You started a business and you want to compensate your early employees. Or you've joined a startup and were offered stock options as part of your compensation. How do those work? Let's do it.
Most startups in the US compensate their employees with a salary, of course, and with stock options. The idea here is giving team members an upside if the collaborate to increase the company valuation. On public companies, that is, companies whose stock has been listed on a public stock exchange, this works somewhat differently, so I won't get into that. I've never worked for one of those. This article is mostly about private companies: startups where the stock is owned by the founders and their select investors.
It all starts with a stock option pool. This is a pool of shares that the company issues, and that it 'reserves' for employees. On paper, this is a legal document signed and approved by the Board of Directors, and it represents a new issue of company shares. We made a video about how stock works, and how shares can be issued to investors, so go check it out if any of this seems confusing.
In 2016, in combination with our investor round (which is usually when Stock Option Pools are created), we decided to create a stock option pool of around 5% of the company. In this case, the company issued 530,000 new shares of stock, additional to the 10,000,000 shares we had when the company was founded.
This means the company now had a total of 10,530,000 shares issued. Those 530,000 represent 5.03% of the total shares the company has issued. Even though our team already had around 10 people then, we wanted to compensate the early employees, those who had joined us when we were in the earliest stage. We also needed some stock options for new, key employees we were about to recruit.
Now, at this time, our latest company valuation was about $2.5MM. Which means each share has a value of roughly $0.2374 dollars.
So, say we want to give 100,000 shares (around 1% of the company) to Dwight. If we just gave him these shares, Dwight would have received assets valued at around $25,000, which would be taxable. He would have to pay taxes for these assets, that he can't necessarily cash out. So, instead of giving them these shares, the company gives them stock options. That is, the option to purchase those shares at a defined value. That value is usually connected directly to the valuation of the company at the time, so in this case, the price per share, or STRIKE PRICE is $0.2374.
Now what's really happening is the company is giving Dwight the right to buy 100,000 company shares at a defined price of $23,740. Now here's where the fun happens. Say a few years the company gets acquired and the startup is no longer valued at $2,500,000 but at $25,000,000. At the time of the acquisition, Dwight exercises his stock options. He has this unique right to pay $0.2374 per share. The buyer, however, has agreed to pay $2.347 per share. The difference, roughly $2.11 per share, is Dwight's margin. So just to clarify, Dwight will never have to pay those $23,740 out of his pocket, he'll simply collect the earnings as part of the acquisition paperwork.
Now, I've oversimplified this to make it easier to understand. In all likelihood, the company will have issued new shares during that time. That's why it's important to understand that the stock option pool is represented in shares, not in percentages. The 100,000 shares Dwight received represented around 1% of the company back then, but later on, they might represent much less. It's the difference between the strike price and the price per share that gives Dwight his edge. This is important to understand, because if the company doesn't increase in value, then those stock options are not really worth much. The employee can still buy them
Now, it's important to note that most stock options are subject to vesting. The norm is s 12-month cliff and a four year vesting period. Check out this video to understand how that works. The point here is, Dwight will only have access to these stock options if he remains as Assistant Regional Manager for a certain amount of time.
Another important point here is most stock options expire after 10 years, or 1 to 3 months after the employee leaves the company. In that case, if the company has actually increased in value, the employee might choose to exercise his or her stock options then. They can either keep them for themselves or sell them, depending on the company policy. A fun fact here is how former employees of Uber are struggling to solve this.
When they leave the company, they have 30 days to exercise their options or they will be lost. Their options might be worth tens of thousands of dollars even at the strike price, but it's almost a guarantee that when Uber finally goes public, the difference in the price per share will give them amazing gains. They just can't access that capital yet. So, if you're an employee receiving stock options, congrats, get back to work and help make your company increase in value! Slidebean might be able to help there. The first 50 people to sign up with this link will get a free year in our platform.
If you're a founder, we have a few free templates of stock option documents at FounderHub.io, you can check them out. If you have questions, let us know in the comments.
This is a functional model you can use to create your own formulas and project your potential business growth. Instructions on how to use it are on the front page.