How Do Startup Stock Options Work? 6 Questions to Ask When Interviewing

Editor's Note: Today, we have guest author Nate Matherson, CEO + Founder of ContainIQ breaking down the top 6 questions you should ask about startup stock options when negotiating your salary. Disclaimer: Stock recommendations and comments presented on angel.co are solely those of the author and quoted.

Startup stock options are one of the most lucrative and misunderstood opportunities when working at an early-stage startup. Options can provide substantial rewards through returns on the contracts as well as the ultimate goal – an increased equity stake in the startup as it develops, expands, and enters mature-stage growth.

How do startup stock options work?

In short, options are derivative assets that allow an employee to buy a set quantity of company stock at a fixed price within a predetermined time frame.

Understanding the function of stock option grants is vital in calculating your total compensation package at a startup. Here are 6 stock option grant questions to ask when negotiating your compensation package at a startup.

1. "What is the strike price?"

A strike price is important in calculating the number of shares you could purchase. For employees, the strike price is the price at which they can purchase shares of the company. Future or expected profits will be earned when the value of the shares rises above the strike price.

How does a startup set the strike price of stock options, and how do you know it’s a fair valuation? The IRS issues specific guidance on setting strike prices that centers around determining a fair market value (FMV) for the stock at the time of issue. Determining the FMV of the stock can be a challenging and opaque process, but Section 409A provides structure to the process. After the 409A valuation assesses the stock’s FMV, a strike price that cannot be lower than the FMV is assigned to the stock.

Typically, employees who join a startup earlier in its journey will have a lower strike price versus employees who join a later stage, or growth stage, startup.

2. “What is the 409A valuation of the startup?”

The 409A valuation is this valuation that will drive the strike price, and have a future impact on profits for employees. This helps the employee understand the valuation of the common stock, versus potentially higher valuations given to preferred equity. At a later stage or growth stage companies, the 409A valuation of common stock might be significantly lower than the valuation of preferred stock. In these cases, the employee could benefit from the eventual, and hopeful, a convergence of valuations between preferred and common stock.

A 409A valuation is the IRS’ prescriptive guidance and sequencing to determine FMV. Its primary use is to provide transparency and protect potential option grantees. The valuation then takes place in three discrete stages:

Calculating Enterprise Value (EV)

The EV can be calculated in one of three ways: the market approach, the income approach, and the asset approach.

• The market approach is used in early-stage firms to measure the company against a set of market-equivalent peers. For example, an early-stage software firm that is not yet profitable is measured against more mature software companies to determine a relative valuation against those comparable firms (i.e. comps).
  
• The income approach is used when a startup is at or trending towards profitability, and financial performance can be more readily predicted. EV is measured using revenue modeling from past performance and growth expectations.
• The asset approach is used early, often for companies' pre-financing. It measures EV based purely on a one-for-one replacement cost via an appraisal of the company’s assets and liabilities at the time of valuation.

Determine the Value of Current Shares

The value of the current shares can be determined by using the EV of the startup and dividing it among all existing share classes (preferred, common, etc.). Since classes of shares can drastically vary, their weighted EV can be assessed in one of three ways:

• The Options-Pricing Method assigns a strike to each share class and considers them notional call options (an option granting the opportunity to buy at a specified strike).
• The Black-Scholes Method is the most well-known method and uses a complex formula, one that earned a Nobel Prize, to account for time, current stock price, risk-free rate, and other variables. It isn’t easy, but it is the most reliable method and is widely used in private startup options grants and publicly traded options pricing.
• The Probability-Weighted Expected Return Method looks at several contingencies and possible company-wide outcomes (insolvency and dissolution, future acquisition, etc). It weighs each with its respective likelihood of occurrence. The agreed-upon rights dictate the share class or series’ specific outcomes in the contract or term sheet.

Discount for Lack of Marketability (DLOM)

The DLOM accounts for the relative illiquidity of private startup options to public equities and discounts them appropriately based on the lack of supply or demand price-setting that traditional options enjoy.

These steps can be further divided but serve as the fundamental framework for valuation and strike price setting. New employees must know when the valuation determining their option strike was performed. For example, if a valuation was done in the early stages of pre-financing for a now-profitable startup, there could be a misalignment of the strike and actual FMV. As a general rule of thumb, the more recent the valuation, the more reliable and fairer the strike.

3. “What is the current funding stage?”

A startup evolves and grows through many rounds of funding. The current, or most recent stage, is the one that most impacts the assigned strike price.

“The strike price reflects the fair market value of the shares of equity at the time of the grant, so the strike price is not so much a reflection of the stage of the company as it is of the value of the company. On balance, though, earlier-stage companies tend to have lower valuations and, therefore, lower strike prices as compared to later-stage companies. Early employees at startups often have the opportunity to exercise their options when the value of the equity and strike price is very low. If given the opportunity, it's often a great time to exercise your options early, sometimes for just a few hundred or a few thousand dollars.” -Lawrence Gentilello, CEO & Founder of Y Combinator-backed company, Optery

To exercise your option simply means the employee agrees to pay cash for the shares today in the expectation that the future price will be higher. To calculate the costs of exercising your stock option, multiply the strike price by the number of shares. For example, to exercise, or purchase, 10,000 shares from a grant with a strike price of $5, the employee would need to pay $50,000 in cash today.

4. “When can I exercise my options?”

Now that we understand a little more about options and their pricing, what happens when you reach expiration or are fully vested? You can typically exercise your options at any time after they are vested.

Exercising your options is a smart strategy if your options are nearing expiration and you are confident that there will be a liquidity event in the future. Assuming you exercise your right to purchase stock at the strike because the current stock price exceeds the strike (an in-the-money option), you are the beneficiary of the number of shares set by your options position.

It also might make sense to exercise your options, after vesting, even if you still have time until expiration.

“It does make sense to exercise early when you believe that the value of not paying short-term gap gains tax at a liquidity event is more than the cost of early exercise. In the later stages, it can cost hundreds of thousands to early exercise large option grants, and you have to be bullish that you'll save more than that amount at sale or IPO. It makes sense in the early days (cost to exercise is usually insignificant) but becomes a much harder question to answer at B/C/D and beyond.” - Alex Cohen, an employee at Alex and Bart’s Angel Fund

Another common and advantageous reason for early exercise is if your startup is private and filing for an IPO. After an IPO, there is often a lock-up period where no employee stock sales can occur. So, correctly timing your exercise with the projected lock-up expiration means you can sell as soon as legally possible (assuming you want to).

5. “What is the vesting schedule?”

Even though options can technically be sold or exercised at any time before expiration, companies will typically include a vesting clause in the grant. This clause dictates the minimum holding or vesting period during which the option cannot be sold or exercised. Why do companies do this? It’s a matter of motivation.

Options are granted to employees on a mutually agreed upon performance basis. The firm expects a minimum period of performance and contribution to the enterprise before you can cash out. It’s the same idea as a sign-on bonus not being paid out until the 91st day of employment. Depending on the total number of options granted, they will vest according to a periodized schedule in blocks:

Accelerated Vesting

Accelerated vesting is a quickening or hastening of the period in which you can sell or exercise your options. Vesting schedules can be adjusted by the firm and accelerated but are more often seen in fundamental or structural changes to the startup. Assessing your options compensation is vital to understanding whether an IPO or buyout will automatically trigger accelerated vesting. This can mean the difference between an early payday and the options expiring worthless.

Cliff Vesting

Cliff vesting negates the periodization and scheduling of vesting. Instead, in a cliff vesting scenario, all options, or a select portion, become immediately sellable or can be exercised at once and is often seen at early-stage companies. Cliff vesting is also used as leverage by more mature companies as a sort of employee probationary period in which a portion of options, commonly 25%, vest after a year of successful employment, with the remaining 75% following the standard vesting schedule.

Post-Termination Exercise Period (PTEP)

The PTEP is a clause in your employment contract that mandates the exercise or sale of the options. Employees are typically provided with an exercise window post-termination, often 90 days, in which they can exercise. Miss out on your window, and you miss out on the gains too. Your options are returned to the total option pool for granting to remaining or new employees if you're not the one to exercise them.

Many startups are now extending exercise windows to be more generous and flexible for employees. “Few candidates and team members understand the value of extended post-termination exercise periods. When strike prices are high, exercising can be very costly for ex-team members at a time when they have no idea whether this investment is a good one or not. Long exercise windows, sometimes seven years now, allow for strong optionality while avoiding spending cash and should be seen as a key employee advantage.” -Alex Louisy, Co-founder and CEO of Upflow

6. “Are options available as ISO or NSO?”

Depending on whether your options are incentive stock options (ISO) or non-qualified/non-statutory stock options (NSO), they impact your taxation rates and timeline. An ISO is a qualified option eligible for preferential taxation on gains meaning it gets taxed at the lower capital gains rate as opposed to an ordinary income rate. Still, it has to be held (not sold for profit) for an entire year after exercise and two years after issuance. An NSO results in employee taxation based on grant and exercise price at the ordinary income rate.

It is typically preferable for an employee to receive an ISO versus an NSO because of the tax benefits described above.

Additional Questions For Your Employer About Compensation Packages

Compensation negotiations are always tricky and can be made harder if you don’t fully understand the details of option comp. We’ve just reviewed the fundamentals of options and your rights and responsibilities with them, but what else should you know or ask before agreeing to an options package?

• Relative Compensation. As you’ve likely gathered, options compensation is the trade of more tangible compensation (salary) now for the potential of greater rewards in the future. To this end, you need to be comfortable with the company's trajectory and growth model, be financially secure enough to forgo immediate cash in your checking account and have enough liquidity to exercise your options at the set strike if feasible. This is also the time to ask about post-employment grant incentive options. How does your startup reward talent? Bonuses are great, but seeking additional incentive options could mean achieving big financial goals sooner.

• Equity. We know options exercised for stock mean transferring some equity from your employer to you, but how much? You need to know the total share count or shares outstanding and divide your potential exercise stock quantity by those total shares. For example, if your startup has 10,000 shares outstanding and you have one option for a block of 100 shares, you would have 1% equity or ownership of the company.

• Runway. In startup terms, the runway is the length of time that the firm can continue operations before its bank account hits zero. Understanding the cash balance and the current runway is vital to inform your decision to sell or exercise your options early. If the startup goes under, your options are worthless. This is also why it is essential to understand the total funds raised and the current round of investing. Not only does it help you determine whether your strike is appropriate, and it gives you an informal estimate about whether the options are worth selling, exercising, or holding until expiration.

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Get Started with Startup Stock Options

One of the most important takeaways to remember when it comes to startup stock options is to have patience, resolve, and belief in the startup. Employee stock options are a lucrative and financially rewarding aspect of a comprehensive compensation plan.

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