee. (So much for making up for a lower salary!)
When Can I Sell My Shares?
In a VC-style company, you could only really sell your shares if 1) the company is acquired, or 2) if the company “goes public” (aka IPOs). The probability of either of those things happening is far less than 100%. Again, if the company never sells or IPOs, your options are probably worth $0.
I’m a huge fan of employees having equity in their companies, and stock options are the most common way to do that. But don’t just assume that 10,000 options should make up for a $10k salary cut. There is a lot of information you need to know in order to value your options.
If you’d like to work for a company solving a big problem, that grants equity to employees, and is transparent about how the company is run, MedCrypt is hiring! We’d love to hear from you. firstname.lastname@example.org