If you have ever considered joining a private tech company then the dream of making millions of dollars from your stock options at a pre-IPO company has probably crossed your mind. (View Highlight)
Types of Compensation
There are two types of compensation provided to employees:
Cash: base salary + variable compensation (if applicable)
Equity: ownership or right to obtain ownership in a company
The cash piece is immediately valuable (you got money in your bank!) while the value of the equity depends on the company you are at.
Equity given to employees of public companies is immediately valuable (once it vests) because they can easily sell it on the stock market.
But private companies don’t have this access. While the very best private companies might have an active secondary market where investors are willing to buy their shares, it is much harder and more costly. (View Highlight)
There are many types of equity that might be given, but by far the two most common are:
Earlier stage companies almost always grant stock options, but when a private company becomes more mature with reasonable line of sight to an IPO they may start granting restricted stock units (RSUs) because the upside potential is more limited, which is where stock options get their value. (View Highlight)
Stock options give you a right to buy (aka exercise) a set number of shares of the company stock at a certain price, also known as the strike price. (View Highlight)
Because your purchase price stays the same, if the value of the stock goes up, you can make money on the difference. The dream is you can sell your purchased shares for a lot more than you pay for them. (View Highlight)
All companies hire a valuation expert to perform a 409A valuation report so they can issue stock options because there are adverse tax consequences if you don’t issue stock options at the fair market value (“FMV”) of the common stock as determined by the report. (View Highlight)
409As are required by the IRS to be done at least annually. But companies will start doing the semi-annually or quarterly once they reach a certain size and closeness to a potential IPO. (View Highlight)
Stock options at tech companies typically “vest” (i.e. you can buy them) over a 4 year period with a 1-year cliff and then monthly thereafter. (View Highlight)
The cliff means that nothing is exercisable (i.e. you can’t buy them) until you have been employed for one year and then 25% of your options become exercisable. This helps protect the company in case they discover you are terrible after 6 months and want to fire you. (View Highlight)
For private companies, you may be waiting a while…
There are 3 ways that private company equity can turn into cash:
Company goes public (IPO) so the stock is publicly traded. Very few companies make it to an IPO.
There is an active secondary market for the company’s stock (i.e. big investors want your private company stock). Only the very top companies have an active secondary market.
The company gets acquired. Perhaps the best chance, but still not very high. (View Highlight)
• What type of stock option is it (ISO vs NSO)?
• There are significant tax differences so do some research. If you are a U.S. based employee then ISOs are typical as they have tax advantages to employees. Everyone else gets NSOs.
• What is the current strike price?
• If they are in the process of fundraising the price might jump up.
• When does the current 409A expire? Will they have to refresh it before your grant?
• What is the vesting schedule?
• Typical is one year cliff and then monthly vesting over the next 36 months (4 years in total vesting).
• What was the preferred stock price and valuation?
• You want to know how big the spread is between what the last investors valued the company at versus what price you can buy the shares at. There are various factors that can make the spread big or small.
• You also need to know how real that valuation is. If they raised their last round in 2021 than it might be way too high.
• What is the fully diluted shares outstanding?
• Big red flag 🚩 if they won’t tell you this. I have heard many companies tell candidates that it is confidential…
• This tells you the size of the pie. Only then will you know how big of a slice you are getting with your stock options.
• The fully diluted shares is the total shares of a company including shares that are currently outstanding and also shares that could be claimed through the conversion of convertible preferred stock or through the exercise of outstanding options and warrants.
• What are the liquidation preferences?
• This will cause a lot of stock options to be near worthless for companies that raised huge rounds at crazy valuations.
• VCs get preferred stock which means they get preferential payouts in the event the company is sold or has an exit event. In other words, they get paid first before anybody else. And some rounds in 2021 were so large at such high valuations that an exit might be lower than the total amount raised, which means employees get nothing.
• While it was much less common during the good times of 2021, “dirty” term sheets have become more popular today. Typically liquidation preferences are 1x which means investors get their money back first but no more. Greater than 1x means they get their money back plus some…. (View Highlight)
• What is the post-termination exercise period (“PTEP”)?
• • Typically this is 3 months after termination, which means you have 3 months after you leave a company to decide if you want to exercise your shares. If you don’t then the stock options are forfeited (i.e. you lose the right to exercise).
• Some companies are more generous and offer longer periods to exercise which can be a great benefit. (View Highlight)
• Can you early-exercise your stock options?
• • For a lot of companies this is a benefit reserved for executives, but some companies offer it to all employees. Early exercising of options starts your holding period sooner so you may pay the lower taxes when you sell.
• Also, you likely won’t owe additional taxes upon exercise if you early exercise your options as soon as they’re granted (at the time of exercise) because you’re buying them at FMV so there is no gain. (View Highlight)
If employees are involuntarily terminated then the company can accelerate vesting.
• This is common when executives are terminated and commonly 3 - 6 months are accelerated.
• It is also somewhat common in large layoffs as part of separation packages.
• It would be unusual for an employee below the VP level to get an acceleration if they were not part of a broad layoff. (View Highlight)
Companies can “reprice” stock options if the fair market value (FMV) drops
• If you joined a company in 2021 when valuations were crazy high then your options may not be worth nearly as much today.
• Your company will have an updated 409A valuation today which determines the FMV. If it’s significantly lower than previous valuations then the company might consider repricing prior stock options. *This is much easier for private companies to do than public companies. Public companies might just issue more equity. (View Highlight)
The company can have a longer post-termination exercise period (PTEP).
• The PTEP can be extended a few months or a few years. It just can’t be longer than the life of the stock option, which is generally 10 years.
• Companies can do this and still grant ISO stock options - the ISOs just turns into an NSOs after 3 months past the termination date (View Highlight)
Will my stock options be worth anything?
Don’t bank on getting rich from stock options. Most people should look at them kind of like a lottery ticket.
I know I am crushing dreams here….but it’s better to have this mindset when you join an early stage company because there is sooo much risk to get to an eventual exit.
The risk/reward analysis is usually pretty bad for employees joining an early stage company. Especially in today’s environment (View Highlight)
