A Beginner’s Guide to Startup Options & Equity
By: Jon Piggins, VP Business Development
A Beginner’s Guide to Startup Options & Equity
In the startup world, most offers of employment include stock “options”, essentially granting you the right to buy shares of the company’s stock in the future at a predetermined price. For example (in a best case, simplified scenario), you accept an offer to work at “XYZ Company”, stay there more than 4 years (to fully “vest” 100% of your options). The “strike price” for your options is $2/share. In year 5, XYZ Company decides to issue an “Initial Public Offering” to begin selling shares of their company to investment banks & the general public. They price their stock at $20/share and it begins trading on the open market (e. “NASDAQ”, where the price will fluctuate based on demand). You now have the right to “exercise” your options, buying them at the predetermined $2/share and then sell them at the market price of $20/share, giving you a gross profit of $18/share.
So now that we have a basic understanding of what an option is, we’ll look at a few more important considerations when evaluating your offer (or current position).
Valuation
While a company is private, it’s valuation is managed by the board of directors (via a “409A Appraisal”) usually one a year (or if there’s a significant change, like a new VC round of funding). The valuation is based on a number of factors, but is intended to be an independent/objective Fair Market Value, or “FMV” (think of a house appraisal). Each round of valuation, in principal, represents an increase in the value of each share in the company. So, each increase in value also means that the cost per share in that company goes up. Meaning, if you started employment at XYZ Company when they were valued at $5 Million and your “strike price” was $2/share and now the company is valued at $10 Million and new hire would now have to pay $4/share for the same option. Hence, the benefit of “early equity”…getting in while the cost to exercise (“purchase”) your options is low (as it allows for more potential profit margin).
Calculations
In simple terms, you can come up with a rough value for your shares by using the following equations (and a company should be able to provide you with this information once you get to the offer stage).
% of “ownership”, how much your potential shares represent of all the company’s outstanding shares:
# of shares/options, divided by “total number of shares outstanding” = % of equity you’d have in the company. (eg. your # of shares/options of 50,000, divided by the total number of outstanding shares for the company of 10,000,000 = 0.005 or .5% equity in the company).
Value (on paper) of your shares/options:
# of shares/options x current FMV strike price – # of shares/options x your strike price = your current spread or profit margin. (eg. 10,000 shares at the last Board of Director’s FMV of $10/share – your 10,000 shares/options x your strike price of $5/share = $50,000 in a “paper” gross profit).
Vesting Schedule
This is simply the rate at which you gain the ability to purchase your options/shares. Industry standard is 4 years, the 1st year vesting (25%) after one year of employment and the remaining 75% vesting each month at a rate of 1/48 over the remaining 3yrs. After 4 years, you now own the right to exercise (“buy”) all of your options.
Liquidity Preference
Venture Capitalists & other investors get paid 1st. So, if a company has taken $40 million in funding and it decides to go public, no one else but the investors get paid until the proceeds exceed the $40M+ mark. Important to note (from an equity standpoint) when looking at a company that’s taken on a lot of funding & doesn’t have good traction, as there’s a good chance you’ll probably never realize any benefit from your options.
Summary
This is meant to be a very high level “Options 101” review of the topic. There are a multitude of factors that can come into play; dilution of shares/equity, different classes of stock, company acquisition, Restricted Stock Units (“RSU’s) vs. Options…but our hope is that a basic understanding of what options are & how you can calculate a rough valuation of a company and what your options represent in “ownership” of that company, you’ll be able to better evaluate your next (or current) opportunity. We’d be happy to answer any questions or do a deeper dive on these (or other) topics, so contact us if we can be of service!