Congratulations on your decision to join a startup. I am sure you did all your home work on what the startup is building, tech stack and product road map, etc. But there is this one thorny detail that you think you understood, but you are not quite sure: your allocated stock options.
Stocks vs stock options
The term equity stands for how much of a company you own.
Stocks represent the equity you own in the company. Stock options represent only the right to buy stocks of the company.
When you are allocated stocks, you don't need to do anything further to convert them into equity. In contrast, you should convert stock options into equity by exercising your right to buy stocks. When you exercise your right, you have to pay some money to the company. How much you should pay is written as part of your stock options grant. Some generous founders may grant stock options at a discount, where as some may grant the stock options at the fair market value (FMV) as of grant.
What they don't tell
When I say "they don't tell", I mean that they conveniently assume that you will read and understand the stock grant document. When the stock options are granted, there are two crucial numbers you should pay special attention to:
- Strike price. This is the price you will pay to exercise your right to buy the stocks. Without paying this price, you don't own any equity in the company. Ask for FMV of the stocks to understand if you received any discount.
- Exercise period after termination. In my opinion, this is even more important than the strike price. This period tells you how much time you have got to exercise your stock options after you leave the company.
Things always don't go as planned. Let us say you decide to leave the company for a better opportunity after a couple of years. All vested stock options will go back to the company's option pool if you don't exercise your stock options within the exercise period. All your sweat and tears is for nothing. I have seen people getting exercise periods like 30 days in their grants. I have also seen grants that allow 3 years to exercise after termination. If you can, you must negotiate to get the longest possible period.
It is common to see that a Series A company may have their fair market value to be in 10s of cents. If you are allocated 100,000 stock options at $0.10 strike price, you should spend $10000 to exercise them. I have seen people unable to move on, even though they have vested all their stock options, because they cannot exercise. Having the luxury of time to exercise your options over a longer period is great.
So pay attention to both of these values, not just how much you were allocated.
Minor detail: Liquidity event
Let us assume that things are going really well and you decide to stay with the company even after all the stock options vest. When will your stock options be converted to stocks? They are converted at the time of a liquidity event. Typically these are: your company getting acquired by another company, your company going for an IPO, or your company is going for a shutdown and all assets are sold. When your stock options are converted into stocks, if you make any profit i.e. the FMV as of the day of liquidation is higher than the strike price, then you will end up paying taxes. How much tax you pay is dependent on if you have already done the early excercise or not. That is a topic for adifferent post.
Disclaimer
I wrote this article with the intention of sharing my knowledge, but you should not take it as is. You should do your research and talk to an expert before making any decision.