So you got an offer from a startup...

Time to understand how your equity works

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A large portion of people join startups without really understanding how they’re compensated, or the implications of the way equity in startups works. Since it’s a large part of startup compensation, it’s really important to understand what you’re getting yourself into (and whether or not that lottery ticket is actually worthwhile). I’m certainly not an expert on all forms of startup compensation (I’ve never held RSUs, for example, so have never actually had a reason to fully understand how they function), but I’ve been through 6 startups at various stages, and have learned some things that will hopefully be useful for others along the way.

Incentive Stock Options for the Rest of Us

The vast majority of startup employees are going to receive what are called Incentive Stock Options, or ISOs. Typically, an offer letter will specify a salary, maybe a signing bonus, and some number of stock options that will be granted to the employee. The most important thing to know about this number is that it’s fairly useless information on its own. If you want to understand the true potential value of the stock options, you’ll need a couple other pieces of information:

• Number of outstanding shares: This is the total number of shares that are held by other employees, investors, or shares that have been authorized by the company for future employees. Critically, this number will change over time, typically when the company raises more funding (this is called dilution, and we’ll come back to this later)

• Percentage of the company represented by options: You only need this number or the number of outstanding shares, because each can be computed with the other. You’ll care about this number because oftentimes when you’re thinking about the value of your stock in total, you will want to calculate it with a company valuation in mind.

• # Options / # Outstanding Shares = Percentage of Company Owned

I’ll say it again that the number of options doesn’t really matter in the scheme of things. It’s not uncommon for companies at later stages to do things like stock splits (where the company trades 1 share of pre-split stock for 2 or more shares of post-split stock) to increase the number of options that can be given in an offer without actually affecting the value of the equity.

A couple other useful pieces of information to know are prices associated with the stock. There’s often two numbers that matter when you’re thinking about your equity value:

• Fair Market Value / Strike Price: There’s really two different prices here, but they’ll generally be the same number when you start at a new company. The Fair Market Value or FMV is the price that the company says your equity is worth (and that auditors and the IRS agrees is a fair price). This is usually established after funding rounds through a process called a 409A valuation. When stock is issued, a price for exercising the options is set at the price of the most recent 409A valuation. However, when later funding rounds happen, the FMV will change, which will have some tax implications (more later). The strike price on a grant will never change, though. Once the grant is issued, the price is the price.

• Preferred Stock Price: When you get ISOs, what you’re really receiving is an option to purchase a share of Common Stock in the company. This isn’t, however, the same stock that investors buy. They buy Preferred Stock, which usually comes with different benefits and terms. If you’re told the current value of the company, typically what you’ll be given is the # Outstanding Shares X Preferred Price. It’s the price that investors are willing to pay to buy their shares, which is likely closer to what the stock would be worth if the company was public, or what the price per share would be in an acquisition. This number is really important in understanding what your shares are actually worth today.

Quick Primer on How Options Work

In case you’re not familiar with the idea of an option, it’s a bit different than owning a share of stock outright (which is typically what you’ll buy if you’ve ever invested money in the stock market or in a 401(k)). A stock option is literally the option to purchase a share of stock for a set price (the strike price), and typically there is an expiration associated with the option (this gets a lot more important after you leave a company).

When you want to purchase a share of the company’s stock, you exercise your right to purchase the option by paying the strike price, and you receive a share of stock from the company in the form of a stock certificate. These days, you won’t typically receive a paper certificate, since most stock certificates are issued digitally through a service like Carta.

So the value of all the stock options in your offer is actually:

# of Options X (Preferred Price - Strike Price)

Obviously, the higher that Preferred Price goes up, the more money your options are worth, since the strike price never changes!

Another important mechanic to understand is that you don’t get all your stock options available on day one. If that were the case, you’d have situations where employees would get job offers, wait for their option grant, exercise all their options, and then run off to the next one. Companies protect themselves by having employees vest options over time.

Understanding Vesting

Typically, stock options plans will stipulate that options vest over four years (it’s not always four years, but four years is far and away the most typically vesting schedule). When an option vests, it’s yours. You can exercise that options whenever you want (unless the option expires, typically due to an employee leaving the company, and lapsing over time).

Usually the four-year vest will be accompanied by a vesting cliff, almost always at the one-year mark. What this means is that until you’ve been employed at the company for one full year, you have zero options. On day 365, you get 25% of those options available to you. The options typically vest once a month after that.

As an example, if you’re granted 1000 options and you start on January 1st, you can exercise:

• 250 shares on your one-year anniversary

• 500 on your two-year anniversary

• 1000 on your four-year anniversary

Fortunately, modern companies typically issue stock through platforms that help you understand this better these days. For example, Carta provides a nice visual to understand how options vest over time:

Four years after you start, you’re done. No more shares vest. For this reason, you’ll often see companies issue refresher grants (sometimes referred to as re-greening) for employees around year 3, so that they have a reason to stick around after four years. As a general rule, your first grant will be your largest, unless your company desperately wants to keep you, or you get significant promotions. That refresher grant will come with a new strike price, a new vesting schedule, and possibly another vesting cliff (sometimes, but not always).

The vesting schedule helps to understand your total compensation, because really you can think of the stock as a bonus each year. If your salary is $100,000, and you receive $100,000 in stock options (based on the value of the shares on your start date), you’re essentially receiving $125,000 in compensation each year. However, the stock might be worth nothing if the company doesn’t do well.

What Happens if you Leave the Company?

I’ve mentioned option expirations a number of times, but so long as you stay at the company, you generally don’t need to worry about it. If you do leave the company, you’ll have to make some decisions about whether or not to exercise any outstanding stock options.

The most common option expiration is 90 days after your last day at the company. If you wait 91 days, the options go back to the company, and they can reissue them to some other employee. This can be problematic for employees who don’t have enough cash on hand to pay the strike price for all the options, forcing them to either stay at the company, or forfeit their stock (this is where the term golden handcuffs comes from).

There’s been a trend with newer companies to extend the option expiration to much longer than 90 days, sometimes as long as 10 years. This is an extremely employee-friendly policy, as it lets employees come and go without worry that they’re going to be locked to a company because they can’t afford to exercise their options. It also means that options become less of a gamble, since you can wait long enough to see if the company is going to have a positive outcome (though this may result in higher taxes!).

Next Time!

Hopefully this has provided a useful introduction to thinking about ISOs and various different forms of equity compensation. Next time we’ll talk about exercising options and taxes, as well as some slightly different forms of equity compensation.