Understanding your stock options is not optional
You’ve landed that dream job and you’re excited to get started. The company is even throwing in some stock options! Since you will be an instrumental part of the company, you might think that the company is poised to take off and those options are going to be super valuable. “Sweet,” you say to yourself. “Where do I sign?”
Well, not to rain on your employment parade, but you might want to take a moment to review the structure of those options, and to understand what exercising an option really means.
What stock options are … not
Options are not equity (=ownership) in the company; they are only the right to buy equity at a set price, under some conditions, at some point in the future. Depending on how the options are structured, you may never even get to see the day when you can exercise them.
Companies play it close to their vest[ing]
Companies often use stock option “vesting” periods to promote retention by gradually doling out the right to acquire equity, rather than granting it all outright at the beginning, when the employee has not yet done anything of value for the company. The initial vesting period is often longer than the subsequent intervals, and is thus called a “cliff,” meaning, you can’t exercise any options until you provide a certain amount of service time – often as long as a year. We have already gone into detail about the pitfalls (pun intended) of cliffs, so I’ll just say here that long cliffs are pretty disadvantageous for the employee. Yes, we’ve seen individuals terminated without cause on more than one occasion, just short of their one-year cliff, precluding the employee from acquiring any equity at the time of separation. How much were those options worth to that individual in the end?
Beyond the cliff, your options will probably vest in small increments over a typical vesting period of about four years. The median employee tenure with a company is 4.6 years, and only 3.0 years for younger employees, so long vesting periods could certainly impact you. If you end up leaving the company before your options are fully vested, you will lose the right to exercise the unvested portion entirely. If you have a long vesting period, you might be leaving a lot of options on the table if you choose to leave the company (or worse, if the decision to leave the company is made for you).
No free exercise
If you think that gym memberships are expensive to exercise your triceps, you should calculate how much it will cost you exercise your stock options. Remember when I said that options are not equity, but only the right to buy equity at some point in the future? The word “buy” is operative here – you have to front the money to purchase those super awesome options. This is called the “exercise price.” If the company’s valuation was not nominal when you started or if you want to exercise to purchase a significant quantity of shares, the cost to you will probably not be nominal either. Moreover, if the company has appreciated in value significantly since you were awarded your options (which is of course what you hope for), you would now have a hefty tax bill to pay upon exercise as well (which is a topic for another post). Given the exercise price and taxes that may be due, exercising your options can be a significant out-of-pocket cost, which is out of reach for many people, unless you are able to structure your options in a more advantageous manner before accepting your employment offer.
Blowing this popsicle stand
If you leave a company, not only will you lose your unvested stock options, but you will also typically have a limited period of time to exercise the options that you earned and vested into. Sometimes that time period can be as short as 30 days and is rarely more than 90 (though a good lawyer can help you try to negotiate around this). In other words, your option is about to expire and you are forced to put up or shut up, i.e., risk real money to purchase shares at the exercise price, shares whose value might not be substantially higher than when you started (unless the company has exploded in value, Facebook-style — and even then your gain is only on paper). If you expect the shares to be worth a lot in the future (which is never assured), you’d have to hold on to your shares in order to realize their value.
Hit the accelerator
Options are usually at their most valuable in some sort of exit event, like the sale of the company. The question then becomes – what happens to your options (and any unvested options) when that happens? Depending on how the option plan is set up, the company could do any number of things with your options. You might want to make sure that some of your unvested options accelerate (become exercisable immediately) if a sale occurs, because the sale of the company may introduce a lot of uncertainty for you. Your position may even be eliminated. If your unvested options don’t accelerate, you might lose them entirely.
I hope it is clear by now that options, while potentially awesome, are not as straightforwardly awesome as they might at first appear. If you are foregoing a significant amount of salary in exchange for stock options, or if the stock options are a big factor in your decision to take or pass on a position, you’ll really want to think about — and get some good advice about — issues like the ones noted above. Depending on the company’s structure and your circumstances, there may be ways to receive equity that are both far less risky and more tax-favorable for you.