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Employee Stock Option Lottery Tickets

Dreams of riches from startup employee stock options

OnlyCFO

Apr 28, 2023

*Not investment or tax advice. Talk to someone other than an anon person

If you have ever considered joining an early stage tech company then the dream of making millions of dollars from your employee stock options probably crossed your mind. “This company could be the next Snowflake, Amazon, Google, etc….and if it is then my stock options will be worth $[X million]!!!

Everyone has a friend of a friend who joined an early stage company that became a huge success and made millions from their stock options so the rest of us can do it, right?

Lets go through how stock options work and some things you need to ask your company when considering your stock options’ value.

Stock Options Refresher

Stock options are a form of compensation. Companies can grant them to employees, contractors, and consultants. They give you a right to buy, or exercise, a set number of shares of the company stock at a preset price, also known as the strike price.

Because your purchase price stays the same, if the value of the stock goes up, you can make money on the difference. The dream is you can sell your purchased shares for a lot more than you pay for them.

Stock options at tech companies typically “vest” (i.e. you can buy them) over a 4 year period with a 1-year cliff and then monthly thereafter. The cliff means that nothing is exercisable until you have been employed for one year and then 25% of your options become exercisable. This helps protect the company in case they discover you are terrible after 6 months and want to fire you.

Once your stock options are vested you are free to exercise them.

Earlier stage companies almost always grant stock options, but when a private company becomes more mature with reasonable line of sight to an IPO they may start granting restricted stock units (RSUs) because there is more limited upside potential, which is where stock options get their value.

The focus on this post is on stock options, but many of the same principles applies to RSUs and other forms of equity compensation.

Hard Truth About Stock Options

You probably won’t make much, if any, money from startup stock options so don’t bank on getting rich.

I know I am crushing dreams here….but it’s better to have this mindset when you join any early stage company because there is sooo much risk to get to en eventual exit.

While part of the allure of joining a startup is becoming rich beyond your wildest dreams, the odds are stacked against you. The below data is from CB Insights for companies that raised their seed round between 2008 and 2010. A large portion of companies fail to ever exit. Even the ones that do exit, the financial outcome for employees is often not great because of further dilution, liquidation preferences, fire sales, etc.

For a while (peaked in 2021), the above statistics improved for tech companies. Everyone was raising new rounds at incredible speed at huge premiums to the last round raised. Every looked like a genius and everyone in Silicon Valley was going to be mega rich from their stock options (at least on paper)…Until all the sudden they weren’t.

Public software valuations fell off a cliff after November 2021. Public companies typically issue RSUs so existing equity awards still have value….just a lot less. Also, public companies typically peg RSU compensation to a certain $ amount so a lot of these employees are getting additional refresh grants to help adjust for the decline in stock value.

Private company stock prices don’t get adjusted on a daily basis like the public market so a lot of folks are still anchoring on their last fundraise valuation which is likely a no longer realistic (at least anytime soon) exit value.

If your company raised at a huge valuation compared to your revenue, then chances are your stock options are underwater or worth very little. 100x - 300x of revenue were not all that uncommon valuation multiples in 2021, but companies are getting a fraction of that today.

What to ask about stock options

Whether you are considering a new job opportunity’s equity package or trying to figure out if you should exercise your stock options, there are some basic questions you should ask:

If companies don’t answer the below questions then consider running away quickly…

What type of stock option is it (ISO vs NSO)? (must know)
- There are significant tax differences so look it up.
What is the current strike price? (must know)
What is the vesting schedule? (must know)
What was the preferred stock price and valuation? (must know)
- You want to know how big the spread is between what the last investors valued the company at versus what price you can buy the shares at.
- But you also need to know how real that valuation is. If they raised their last round in 2021 then it might be way too high.
What is the fully diluted shares outstanding? (must know)
- This tells you the size of the pie. Only then will you know how big of a slice you are getting with your stock options.
- The fully diluted shares is the total shares of a company including shares that are currently outstanding and also shares that could be claimed through the conversion of convertible preferred stock or through the exercise of outstanding options and warrants.
What are the liquidation preferences? (must know)
- This will cause a lot of stock options to be near worthless for companies that raised huge rounds at crazy valuations.
- VCs get preferred stock which means they get preferential payouts in the event the company is sold or has an exit event. In other words, they get paid first before anybody else. And some rounds in 2021 were so large at such high valuations that an exit might be lower than the total amount raised, which means employees get nothing.
- While it was much less common during the good times of 2021, “dirty” term sheets have become popular again. Understand what these liquidation preferences look like because they can destroy any chance of employees making money.
What is the post-termination exercise period (“PTEP”)? (must know)
- Typically this is 3 months after termination, which means you have 3 months after you leave a company to decide if you want to exercise your shares. If you don’t then they are forfeited.
- Some companies are more generous and offer longer periods to exercise which can be a great benefit.
Can you early-exercise your stock options? (must know)
- For a lot of companies this is a benefit reserved for executives, but some companies offer it to all employees. Early exercising of options starts your holding period sooner so you may pay the lower taxes when you sell.
- Also, you likely won't owe additional taxes upon exercise: If you early exercise your options as soon as they're granted (at the time of exercise), you're buying them at FMV so there is no gain.
What benchmarking percentile is used for equity grants? (nice-to-know)
- Understanding if an equity grant is “fair” can be hard especially for non-executive roles.
- Ask how equity is benchmarked and where your grant falls (25th percentile, 50th percentile, etc)
Unallocated size of the employee stock option pool? (nice-to-know)
- This represents how big the pool is for future employee stock option grants. If it is really small then the pool will have to be increased soon which will increase the fully diluted shares outstanding, which will increase dilution (i.e. shrink your size of the pie).

Share these questions with your friends so they know what should be asked!

If employees are involuntarily terminated then the company can accelerate vesting.
- This is common when executives are terminated and commonly 3 - 6 months are accelerated.
- It is also somewhat common in large layoffs as part of separation packages.
- It would be unusual for an employee below the VP level to get an acceleration if they were not part of a broad layoff.
Companies can “reprice” stock options if the fair market value (FMV) drops
- If you joined a company in 2021 when valuations were skyhigh then your options may not be worth nearly as much today.
- Your company should have an updated 409A valuation which determines the FMV. If its significantly lower than previously, then the company might consider repricing prior stock options. *This is much easier for private companies to do than public companies. Public companies might just issue more equity.
The company can have a longer post-termination exercise period (PTEP).
- The PTEP can be extended a few months or a few years. It just can’t be longer then the life of the stock option, which is generally 10 years.
- Companies can do this and still grant ISO stock options - the ISOs just turn into NSOs after 3 months past the termination date
There are tax considerations on the date of exercise and the date of sale.
- Do your research
The fair market value (FMV) is determined at least annually for private companies by performing a 409A valuation.
- More frequently is required if significant events occurs - like a fundraising.
- When a company is 12 - 24 months from an IPO it is usually performed quarterly.
- Highly valued companies often have 409As performed at least semi-annually even if they are further away from an IPO given the higher risk.
Qualified small business stock (QSBS) is an amazing tax break for folks who acquire shares while a company qualifies as a small business.
- The main criteria is gross assets must be <$50M at the time shares are acquired, which means stock options don’t count.
- You have to own the shares while is qualifies.
- Other rules apply so check out the criteria.

Will my stock options be worth anything?

This is a much harder question to answer. As I said earlier, don’t bank on it. But…you should understand the potential of your company. I will cover the evaluation process I use in a future post.

Concluding Thoughts

The less transparent a company is about this stuff the bigger the red flag. The questions I listed above should be addressed by the company. If they are hiding anything then maybe that isn’t the company you want to work for.

Do your own research. This was meant to spark some questions/ideas, but should not be considered investment or tax advice.

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