My Lessons Learned post sparked some discussions among friends about my stock option experiences. After spending over a decade at three successful startups I’m pretty sure I’ve made or heard of most common stock option mistakes and thought a post on the topic made sense.

Part of the lure of an early stage startup is that you’ll get equity in the company, in the form of stock options. This equity comes with a salary that is lower than what you might expect at a more established company, making it vital that you have a good understanding of how stock options work. I feel all posts that involve financial topics should come with the disclosure that a professional should be consulted before making complex financial decisions.

As part of your offer at a startup you’ll be given a stock option grant. Each option included in the grant allows you to buy a share at a fixed price (the “strike price”) at some point in the future. This secures for you the right to buy shares at that fixed price in the future even if the share price increases dramatically. To convert these options into shares you’ll have to write a check (strike price * number of options) to the company (this is known as “exercising your options”). Initially these options are “unvested”, which means they’re not actually your options until you spend a certain amount of time at the company (the “vesting schedule”). The most common vesting schedule is over four years and will include a “1 year cliff”, meaning none of the options will be yours until your one year anniversary with the company. After one year, 25% of the options will be yours (“vested options”). You will continue to vest the remaining options on a monthly basis (getting 1/36th of the remaining each month) until your fourth anniversary at the company.

If you stay at a company long enough you’re likely to get additional grants (and you should expect them if the company is trying to retain your services). I have heard of and experienced alternate vesting schedules but more often than not these schedules tend to be skewed in the company’s favor. I’d suggest thinking through any alternate vesting schedule carefully (on a case by case basis) and deciding whether you want to push for the traditional 4 years (1 year cliff) schedule. Some very strong arguments should support any objections to your request to have a traditional vesting schedule.

1. Incorrectly Valuing Stock Options

Putting a realistic value on your stock options is the first step in figuring out what your total compensation is worth. The thing to realize is that the number of stock options means NOTHING, you need to figure out what percentage of the company those stock options represent. Companies will often do a stock split to make the number of options they’re granting sound more appealing (e.g. given someone 100,000 options sounds much better than 10,000 options – even though the percentage of the company they represent could be the same).

Some back of the envelope arithmetic that you should do is to ask for the “total number of outstanding shares” (if the company you’re thinking of joining is not forthcoming with this number you should be suspicious). Once you have that number it’s simple to calculate the percent of the company that your options represent (e.g. total outstanding shares of 100 million will mean 100,000 options represent 0.001 percent of the company). Once you have the percentage you can start to figure out what you’ll potentially make depending on the valuation of the company.

It is very important to do worse case scenario calculations. Doing calculations that assume the company will become the next Google or Apple are likely to be unrealistic. Calculate for a reasonable amount of success based on the current traction and valuation of the company. You should also realize that the total number of shares is likely to increase over time (known as dilution), thus reducing the percentage of the company that you have rights to. For example, it’s not uncommon for every round of funding to increase the total number of outstanding shares by at least 10%.

Summary:

Understand the percentage of the company that you’ll own and use a realistic valuation. Keep in mind that it is impossible to predict the impact of dilution on the value of your shares. There is nothing to prevent a board from increasing the total number of shares by a large amount, thus reducing the value of each of your shares.

2. Not Demanding “Early Exercise” Rights

Stock options don’t become shares until you “exercise” them, “exercising” is the process by which you purchase the shares that the stock options represent from the company. The most common time to exercise stock options is after you’ve “vested” (as discussed earlier in this article). Companies can grant the right to “early exercise” stock options, this is the ability to buy the shares before you have vested. It means you pay money to the company upfront and the tax benefits of doing so can be significant, such as turning any gains into those taxed at long-term capital gain rates (assuming the company does well).

Let’s walk through a hypothetical situation:

A person joins a startup and is given 1,000 stock options (strike price per share is $0.50). Total cost of exercising these shares is $500 (1,000 * $0.50).

The person decides not to “early exercise” even though they were given the opportunity to do so.

Four years later the person is still employed by the company and the price per share has increased to $10 (a gain of $9.50 per share).

The person decides to leave the company while the company is still private. They will normally have 90 days after departure to exercise their stock options (if they don’t the stock options expire and the shares go back to the company).

The person decides to exercise their stock options and writes a check for $500 to the company. The catch here is that if the Fair Market Value (normally set by the board) is now $10 per share it’s possible the person will be taxed on the “unrealized gain” of $9.50 per share. This is related to Alternative Minimum Tax and is a topic to cover with an accountant. In short, the person is deciding to buy shares at a price that is lower than the fair market value and the tax man basically wants a cut of that gain. Even though the shares haven’t been sold at a profit yet, the person may be on the hook for a significant tax bill. If the person had taken the opportunity to early exercise when they joined the company they would not be taxed until they actually sold the shares at a profit (assuming the strike price and fair market value price were the same when they wrote the check).

Summary:

If you’re joining a startup and the price of exercising your stock options (or a portion of them) is an amount you can manage you should probably fight for the right to “early exercise”. Once you have that right it’s a personal decision as to whether you want to take the risk inherent with buying stock in a company.

3. Not Understanding The Tax Consequences

Taxes relating to stock options can be very complicated and it merits research if or when you’re in the position to exercise or sell shares. Many people were hurt during the dot-com bust by not understanding the tax consequences of their stock option actions. For example, an early employee at a high profile company at the time had a very low strike price. During the early part of 2000 they decided to exercise their options (when the shares were valued at a much higher price). Exercising their options put them on the hook for an unrealized gain and the total tax bill was likely to be ~$200,000. The employee decided not to sell enough stock to cover that tax bill immediately, thinking that the stock would continue to rise before the tax bill was due. Unfortunately the company’s stock tanked and bankruptcy was filed. The employee was left having to deal with a massive tax bill relating to stock that was now worthless.

Summary:

If you’re at a company that is seeing success make sure you understand the tax consequences before exercising stock options. If you’re going to expose yourself to a large tax bill make sure you have the cash to cover the bill. In the interest of diversification it’s probably best not to use your savings to cover the bill but to instead use money from the proceeds of selling some of the related stock.

4. Mishandling Stock Options When You Leave A Company

When you leave a company you normally get 90 days to exercise any vested stock options that you have yet to exercise. Ultimately this decision comes down to whether you believe the shares you’re buying will be worth more than the strike price of your stock options. If you do decide to exercise the stock options make sure you understand the tax consequences. If you’re confident the shares will be worth more than the strike price and the company is private you may want to explore selling some shares on the secondary market a topic that will be covered in the next point.

Summary:

Know how long you have to exercise any vested unexercised options when you leave a company. If you’re confident the shares will be worth more than the strike price talk to a financial advisor or accountant to figure out the best way to handle any tax liability.

5. Misunderstanding Your Liquidity Options

Liquidity in startups is a complicated topic and an area that is constantly changing. If you’re lucky enough to join a successful startup you’ll eventually want to be able to sell some of your shares (after all diversification is an important aspect of any investment portfolio). Traditionally, liquidity becomes available in startups when the company is acquired or IPO‘s. Selling shares in private companies is more involved but you can find firms or individuals that are willing to buy your shares. Since the company is private those investors will have to purchase the shares without knowing all the financials of the company (be very careful not to disclose any confidential information when having discussions with potential buyers). The buyers will more than likely need to be accredited investors (basically wealthy enough in the eyes of the IRS to be capable of making high risk investment decisions). Having to deal with liquidity issues is a high class problem since it likely means you’ve got shares in a successful company so spend the time to figure out the liquidity opportunities available to you.

Summary:

Once you’ve vested and exercised your options you’ll own shares in a company. At that point they are your shares to sell if you wish.

Selling shares in a private company is more involved and will require investigation into the secondary market. Some services such as secondmarket and sharespost facilitate the sale of stock in certain private companies but you can also approach firms and individuals that might be interested in buying directly.

I’m sure there are other lessons to be learned about stock options so feel free to comment with additional recommendations. I hope this post has been helpful and feel free to contact me with any questions or comments.