I didn’t know much about stock options when I first started working in software. It’s not something that was taught in school, nor is it something I learned from family or friends growing up. I gather that that’s not an uncommon feeling in the industry. I’ve learned something about them over the years, and wanted to write that knowledge down. If nothing else, I can look here and see the various references I’ve used to understand this stuff.
Schwab has some good articles introducing stock and options. In short:
- Ownership of companies is divided into portions or shares. The collection of all of the shares 1 is called the stock of the company.
- A share of a company’s stock gives you part ownership over the company. Shares of stock can give you voting rights, entitle you to a dividend (a per-share cash payment, usually made quarterly, out of company profits or assets) if one is paid, and give you a claim on proceeds of a company if it’s sold or goes bankrupt. 2
- An option, for the purpose of this post, gives you the right (but not the obligation) to purchase a share of stock for an agreed upon price at some point in the future. For example, holding an option for a share of Apple stock at $10 allows you to purchase the stock for $10, but you can choose not to if you don’t want to. You usually need to pay to purchase the stock associated with an option; this is called exercising the option.
Public vs. Private
Most shares of stock you’d normally buy are for publicly traded or simply public companies; companies whose shares can be traded by normal people through a normal brokerage. Some companies are not publicly traded; these are called private companies. Most startups that issue options are private, at least when they issue options. When a private company lists on an exchange for the first time, it’s said to go public (or IPO, for initial public offering).
Public companies, in general, are subject to stricter reporting, auditing, and other requirements than private companies. Many companies prefer to remain private to avoid these requirements.
When an asset (a share of stock, a collectible, etc) can be quickly and easily turned into cash, we say that it’s a liquid asset. Some assets are illiquid, meaning that they can’t be converted to cash easily or without a substantial price penalty. A share of Apple stock is liquid; there’s a lively public marketplace where I can sell it quickly for a fair price. A home is illiquid by comparison; it can take months to find a buyer and actually sell a home for a fair price, and I’d take a big price hit if I needed to sell my home very quickly. Pre-IPO startup stock is best regarded as illiquid; selling it may not be possible at all, may require extra steps stipulated by an option exercise agreement, and the number of potential buyers is much smaller because it isn’t publicly traded.
In startup lingo, a liquidity event is when previously illiquid company stock can be (or must be) sold. IPOs and private sales (selling the entire company to another company) are examples of liquidity events.
How do I know if I have options?
Typically you’ll see a blurb like this in your offer letter or employment contract
Subject to approval of the Company’s Board of Directors (the “Board”), you will be eligible to receive a stock option (the “Option”) exercisable for up to 9,999 shares of Common Stock of the Company under its 2020 Equity Incentive Plan (the “Plan”) at an exercise price per share equal to the fair market value of the Company’s Common Stock, as determined by the Board on the date the Board approves such grant. The shares subject to the Option will vest at the rate of 25% at the end of your first anniversary with the Company, and an additional 2.083% per month thereafter, so long as you remain employed by the Company. This Option grant will be subject to the terms and conditions of the Plan and the stock option agreement to be entered into between you and the Company. This representation about your eligibility for an equity grant is not a promise of compensation and is not intended to create any obligation on the part of the Company.
At some point after your employment starts (it may be a few months, depending on when the board meets), you’ll get a follow up message confirming the details of the grant, including:
- The number of shares you’ve been granted and vesting schedule (which should match what was in the offer letter and/or employment agreement)
- Exercise price (how much you will pay per share to exercise the option)
- Type of grant (Incentive Stock Option, or ISO, or Non-Qualified Stock Option, sometimes abbreviated NQSO or just NSO).
- How long you have to exercise the options after you leave the company.
When an option is vested, you’re allowed to exercise it. If an option is not vested (or unvested), you can’t exercise it. Employee option vesting is most often time-based: your options gradually vest as you continue to work for your employer. The details of this time-based vesting are part of the vesting schedule, which is outlined in the option agreement and (hopefully) offer letter. If you leave a company with unvested options, those options are effectively lost to you; time based vesting typically stops when you leave, so they will never vest.
The example given above is one of the more common vesting schedules: a 4 year vest with a 1 year cliff. The first 25% of the grant vests on the 1 year anniversary of employment, all at once. Every month after that, you vest another 2.083% of your grant. After 36 additional months (3 years), you’ve vested the remaining 75% of your option grant. So, you’re fully vested after 4 years. The “4 year vest” refers to the amount of time the grant takes to fully vest; the “1 year cliff” refers to the fact that you vest nothing at all until you’ve worked there for a year.
Some grants don’t have a cliff, but they’re fairly common (and probably hard to negotiate away, though you can try). Cliffs are appealing to companies because they avoid giving vested options to people who aren’t a good fit/leave very soon after joining, and because they’re thought to incentivize people to stay long enough to make a difference, among other reasons. 3
Some other common schedules:
- 4 year vest, no cliff: you start vesting immediately after you start employment. Many larger, public tech companies (Google, Snap) are known to do this with stock grants.
- 4 year vest, 1 year cliff, uneven vesting over 4 years. For example, you might vest 10% of your options after your first year (on your hiring anniversary, so there’s still a cliff), 20% the year after that, 30% the year after that, and 40% in the last year of the schedule. I know Snap used to do this, and have heard that Amazon does/did as well. This is thought to keep people at the company longer; if you lose out on the majority of your grant unless you stay for at least 3 years, you have a pretty big incentive to stay for that long. 4
ISO vs. NSO
I also mention two types of grant: ISO (Incentive Stock Option) and NSO (Non-qualified stock option). For what it’s worth, every stock option grant I’ve had in my career has been an ISO grant. The main difference between the two types of options is how they’re treated for tax purposes.
ESO Fund has a detailed explanation of the differences between the two for tax purposes.
The spread, mentioned in that writeup, is the difference between what you pay to exercise an option and the “fair” value of the underlying stock. For example, if I have an option to buy a share of ACME stock for $1, but the fair market value of ACME is $10, there’s a spread of $9. 5
The key takeaway is that there’s a potentially large tax bill if you exercise either kind of option 6. Worse, because pre-IPO stock is illiquid (as discussed above), you typically can’t just sell some of the shares to cover the tax bill. 7 This creates some risk to exercising stock options for a non-public company. The nightmare scenario is when you exercise stock options in a promising tech company, pay AMT/income tax as appropriate (possibly borrowing money to do so), and then the company goes bankrupt and your shares are worthless. 8 To avoid this, most people prefer to hold unexercised options unless forced to exercise for some reason, or unless the shares can be easily sold to cover any tax bill.
One notable quirk with ISOs is that, by law, you have to exercise or forfeit them within 90 days of leaving a company. This effectively forces you to make the potentially ruinous decision above if you leave a company: pay to exercise, pay tax, potentially lose a lot if the company goes under, or forfeit, avoid tax, and potentially lose a lot if they company is wildly successful. Some companies, in an effort to be friendlier to employees, have started to allow conversion of ISOs to NSOs on departure. NSOs don’t have a legally enforced 90 day exercise limit, and companies that do this type of conversion tend to be generous with whatever exercise limit they put in place (bumping it sometimes years into the future). This allows employees to leave (to grow their career somewhere else, further their education, take care of family, etc) while still sharing in an eventual IPO or sale that their hard work helped bring about.
Dilution, Liquidiation Preferences & more technical gotchas
Dilution can occur when a company issues more stock. If you owned 1 out of 100 shares, and then company decided to issue 100 new shares to a new investor, you’d own 1/200 shares; since you own a smaller share of the company than before, your ownership interest has been diluted. Dilution often occurs during fundraising rounds, when new stock is issued to new investors.
Preferred stock, liquidation preferences, multiples on liquidation preferences, and other aspects of fundraising act to safeguard the positions held by investors by giving them different ways to make money during a sale, but often come at the expense of employees with options (who have fewer such protections, and lack the leverage to demand or negotiate for them).
For more details, I’d recommend reading this a16z post on options ownership; in particular, the explanations on preferred stock and how it influences the distribution of sale proceeds. If you remember one thing about that 9, remember that it’s possible for your company to sell to another company for billions of dollars and for your stock options to be worthless at the same time.
RSUs, stock grants, and how this works at public companies
Rather than an option grant, many public companies will simply grant shares of the company stock to employees. These are called RSUs, for restricted stock unit. RSUs typically have similar time-based vesting requirements as options, but you never have to exercise anything to get them; they just show up in your brokerage account every so often. As with options, your RSU grant is typically outlined in your offer letter, along with whatever vesting schedule applies to them.
Aside from the fact that you’re receiving an asset rather than an option to buy an asset, the key difference between RSUs and pre-IPO startup stock options is liquidity. RSUs in public companies are much more liquid than pre-IPO startup stock. If you have a share of Facebook stock, you can just go and sell it to another investor on a public stock exchange. 10 You don’t need board approval. You can set whatever price you want, and you can look at past trade data to figure out what a fair price is. That is not true for pre-IPO stock.
Like options, RSUs do have an associated tax bill (typically they’re taxed as part of your income). Fortunately, because they’re liquid, you’re usually able to cover your tax bill by selling some of your vested RSUs. Many companies will automatically withhold & sell some shares of an RSU grant when it vests to cover tax obligations.
People usually think of the outstanding shares of company stock; that is, the stock that is not owned by the company itself. Technically a company might hold some of its own shares in reserve for various purposes. ↩︎
Many tech companies don’t pay dividends (many make no money with which to pay them; others choose to invest money back into the business rather than returning to shareholders), and many (Facebook and Snap being among the more famous examples) implement share structures such that the shares of stock held by the founders have more votes than ordinary shares that you or I could buy (this allows them to retain majority or substantial voting power even if they don’t actually own that many shares of stock). Also, pre-IPO stock purchased via options in a startup frequently confers no voting rights. ↩︎
I think these points are debatable; I’m just trying to present some of the arguments I’ve heard in favor of vesting cliffs to give some color. ↩︎
Personally, given how long (short) average tenure is at most tech companies, I think this is deceptive. Your eyes might light up at the big $ number in the grant, but how likely are you to actually be there in 3 or 4 years, when the bulk of it vests? To say nothing of layoffs and other things outside of your control, even if you want to stay. ↩︎
Valuing stock or an asset is pretty easy if you can easily see what other people are paying for it. To value a house, you could look up other houses that have sold recently. To value a share of stock in a public company, you can look at recent trade data for that stock. Valuing a share of pre-IPO startup stock is, for a normal employee, harder. There’s no comparable way to see what it’s selling for, and companies are often extremely secretive about how they value their own stock. ↩︎
If you’re a nerd about money it’s sort of interesting to understand how AMT, income tax and capital gains factor in, but it’s not really important. No matter how smart you think you are about taxes, you should talk to a pro before you exercise options. ↩︎
Selling shares is how you’d typically cover the tax bill for an IPO or for RSUs in a publicly traded company. ↩︎
There are a number of horror stories from the first dot com bust about people doing this. Sometimes people paid (and lost) hundreds of thousands of dollars in this scenario. It’s an awful situation. ↩︎
Like the tax discussion, it’s interesting if you’re interested in money, but you don’t need to understand all of the jargon to understand the points being made. ↩︎
This isn’t quite true. Most public companies will have blackout windows around earnings calls and other important announcements. During a blackout window, an employee would be restricted from trading company stock. This helps guard against the appearance (or actual fact) of insider trading (e.g., dumping all of your stock 2 days before a particularly negative earnings call). ↩︎