Whether you are evaluating your equity package before joining a start-up or you are thinking about exercising your vested stock options, it is good to have the right tools and information at your disposal so you can make the best decision.
Each stage of your employment life cycle at a private company will present its own line of questions and challenges for evaluating the value of your stock options.
We have broken this journey into three segments: when you receive your offer to join a company, when you reach your vesting cliff, and when you leave. It is important to ask the right questions at each stage to understand the level of risk you must assume in order to receive the possible benefits from your stock options.
We will use the following example throughout this three-part series:
You join a software company and receive 100,000 incentive stock options (ISOs) at a $1.00 strike price. The 409A valuation (or the Future Market Value, also known as the FMV) of the stock is $1.00. The most recent round of funding values the company at $250 million. You ask the necessary questions and understand this is a good offer.
Fast forward two years: the company raises its Series D valuing the company at $750 million. You receive a promotion and 50,000 additional ISOs at the new $3.00 strike price, and your original grant is already half vested (and has dramatically increased in value).
One year of vesting later you decide it is time to leave the company.
Part One: Evaluating your options package when you receive an offer to join a new company
Part one of this series will help you evaluate your options package. At this stage, it is critical to ask the correct questions to fully understand your options package and your true future earnings potential. Taking the time to learn now can help you develop a plan for your eventual exercise and, more importantly, give you time to understand and manage the risk.
Starting with the basics of your options package, you should understand what type of stock option you are being offered. There are two types of options: incentive stock options (ISOs) and non-qualified stock options (NQSOs or NSOs). Most typically, ISOs are awarded to employees and NSOs to advisors or contractors, but this is not always the case. The main difference between ISOs and NSOs lies with the IRS: they differ in their respective tax treatment at the time of your future exercise.
Because ISOs are statutory stock options, any taxable spread or gain at the time of your exercise will not be included in your gross income (“taxable spread” or “gain” meaning the difference between your original stock option strike price and the FMV of these stocks at the time they are exercised). It is worth noting, however, that if your gain is large enough you may trigger the alternative minimum tax (AMT) – more on that another time.
NSOs, on the other hand, are non-statutory, meaning any taxable spread will be included in your gross income and taxed at the time of your exercise. At this stage, it is important to simply recognize that there is a difference in the way you will be taxed once you exercise your options in the future.
In our example, you are granted 100,000 ISOs at a $1.00 strike price, great! So you now know there is some potential future tax benefit due to the options being ISOs, but how exactly do you make sense of the offer? If you are new to stock options, there are a handful of critical questions you should be asking and concepts you should be aware of before accepting the offer.
1. What is the company’s fully diluted share count?
This is the number one question to ask the company.
Why? It puts the numbers listed in your offer into perspective. The fully diluted share count is the sum of the convertible preferred shares, common shares, options, and warrants. In other words, if the company were to go public tomorrow, this is the absolute maximum number of common shares that can become outstanding. For example, if you find out the company has 100 million fully diluted shares, you then know:
1) Your fully vested ownership is 0.10% (100,000 ISOs /100,000,000 fully diluted shares).
2) Excluding taxes, your investment break-even valuation is $100 million ($1.00 strike price x 100,000,000 fully diluted shares). In other words, the company will have to sell and distribute $100 million to the common shareholders for you to break-even.
Tip: if the company will not disclose the fully diluted share count, asking instead for your fully vested ownership on a fully diluted basis will suffice.
2. What is my vesting schedule?
The company will include a vesting schedule in your option grant to incentivize your continued employment and to protect it from dilution if you were to leave prior to your vesting period. Most commonly companies offer a four-year vesting schedule with a one-year cliff with regular monthly vesting over the remaining three years.
Since vesting is typically linear, what this schedule means is that you will receive 25% immediately following the cliff (after year one) and roughly 2.8% every month thereafter, representing 25% total in each of the four years. To illustrate, the 100,000 ISOs in our example will have the following vesting schedule:
While the one-year cliff with monthly vesting thereafter is the most common four-year vesting schedule, there are other schedules: you also may be offered quarterly or annual vesting.
To illustrate the difference, assuming you are in month 20 of your employment, under the traditional vesting schedule you will have 39,583 vested options that are currently exercisable. These are yours for the taking.
In contrast, under the annual vesting schedule, you will have 25,000 vested options currently exercisable with 25,000 additional options vesting once you reach month 25.
At this stage (pre-employment), it is worthwhile to note which schedule your options would vest on. Later in your employment though, since it will cost you money to exercise your vested options, understanding exactly when your batches of options will vest is very useful for planning your personal cash flow.
3. What is the company’s post-termination exercise policy?
Driven by IRS tax policy, many companies have adopted and, to an extent, standardized the 90-day post-departure exercise window for their employees.
This means there’s a good chance that you will be subject to this short window too.
Why does this matter? For many people at high growth companies, it can be prohibitively expensive to exercise their stock options and cover the associated tax bill.
Take our example: once fully vested, excluding taxes, it will cost you $100,000 to exercise the options you’ve earned. This amount is clearly substantial.
Failure to plan for this event and/or not fully understanding the time constraints you are working with can leave you with a limited amount of choices when the time comes. If placed in this situation, you might be required to choose between risking a significant amount of your personal wealth to invest in the company or potentially missing out on life-changing wealth by forfeiting your vested options.
So, similar to your vesting schedule, it is important to take note now to understand the company’s post-termination exercise policy to help you better manage your exercise planning.
4. Am I eligible for early exercise?
While many companies do not offer early exercise, if your company does, (and it's executed correctly), it can result in enormous tax savings.
An early exercisable stock option is just like a normal stock option, with the key difference being the ability to exercise before any options have vested. You can exercise up to all four years of your unexercised options now and receive common shares in the company as your options vest.
While the initial cash outlay can represent a massive risk, the potential tax savings might make the juice worth the squeeze. It’s important to note that with an early exercise, it is imperative you submit an 83(b) election form to the IRS. This form indicates your intent to exercise your unvested options now and be taxed accordingly. The best part? By exercising when your strike price is equal to the 409a (Fair Market Value) price, your taxable gain will be $0.00. Each time your options vest over the subsequent four years, you will not be required to pay taxes on the gain (because technically, you already did). While this sounds great, it is important to keep in mind the amount of risk you will assume to receive the potential benefit.
In our example, if you were to exercise all 100,000 ISOs now, you will have to pay the company $100,000. Yes, exercise taxes will be $0.00 but it is very possible the company does not perform as expected and you lose your investment. Also, keep in mind that if you go this route and leave before your options have vested, the company will simply repurchase all unvested options at your strike price. So, if you make it to month 11 and decide to leave before your one-year cliff, the company will reimburse you the $100,000 you had previously invested, and you will be left with 0 shares in the company. Before you commit to an early exercise, it is good to critically evaluate the company and your desire to remain at the company for an extended period of time.
Now that you have a better understanding of the option package you’ve been offered, it is useful to ask the company specific questions to better predict the future value of your options. Seeing this opportunity through an investor lens can be quite beneficial.
We all like to dream about the multi-billion-dollar unicorn company that could be but it’s important to keep grounded through this process. Evaluating the downside scenario and your risk exposure could be the difference between making some money and losing a lot of money.
Investors thoroughly evaluate the risk of each investment they make, and as a potential investor in this company, you should too.
5. What is the minimum price the company has to sell for in order for my investment to break-even?
Since this is a loaded question (and depends on a handful of complex deal terms issued by the eventual preferred investors in the company), you might not receive an exact number, but worst case the company should provide you with a fairly accurate estimate.
You already know that your personal break-even is when the company sells and distributes $100 million to common shareholders. This is a start. However, given preferred shareholder benefits the investors would hold (such as liquidation preferences, cumulating dividends, anti-dilution rights, etc.), the actual company sale might have to be significantly higher than $100 million for $100 million to be distributed amongst common shareholders.
For example, there might be a $200 million liquidation preference which would mean that the company would have to sell for $300 million for you to break-even.
Once you receive this number, be sure to critically evaluate the company’s ability to achieve this outcome. What revenue, growth rate, profitability, etc. will the company need to reach to sell for this price? Is the likely buyer a strategic company or a private equity fund?
Of course, there are many factors to consider, but at a minimum, you should be reasonably comfortable with company’s ability to potentially reach this sale price.
6. What is my vesting acceleration in the event of an acquisition?
Knowing if your options will vest on an accelerated basis in an acquisition is critical - it could be the difference between making lots of money and making no money at all.
There are two common types of accelerated vesting to keep in mind: single trigger and double trigger.
Single trigger acceleration allows you to exercise some or all of your unvested options on an accelerated basis if a single event – like a change of control or acquisition – is triggered.
On the other hand, two such events will have to be satisfied for your vesting acceleration to occur in double trigger acceleration. Typically, there will be, 1) a change in control or acquisition and 2) termination without cause or termination with good reason, for your vesting acceleration to occur if you have a double trigger clause.
Why is this important to understand? Vesting acceleration is not the norm and will likely have to be a negotiating point on your end. It’s important to realize that if you do not have a vesting acceleration clause, you could run into a situation where your company is acquired, and you are terminated without the ability to exercise at all.
To illustrate this with an example, imagine that you are in month 10 of your employment and the company is acquired. At this point, if you are terminated or made redundant prior to your vesting cliff, you may end up with no equity if you do not have a vesting acceleration clause in your contract.
This is a risk that you can potentially mitigate at the onset.
7. What are my shares worth at a $300 million exit? $500 million exit? $1 billion exit?
After considering your downside risk, it is time to dream big and consider your upside.
If the company were to sell or go public, what are your shares worth at various valuations? We will start with an IPO since all shares will convert to common and investor preferences become less relevant. To review, we have the following:
- 100,000 ISOs with a strike price of $1.00
- The current valuation of the company is $250,000,000
- The FMV of the stock is $2.50
- The fully diluted share count is 100,000,000
When a company issues more shares or their employees exercise their options and warrants, the company's fully diluted share-count increases.
Let's assume 10% dilution from the IPO and option and warrant exercises.
1) At a $300 million exit, our returns look like the following:
2) At a $500 million exit, our returns look like the following:
3) At a $1 billion exit, our returns look like the following:
Clearly, exit valuation is the largest factor in whether we profit from our options. Dream big, but remember, it's estimated 90% of startups fail, so the "worthless" column is not something that should be ignored.
When you partner with ECP, we're able to take on the entirety of your risk and eliminate that scary left-most column. It’s a win-win situation that’s worth exploring further if you have questions.
We also realize that we threw a lot of terms at you in this article, so if you want to discuss your situation in particular, give us a call.
Either way, check back in for part 2 on this series soon!