How Stock Options Work
- #finance
- #hiring
- #stock
Segun Adebayo
When you join a startup as a developer and you're offered stock options as part of the compensation. Hearing the word "stock options" might initially sound unclear or confusing, common questions that pop in your mind like:
- How do stock options work?
- Does it mean I have equity in the company?
- What value does it give me? Please skip it and pay me just salary.
To answer this question, I listened to this Twitter space organized by Manji Cheto and here are some tips I extracted.
If there's one thing you should take away from this article, it's the fact that stock options is not the same as owning equity or shares in a company.
Stock options vs Equity (or shares)
"Equity" represents an ownership of a company while "Stock options" represents the right to purchase equity of a company at an agreed price (usually known as the strike price).
Stock options or ISOs give you the "right to purchase", not the "right to own" the equity. This means you'll have to purchase the equity in the future to actually "own" it, provided you meet certain criteria.
Stock options is an underrated wealth creation instrument. It might sometimes look like a useless part of compensation and it doesn't matter, but it does. Unlike salary, stock options have unlimited upsides, they grow as fast as the company grows and requires no extra effort on your part.
There two types of stock options, non-qualified stock options and incentive stock options. Incentive stock options (ISO) is typically issued to employees of a company.
How it works
Let's take a sample compensation for a developer role at Naruto Inc.
$100k base salary
1,000 stock options (at $4, 4-year vesting period, 1-year cliff)
Start date: 10th Dec. 2022
Remember, getting 1,000 stock options doesn't mean you have 1,000 shares in the company.
When you join Naruto Inc, you'll be granted an employee stock ownership plan. This is usually managed in a software like Carta.
Stock Option Value
The above stock options means you have the right to purchase 1,000 shares at $4 per share when you meet the the vesting and cliff criteria (I'll explain this soon). $4 is the subsidized stock price for employees, the actual stock price might be higher. You'll pay $4,000 (1,000 x $4) after four years.
The hope is that, as the company grows, it's stock price will grow as well which increases your profit. Assuming the stock price grows to $40 after 4 years, your shares will be worth $40,000.
You bought the stock at $4,000 and sold at $40,000 (assuming a 10x growth in stock price). That means your profit is $36,000
Vesting Period
A 4-year vesting period means that you'll get the right to purchase the full 1,000 stocks after 4 years, from the date you signed the employment contract (or stock option grant contract). It is designed to ensure you're committed to and add value to the company.
Here's the breakdown of how you'll get the options:
| Year | Stock Options | Description |
|---|---|---|
| Before Year 1 | 0 | You own nothing! |
| Year 1 | 250 | right to buy 250 stocks |
| Year 2 | 500 | right to buy 500 stocks |
| Year 3 | 750 | right to buy 750 stocks |
| Year 4 | 1,000 | right to buy 1,000 stocks |
Cliff period
This is the mandatory amount of time before the shares are allowed to vest. The vesting period is the amount of time to hold those options before they can be converted into shares. This means if you leave the company within 1 year, you don't get any stock option.
Exercising your stock options
After the minimum vesting period or cliff, you have the right to purchase the company shares at any point. If you wait till the end of the vesting period (4 years), you'll have 90-120 days to exercise your options.
Exercising your options means buying the company's equity on or after the minimum vesting period.
Conclusion
Most companies don't take the time to explain how stock options work. Because stock options are a viable means to make money, it's important to do your own due diligence by asking questions.
Here are some important questions to ask when offered stock options:
- How many stock option units are you entitled to, and what's the strike price?
- What's the grant date, vesting period and cliff period?
- Does the options dilute after each fund raise?
- What happens to the options if you decided to leave the company?
- What happens to the options in event the company gets acquired?
- How are the options taxed?
If you find this useful, kindly share this article to help educate others when negotiating a new role.
