It’s increasingly common for startups to offer new employees stock options (equity) as part of their compensation package. There’s a lot of misunderstanding around how options work and how you should think about their value. After reading this I hope you’ll have a better understanding.
There’s a lot to cover on this topic so it’s a long article. I’ve written a summary at the end if you want the quick punchlines.
Important note: I’m not a financial advisor, so the following is only meant for informational purposes. It’s always best to seek out qualified advisors for specific questions.
Why is it important to understand options?
Most startups include options as part of the compensation they offer. If you’re not clear on how they work, or how to think about their value, then it’s tricky to assess your offer or compare it to other opportunities. At the same time, startups will often give you the choice between different salary/option packages (e.g. lower salary and higher options vs higher salary and lower options). With this post, I’m aiming to leave you in a position where you understand the value of options so you can make more informed choices.
What is an option?
A stock option is a contract that gives you the ability to buy stock in the company. There are three crucial elements of this contract:
- The number of options. This translates to the number of shares you are able to buy
- The strike price (sometimes referred to as the exercise price). This is the predetermined price that you’ll pay when you buy shares using your option contract
- The vesting schedule. Most companies issue you with options that vest over time. Vesting is a trickier concept so I’ve written a whole section on this below
Often the word ‘exercise’ is used, this is simply another word for actioning the option contract, when you buy at the strike price and turn the options into shares that can be sold.
Why are you offered options in the first place?
- Founders want to attract you to work for their business: You’re taking a risk by joining an early stage company. They’re exciting places to work (I wrote a post about how startups can be the perfect place for people early in their career), but are more likely to fail than more established companies. I think offering options is a great way to attract talent for two reasons: a) you feel like you’re part of the business you’re building and b) there are opportunities to share in the rewards if the business is successful
- Founders want to motivate you to work hard while you’re there: Your options in the business will only be worth something if the business is a big success. At early stage companies, having all the employees motivated to work hard is vital for making that happen. If you benefit financially when the company does well you’re more likely to work hard while you’re there.
- Founders want to keep you there: As you’ll read below, you aren’t just given your options on day 1, you earn them over several years working for the company. If the company is growing fast, the options you’re earning can start to have serious value, and so you’re more likely to stay
What is vesting?
When you join a startup, the company won’t immediately give you all your options on day 1. The main reason is that if you left the next week, you would walk away with a lot of options without adding value to the company. Vesting is a mechanism whereby you earn options over time, ensuring your interests are aligned with the company.
A standard vesting schedule used in UK and US startups is ‘4 years with a 1 year cliff’. Here’s what your vesting schedule could look like if you are given 10,000 options and work at the company for 4 years:
- Day 1: 0 options vested
- 6 months: 0 options vested. The 1 year cliff means you don’t vest any options until you’ve been at the company for 12 months; this incentivises employees to stay for at least a year
- 12 months: 2,500 options vested. At the one year mark, you’re ¼ of the way through your 4 years and you’ve passed your 1 year cliff, so you get the first 25% of the options
- 15 months: 3,125 options vested. Once you pass the 1 year cliff, typically you’ll vest options every month. At 15 months you’ll have earned 31% of your options
- 36 months: 7,500 options
- 48 months: 10,000 options. At the 4 year mark you’ve earned all your options from the original grant, so there are no more options to accrue.
This is important to grasp, as if you think you’ll only be at the company for 18 months, you’ll only earn 38% of your options.
Note, the above is just an example. I’ve also heard of 4 year vesting schedules where you only earn 10% of your options in the first year, 20% in the second, 30% in the third and 40% in the fourth (a more aggressive approach that encourages employees to stay longer). It’s important to understand your vesting schedule, so be sure to ask questions of your prospective employer. Asking for a worked example like the above can be useful.
How to think about valuing your options
The value of your options depends on the difference between the strike price and the value of the shares the option converts to (determined by the share price). It’s worth noting the strike price depends on a lot of different factors, including the rules of the option scheme your company subscribes to and the stage the business is at. Strike prices can be as low as £0.00001, making them essentially ‘free’ to exercise (apart from any tax you may incur). Equally, the strike price could be £0.30, meaning you may need to find cash to exercise your options.
What are my options worth today?
Let’s suppose you are given 10,000 options in the fast-growing (imaginary) startup ABC. The strike price is £0.01. If you had vested all your 10,000 options at ABC, you could exercise your options by paying £100.
If the share price is £0.50 your shares are worth £5,000. If there was an exit event (more on this below) and you sold your shares, you would make £4,900 (the value of your shares minus the price you paid to exercise your options).
Establishing the current share price is generally easy: you divide the value of the company at the latest fundraising round by the total number of shares. Your company should be happy to tell you the current share price.
What could my options be worth in the future?
The future value of your options depends on what happens to the share price. If the share price went up to £5.00, your shares would be worth £50,000 and you’d make £49,900 at the exit event.
It’s worth noting that if the startup is worth £20m today and the share price is £0.50, it’s not as simple to say that at a £200m valuation the shares are worth £5.00 each. This is because new shares are issued every time the company raises money, increasing the total number of shares (this is called dilution).
Startups will often tell you how much your equity could be worth if the company goes on to have a £500m or £1bn exit. Thinking about how much the company will be worth in the future is really hard. It’s not easy to predict the future value of a high growth startup (many people get paid lots of money trying to pick winners such as Airbnb or Facebook!). It’s important to understand that big success is an unlikely outcome for an early stage business.
Your company should help you to understand the various outcomes and what returns you could get from your options, but it’s always best to view their predictions with a bit of cynicism. Companies will always try to paint a somewhat optimistic picture to get you excited about joining!
I’d recommend seeing big success as having low probability, and a nice surprise if it comes true. This line of thinking makes it hard to assign a monetary value to options.
If you are viewing options as providing a potential nice surprise, then you want to make sure you at least have the potential of upside if the business does well. If your 10,000 options will only be worth £3,000 if the company sells for £200m, then you probably shouldn’t place much weight on the options part of your package.
Whatever future value you think they might have, you should never rely on getting cash out of your options until the company is on a path to its exit. Personally, I don’t think it’s wise to consider options to be your pension or your route to buying a house. When I worked at a startup I viewed my salary as my only earnings. If you’re thinking your options will be worth £1m, so you don’t need to worry about saving for a house, you might be very disappointed if the startup fails to exit in 10 years time and you have no savings!
When will I get the money from the options?
As explained above, options are usually only worth something when the company goes on to be a big success and has a successful exit. An exit is otherwise known as a liquidity event for the company. It’s called this because the event converts ownership stakes in a company into cash (liquidity). For successful startups, a liquidity event will typically occur when the company is acquired by a bigger company, or if the company lists on a stock market via an IPO.
Unless you’re joining the company at a very late stage, it’s unlikely you’ll have any certainty on when this liquidation event is going to happen (or if it’s going to happen at all). This is another reason it’s difficult to rely on getting the cash for a specific purpose. Uber recently went public after 10 years of raising money in the private markets, so employees that joined 8–9 years ago are only now being able to get their hands on the full cash value of their options.
Some scale-ups let their employees sell some of their shares in later stage fundraises. This is typically for early stage employees who can have a lot of their wealth tied up in options. For example, employee #20 at a scale-up about to raise £200m at a £2bn valuation may be allowed to sell 10% of their options.
There are additional complexities around timing of when you can get the cash. For example, you may be subject to a lock-up period if the company goes through an IPO, where employees and ex-employees aren’t allowed to sell the stock for a certain period of time after the IPO.
Another important consideration when it comes to the exit event is whether the company has any “preferred shares”. Venture capital (VC) firms nearly always get preferred shares when they invest in companies. Preferred shares have a few features, but the key one here is that when there’s an exit event, they get their money before other shareholders (in some cases, preferred shareholders are entitled to their money back plus a certain return on top). The rest of the ‘ordinary’ shareholders then share whatever is left. For example, consider a company that has raised £500m using preferred shares, entitling the VCs to a 1.5x return. If the company sold for £750m then employees wouldn’t get any of the cash, despite the business being valuable.
The reason I’m explaining this is because there are cases where companies sell for big figures (e.g. £1bn), but the employees get nothing because the proceeds go first to the VC firms and founders. The value of your options continues to get more confusing and uncertain!
How to think about comparing salary/options packages at the same company
Often, you’ll get the choice between a mix of salary and option packages. For example, your startup may have said you can choose between £30k salary + 5,000 options or £33k salary + 3,000 options. To decide you have to make a trade off between certain cash now and potential cash later.
Some people get worried about how it looks if they take the higher salary and lower options package, but that should not be a concern. Everyone is in a different financial situation and you need to make a decision that’s right for you. I believe there shouldn’t be such a stigma around discussing compensation, and these conversations are always forgotten by the time you join.
In my view, your focus should be on whether the salary is enough on its own to satisfy you. If you have strong conviction the company is going to be a huge success and can manage the lower salary, you may be more inclined to take the package with higher options.
How to think about comparing salary/options packages at different companies
Comparing salary/option offers at different companies can be especially difficult. Imagine you have offers from a scale-up worth £2bn and a Series A startup worth £50m.
Say the scale-up offers you options worth £20k today, and the Series A startup offers you options worth £6k worth today. There is a risk-reward trade-off to be made:
- You’re probably much more likely to realise the value of your options at the scale-up, but the potential upside is much lower (How much can the valuation of a £2bn business increase? Any more than 3–5x is very unlikely).
- At the Series A startup, your options could increase by 20–30x if they manage to reach a £2bn valuation (it’s not just 40x as you need to account for dilution from fundraises along the way), so your options could be worth £120–180k. However, there are very few startups that make the jump from Series A to £2bn valuation
I recommend considerations outside of the potential value of options when weighing up different offers. Perhaps the startup will give you a faster pace of learning, and this is important to you. Or perhaps salary growth is crucial and this is going to be more likely at a scale-up.
Other important considerations
There are other complexities around tax which I won’t go into in this post. If you do have a significant amount of options and your company has an exit event on the horizon, it’s worth investing time to understand the tax implications. The company should be able to give you advice, or you can seek advice from an accountant.
Linked to tax is knowing when to exercise your options. This varies for different option schemes so I don’t want to go into details, but it’s key to know the dates when you should do this to make sure you don’t suffer tax implications. Also, if you forget to exercise your options altogether then the contract may expire and you’ll be left with nothing!
Last but not least, I’d advise you to read your options contract carefully and make sure you understand all the key points. If there’s something you don’t understand, ask your prospective employer and get them to explain it in plain english. I’ve seen one option contract where the individual was unable to exercise their options once they left the company, even though they had vested them all. This essentially made the options contract worthless to anyone not wanting to stay at the company for a very long time!
Once you’ve understood the mechanisms of options, here is a summary of my advice:
- Make sure you can manage with your salary from a startup
- See future upside from options as a nice surprise but a low probability event. There is so much uncertainty around whether they’ll be worth anything and even then there might not be an exit event you can benefit from
- Work out if your options are going to be worth much if the business is a big success. As a general rule, I recommend getting an estimate for an exit at £200m and £1bn. Your employer should be able to help you. If they aren’t worth much when the business is worth £1bn then it’s best to ignore them
- If you’re deciding between two offers, think about your risk appetite. Do you want a lot of potential upside (go for a startup), or do you want more certainty (go for a scale-up)?
If you need any help with how to think about your options offer, or anything else to do with your next move, email me at firstname.lastname@example.org