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The ABCs of Stock Options at Early Stage Companies

It’s not uncommon for early stage tech companies to pony up stock options to lure key employees on board. For a new business without a lot of cash available, it makes sense to offer options in lieu of hefty paychecks. From the company’s vantage point, employee options encourage people to work hard and feel like they’re “a part” of the business.

But for employees, the considerations are much different. Given the demand for talented development people, the lure of stock options isn’t what it used to be. For one thing, not every company’s going to become a Microsoft or an Instagram. Most startups pitter along or simply fail, making options worth little to nothing in the end. The bottom line is that options shouldn’t be the only factor to consider when you’re deciding whether it’s time to leave your day job.

Understand It

Often, people don’t understand what an option actually is. First off, they’re not shares. They give you the option to buy shares at some designated point in the future. They’re priced at the company’s fair market value at the time they’re granted. That’s called the strike price. When you exercise the options, they could be worth much more — or much less — than that price. That’s where the risk comes in. Of course, options can offer a much greater upside potential if the company really takes off.

The company’s assuming you’ll sit on the options as long as possible in the hopes you’ll get more than the strike price. However, there’s a window during which you have to exercise them, and if you leave the company, you’ll often have to exercise them or forfeit them. Says Tony Wright, founder and former CEO of analytics firm RescueTime, “This could mean writing a $20,000 check around the time of your departure — a time when you might be least confident in the success of the company.”

It’s a Gamble

Since so many tech firms fail, making a mint on options is a crapshoot. “It’s a gamble, so people need to make a decision that’s right for them,” says Doug Bend, principal of Bend Law Group, a San Francisco law firm that focuses on small businesses and startups. “You’re making a trade-off — a lower salary for equity.”

Depending on your stage of life, much of the decision may be made for you, he notes. Younger professionals might be willing to take the risk, while someone married with kids and a mortgage may not.

What’s the Standard?

Most non-executive employees will get 0.1 to 1 percent of a company’s options, says Wright. Your exact proportion can vary wildly based on your value, the stage of the company and its funding situation. A four-year vesting is standard for tech startups with a one-year cliff. In other words, if you leave the company inside one year, you’ll leave with nothing. If you leave at the two year mark, you may get access to half your options. Another important clause to understand is the “acceleration” clause, or what happens to your agreement if the company gets bought before you’re fully vested.

The Tech Firm Advantage

Options only have a real value when there is liquidity. Says Wright, “For the most part, there are no buyers for stocks that aren’t publicly traded. Tech startups, when they take on investors and give options to employees, are making the implicit promise that someday they will either sell to a big company or will [go public].” The good news: Such “liquidity events” are much more common in the tech world than they are in many other industries, so there is a bigger upside for employees there. But make sure to check out the details of the options contract to find out the specifics of what happens when there’s a buyout.

Another thing to consider is how much a startup can teach you, contends Wright. “You should accept the comparatively lower pay at a startup because it’s an awesome learning experience and some of the most satisfying work you can do, not because the options will make you rich,” he says. Plus, he notes, getting filthy rich from options is rare, and they usually come with a load of situations and stipulations that change their value.

Wright says you’ll need to know what percentage of the company you’ll own after a typical four-year vesting period. “Ten thousand options is a lot more appealing if there are 1 million outstanding shares than 10 million shares,” he explains.

Restricted Stock vs. Options

So, what’s a safer deal than options? A growing number of tech companies are using restricted stock in order to get the best and brightest, says Bend. You buy the restricted stock when you join the company, and it vests over time. Unlike options, there’s no expiration date.

That all makes restricted stock a better lure, since it often comes without a purchase price, or a very low one. Its fair market value is usually the par value of the shares at the time they’re awarded. As with options, there’s a vesting period. Once they’ve vested, you can sell your shares for their market value, which, of course, is hopefully higher than when they were awarded. Again, though, these shares are most valuable if the company’s gone public or has had some other kind of liquidity event.

Of course, options can offer a much greater upside potential if the company really takes off. But if it doesn’t, restricted stock will hold some value, even if it fluctuates — unless of course the firm goes belly up.

Image: Ismagilov/Shutterstock.com

About Myra Thomas

Myra Thomas is an award-winning business reporter. She started her career in finance, eventually becoming AVP for a Lloyd’s of London intermediary. She applies her extensive business knowledge to the world of reporting. Her stories run the gamut of topics, including tech, banking, healthcare, personal finance, and small business. She has a BA from Vassar College and an MFA from Fairleigh Dickinson University. Myra lives in Fanwood, New Jersey with her husband, two daughters, and two fierce Cairn Terriers.