Startup Stock Options 101: Part 1 - Must Know Terminology
Let’s face it: trying to understand stock options for the first time is confusing. And the thing is, everyone seems to talk about them as if they are experts. Or at least they appear to know what they are talking about. Over the years I have gotten a lot of questions about stock options. And I have seen that there is a lot of confusion and many misconceptions. The first problem is understanding the terminology. Once you understand the vocabulary, you can start to understand how they work, what they are really worth and how startup founders can create a plan for them.
Let’s start with some vocabulary now. Then, in Part 2 we can talk about how stock options work. Here I am giving you my personal definitions of the must know terms when it comes to startup stock options. I tried to explain it in plain English so that it is easy to understand.
Stock Options - Equity shares in a company that give the holder an ownership right to the company. Stock options are “options:” because the holder has the option to buy the stock at the strike price at which it was granted.
Equity - Equity means having an ownership stake in the company. Equity ownership can come via an investment in money (from investors) or money and time (employees and advisors). The other type of ownership can come via debt, which means that the bank or whoever lent you money essentially has a right to a portion of your company if you do not pay them back or break the loan terms. Debt is actually much more complicated, so let’s not get into it here.
Strike Price - The strike price is the current fair market value of the stock option at the time of grant. The strike price will be indicated on the option grant and is the price that the option holder can purchase the options. The strike price can increase or decrease at any time due to a financial event, for example a round of fundraising, or greater macroeconomic events, for example a market crash, and will be evaluated and assigned by a third party valuation firm. The strike price on a grant will never change.
Capital Gains (or Losses) - Categorizing capital gains is directly related to tax issues for the option holder, which I don’t want to get into here because it is complicated and based on the individual’s particular circumstances. To make this as simple as possible: capital gains or losses are the difference between the strike price paid for the stock options and the current fair market value. For example, a grant from last year indicates a strike price is $0.25 and the current fair market value is $0.50, the gain is $0.25 per share.
Capital gains and losses are determined once options have been exercised (purchased).
Option Exercise - Exercising options simply means purchasing options and becoming the stock holder.
Stock Option Plan - All Corporations will have a stock option plan created by their lawyers. This document will outline all of the details of how the options work: eligibility, terms and conditions of the options and sales, payment and other information. This plan will be provided to all stock option holders.
Fair Market Value - The fair market value of common stock is the current strike price at which options are granted. The difference between the fair market value and the strike price is that the strike price was the fair market value at the point in time in which the stock options were granted and the fair market value is the value of the stock options today.
For example, a company raises money from investors and the fair market value of the stock options increased. Or competitive companies have recently been acquired at much less than their previous valuations, the fair market value of the stock option may decrease. The current fair market value is assessed by a third party valuation firm.
Stock Option Grants - Stock options must be granted by the board. This means that the board will review the proposed stock option grants and approve or deny the grant. The board will want to know: who the grant is for, their relationship to or role in the company, the number of shares and the current ownership percentage. The person who was granted the options must sign the option grant in order to officially have the ownership right to those options.
Common Stock - Common stock is basic ownership in a company and is typically reserved for employees and advisors although investors may also get common stock.
Preferred Stock - Preferred stock typically has a higher value than common stock and also comes with additional rights. For example, preferred stock holders are typically paid first in the event of a liquidation (sale of the company or stocks).
Vesting - Startup stock options vest over time. This means that if you grant 100 options and it takes four years to vest, after the first year the holder will have vested 25 options. Often times, there will be a “cliff” with vesting. Vesting may also have an acceleration, which means if event A occurs, then vesting acceleration is triggered and the total time to vest decreases. Exact details regarding vesting will be outlined in the stock option plan as well as on the grant itself.
Although the option holder does not own all of the shares immediately, some companies may allow early exercising of the grants. This may have tax implications and the exerciser must file the form 83(b) and the company must report this early exercise to the IRS with the current fair market value.
Vesting Cliff - The vesting cliff means that until a certain amount of time has passed, no options will vest. If the employee leaves before this initial period, they will forfeit all of the options granted. For example, stock options granted to an employee with a one year cliff means that this employee must stay with the company for one year in order to have the right to any of those options.
The cliff is used to reduce the risk of granting options to employees or advisors who do not put in enough work and time in to add value.
Option Expiration and Termination - Stock options will expire after a certain date, which is indicated on the grant if not purchased. Usually the expiration is about 10 years. Additionally, the option to purchase stock options usually terminate depending on the stock option plan details.
For example, a terminated employee (someone who leaves your company voluntarily or involuntarily) with unpurchased stock options has the right to purchase their vested options until 45 days after termination. Any options that expire or terminate and have not been purchased before that date will be thrown back into the option pool.
Incentivized stock options (ISO) - The stock option paperwork will indicate whether the grant is ISO or NSO. The only thing that matters here is the tax treatment of the options for the option holder. Although this can get complicated, essentially it has to do with the income being taxed as regular income or capital gains. Usually full time employees are granted ISOs. Since personal taxes are complex each individual case will need to be reviewed by that person’s tax advisor to determine the tax treatment.
Nonqualified Stock Options (NSO) - The stock option paperwork will indicate whether it is ISO or NSO. The only thing that matters here is the tax treatment of the options. Although this can get complicated, essentially it has to do with the income being taxed as regular income or capital gains. NSOs are not eligible for special tax treatment.
Capitalization table (Cap table) - The cap table is a breakdown of every option holder, amounts of stock options received, strike price and dates granted. It will include information regarding the total number of outstanding options and fully diluted percentage ownership. The cap table will be managed by lawyers and / or option management software, like eShares.
Employee Option Pool - Although it is not required that startups grant options to employees, most do. In doing so, the founders will put aside a certain amount of options, let’s say 10% of the company, to grant to employees. As the company grows in terms of employees, the employee option pool may be refreshed depending on the projected hiring plans.
409A Valuation - All private Corporations must have their business valued at least once per year or after every raise, whichever happens first. The 409A valuation is performed by a third party firm and evaluates the entire business: the business plan, financials, sales and other key performance metrics. If the valuation comes after a raise, the term sheet and other closing documents will also be evaluated. The result of the valuation is a report with a fair market value which is assigned to the common stock. The report consists of the firm’s valuation research and details about how they arrived to the fair market value.
Board Approval - All Corporations must have a board. The board of a private company, which is typically chosen by the founders, must approve all stock option grants. Boards in startup companies are made up of investors, each major investor usually has one seat.
Dilution - Dilution happens when the total number of outstanding options increases. The result is that each stock option will be worth less in terms of percentage.
Think of equity as a pizza pie. The size of the pizza never changes, but the size of the slices of pizza that each person (option holder) gets will vary. The value of the pizza should increase over time. The more options that are given out, the smaller the slices of pizza. Refreshing the employee option pool and adding new investors will typically lead to dilution.
You will hear people talk about not wanting to get diluted, but it is not always a bad thing. For example, you own 10 options, and the total number of outstanding options is 100, you own 10% of the company. If the company increases the total number of outstanding options to 200, you now own 5% of the company.
If the company is doing well, the valuation has increased, which means it is not bad. Let’s say that you have 10 options, the total outstanding options increased from 100 to 200, and the valuation increases from $5 million to $25 million. Now instead of owning 10% of $5 million, which is $500 thousand, you own 5% of $25 million, which is $1.25 million. Not too bad. Check out Part 2 to learn about how options work, when they can be granted, the value of options and stock option planning.