Did you just get a job at a startup? Did they tell you that by cutting your cash salary and accepting stock options, you could make a lot of money when the company is acquired? Do you think whomever wrote the grant is smarter than you? If you said yes to any of these questions, keep on reading. It might be saving you some time and money.
Here are some terms you need to know before we continue:
Stock Option/ Option Grant.
A stock option gives an employee the right to buy a certain number of shares in the company at a fixed price for a certain number of years. The price at which the option is provided is called the “grant” price (strike price) and is usually the market price at the time the options are granted.
Vesting refers to the process by which an employee earns her shares over time. The most common form of vesting in Silicon Valley is monthly over four years with a one-year cliff.
A vesting schedule dictates when you may exercise your stock options or when the forfeiture restrictions lapse on restricted stock.Vesting is determined separately for each grant. A schedule is time-based (graded or cliff) if you must work for a certain period before vesting.
The price per share at which the owner of am option is entitled to buy or sell the underlying security.
The point at which your vesting schedule allows you to first begin buying back options. Sometimes, there is a one year cliff on stock option grants, meaning if you get fired before the ‘cliff’ date is reached, you will not be granted the right to buy back stock options.
Liquidity Event (Exit)
In corporate finance, a liquidity event is the merger, purchase or sale of a corporation or an initial public offering. A liquidity event is a typical exit strategy of a company, since the liquidity event typically converts the ownership equity held by a company’s founders and investors into cash.
Now that you know the lingo, it’s time to see what it looks like in practice. Below is a picture of an actual Stock Option Grant from Evil Corp.
You can see the grant is structured to vest 1/4 of the options after the completion of one year of employment. This one year period before the options are actionable is the Cliff. The ratio also determines the length of the vesting schedule. Since this grant vests 1/8 every 6 months, the plan will take 4 years for all the options to be fully vested.
The Exercise Price is also known as the Strike Price. This means the employee must pay that amount for each option in order to liquidate their stock. In this plan, there are 40,000 allotted options, which means the owner would have to pay $40,000 ($1 * 40,000 = $40,000) in order to exercise the options and own their shares. From that point, they are free to sell the stock to whomever they want (permitted in the option agreement).
You should note, shares are worth nothing unless you have someone to buy them. Therefore, vesting and then exercising the option does not make the share worth anything at all. It just means that you own the shares indefinitely. Most startup employees fall into the trap of vesting shares and not being able to afford the strike price, thus rendering them worthless after they dissolve.
Well, that’s the basics! If you want to learn all the exceptions to these rules like dilution, capital structure, odds, qualified vs non-qualified stocks or taxation, stay tuned by subscribing.