Stock options can be wondrous things. They can also be smoke and mirrors, or a pea under a whole bunch of walnut shells. So here are some points to keep in mind, whether you’re the founder offering options to your startup employees, or the employee being offered the options.
- The classic stock option is an option to buy a share of stock at a specified price. Say you get to buy some number of shares for a penny each. If those shares are worth (meaning they can be sold legally for) more than that penny, you make money. In theory.
- Understand the basic numbers on shares in a company: charters specify how many shares there are, and if you know that number then you can guess what a share is really worth by dividing what the company might be worth by the number of shares outstanding. So if that option to buy a thousand shares for a penny each is for a company that has 10,000 shares outstanding, it means you can buy 10 percent of the company for $10. Pretty cool, if the company is worth more than $100. But if there are 10 million shares outstanding, then even if the company is worth $10 million, your options are still only worth about $990. That’s hardly a great bonus. Notice how important the number of shares outstanding is: knowing that it’s 1,000 shares does you no good until you know how many shares exist (which means they’ve been issued, or promised). Quick quiz: Which is better–options on 1,000 shares in a company worth $50 million with 10,000 shares outstanding, at $1 each, or options on 10 million shares at one penny each, in a company worth $200,000 that has 200 million shares outstanding? (The first case is worth $4,999,000, and the second is negative, because each share is worth only one tenth of a penny, and you have to buy it for a penny.)
- None of this matters until a company is actually traded. Call that a liquidity event, and investors call that the exit. That’s when those shares suddenly mean money. It used to be that successful startups would “go public,” meaning they’d register their stock on one of the major markets, following carefully regulated procedures, and then it became legal for normal people to buy and sell the shares. That’s also called the IPO, or initial public offering. Until then, only “accredited investors” could buy them. Meaning that it was pretty hard to sell them; usually impossible.
- Shares can also be worth money when a big company buys a startup. If the buyer pays cash, then people with options get to cash in as long as their option price is lower than the per share price of the acquisition. These days IPOs are extremely rare, so exits are usually by acquisition.
- There are a lot of legal restrictions. Stock options have been abused for years. For example, they’ve been used by companies to pay people in a way that ends up getting taxed as capital gains, instead of regular income–a much lower rate. So the government watches them very carefully. Issuing stock options takes some legal work.
- People get fooled by stock options. I know someone who left one company to go work for another because the second one gave lots of stock options. It felt like a lot of ownership, but there was no chance the second company was ever going to succeed and achieve an exit. So options can end up being like shiny things to lure people, with very little value.
- When you get offered stock options in a startup, you have some tax choices to make. If you buy the options quickly, then you’ll hold them longer and pay long-term capital gains taxes (which are lower) when you cash in. On the other hand, if you don’t buy them, and the company never gets to an exit, then you’ve saved yourself money.
- Your share percentage can change. You might have options for 100,000 shares in a company that has 10 million shares outstanding. That’s a 1 percent ownership. But sometimes that same company can issue new shares and bring in new investors in a way that dilutes your option shares. So they decide to get investors in by giving them 10 million shares and they just issue those shares. Your 1 percent just became half a percent. Depending on terms of the options, rights, and legal maneuvers, that may or may not be legal (caveat: I’m not an attorney; I’m sharing my experience in the field, not legal advice.)
- Companies that give away options too easily can hurt their capital structure. If a lot of consultants and advisers and accountants and lawyers are getting compensated for their professional work with stock options, then investors are less likely to value the stock. A lot of startup business plans try to define how much stock ends up in the hands of founders, employees and investors. Things change, of course, but it’s a good idea to have some sense of proportion.
- The best use of stock options in a startup mode is as a message. The people who get the options should realize that these are very long odds, but there is a message, from founders to employees: “Work with us, stick with us, and if we make it big you’ll make money, too. ” That’s a nice message to send.
Here’s an interesting tidbit in business history: when Apple Computer went public in 1980, it generated more millionaires (about 300) than any other company in history. That included some people who were very low on the pay scale but had been given options early.
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And a late addition, a week later: Oh no, I forgot to discuss vesting. Stock options are normally vested over a period of time, rather than given all at once. Options are not really yours until they are vested.
For example, options might be vested over two years. Depending on the fine print, that could mean either that you get them all at the end of two years if you manage to stay with the company; or that they are vested according to some schedule, like half after the first year and the rest after the second, or 1/24 of them every month for 24 months. Vesting makes a big difference.
Tim Berry is the founder and chairman of Palo Alto Software and Bplans.com. Follow him on Twitter @Timberry.
