You've received a new job offer at a pre-IPO company, and you’re likely jumping for joy (at least, we hope you are). But the offer includes equity compensation in the form of stock options — and you’re not quite sure how to value it.
Remember, this is really exciting! Stock options are a significant driver of personal wealth among startup employees, with countless stories of people who got in on the ground floor, exercised their stock options at the right time, and cashed out after a big IPO or acquisition.
There’s no universally accepted way that equity compensation is explained in offer letters, which can make it tough to evaluate, especially against competing offers. And it’s common for candidates, and employees, to have many questions about their stock options — even after they’ve accepted an offer.
This article is designed to answer common questions people have about stock options before (and after) accepting a new job.
In this article, we’ll cover:
- Why stock options are important
- What are employee stock options, and how do they work?
- Understanding stock options in an offer letter, and potentially negotiate for more equity
- Building a plan for your stock options
Why stock options are important
The ownership of virtually every pre-IPO startup is split up into millions of shares. Founders sell shares to investors in return for working capital, and offer shares to employees as part of their compensation packages.
Investors buy shares at a negotiated price and hold onto those shares in hopes that the company will eventually go public, or get acquired at a higher price than they paid.
For example, in 1998, Google was a tiny startup being run out of a garage in Silicon Valley. That year, an angel investor purchased 3.3 million shares of Google stock for $250,000 — roughly 7 cents per share.
Google used that money to fund its operations, and by the time it went public in 2004, those 3.3 million shares were worth an estimated $280 million.
Meanwhile, hundreds of early Google employees were granted stock options in the company, giving them the ability to purchase pre-IPO shares for, in many cases, less than 25 cents per share. When the company went public, many of those early Googlers became multi-millionaires overnight.
Fast-forward to today. Investors are on the hunt for the next Google, and so are job-seekers.
If you’re actively interviewing at multiple startups, it’s important to look for signals that suggest a company is growing, managed well, and that you’re compatible with its corporate culture. Understanding these signals is crucial to valuing the startup’s stock options.
First, look at the startup’s founders and its management team. Have the founders built a successful company before, or is this their first? If this is their first company, what other relevant experience do they have? Have they hired an executive management team that has experience in the startup’s space? Have the founders or management team worked together previously?
Next, look at the company’s employee base — use LinkedIn to estimate how many people work there. Take a look at your future team: Have they worked at successful startups or well-known companies? Use anonymous review sites like Glassdoor and Blind to learn more about the startup’s culture.
Consider the startup’s funding and its investors. Sites like Crunchbase and Pitchbook can tell you how much money the startup has raised to date, and from which investors. Look at the track record of the startup’s lead investors; one of the greatest predictors of startup success is its investors. Occasionally, startups will say what their most recent valuation is.
Finally, look at the startup’s product or service — is it unique? Have they succeeded in selling it to other companies (in the case of a B2B startup) or to lots of people (in the case of a B2C startup)? Who are their competitors, and how do they compare? Do you find this startup’s space interesting?
Together, these signals are crucial when deciding which startups to interview with, and which startup to choose if you receive multiple job offers.
What are employee stock options, and how do they work?
There are three major types of employee stock options — incentive stock options (ISOs), non-qualified stock options (NSOs) and restricted stock units (RSUs). Check your offer letter to see which type of stock options you’re earning. ISOs and NSOs are more popular with early-stage startups, while RSUs are more popular with late-stage startups and publicly traded companies.
The big difference between ISOs, NSOs and RSUs is around how you acquire them, and how they’re taxed — you purchase ISOs and NSOs, and you earn RSUs outright. All three types of stock options are taxed upon exercise, and taxed again when you sell them.
When you’re granted stock options, you’re given a vesting schedule, which typically shows you how long you need to remain employed to unlock your stock options. With ISOs and NSOs, you’re unlocking the ability — or option — to purchase shares at a specific price (also known as a strike price), while with RSUs, you’re unlocking the shares themselves, which are given to you outright and taxed as if they were a cash bonus.
With ISOs and NSOs, you purchase shares through a process called “exercising.” When exercising shares, you buy shares from your company, and then pay any associated taxes to state and federal tax authorities.
With ISOs and NSOs, your strike price is set when you’re given a stock option grant, and doesn’t change for the life of that grant. However, the total cost to exercise your ISOs or NSOs can rise over time due to taxes. Waiting to exercise your stock options usually results in a higher tax bill in the future.
If you leave your startup, you’ll have a limited amount of time to exercise your stock options, or risk losing them forever. The standard post-termination window to exercise your stock options before forfeiting them is 90 days. However, there are more companies offering and championing for longer windows, up to 10 years.
Once you exercise your stock options, you own shares in the company, and can decide how and when to sell them in the future. The most common way employees cash in their stock is during an exit event — when the startup goes public, or gets acquired.
But, it is becoming more common to find other ways to get liquidity, or cash, for shares before an exit event. The typical ways to do this are to sell them to investors in company-organized tender offers, on secondary marketplaces, or through liquidity financing options.
Understanding stock options in an offer letter
Now that we’ve given you a crash course in employee stock options, you should be able to better decipher the equity portion of your offer letter. Don’t be afraid to ask your recruiter or hiring manager for more information — most offer letters we see today are still missing key information around employee stock options.
For example, here’s the stock option section of a real offer letter we recently reviewed:
“Stock Option. Subject to the approval of the Company’s Board of Directors, you will be granted an option to purchase 15,500 shares of the Company’s Common Stock (the “Option”). The exercise price per share of the Option will be determined by the Board of Directors when the Option is granted. The Option will be subject to the terms and conditions applicable to options granted under the Company’s Stock Plan (the “Plan”), as described in the Plan and the applicable Stock Option Agreement. Subject to the terms of the Plan and Stock Option Agreement, the Option will vest over 4 years; 25% of the total grant will vest after 12 months of continuous service, and the balance will vest in equal monthly installments over the next 36 months of continuous service.”
This offer letter tells the employee how many shares they’re earning, but it doesn’t tell the employee what the strike price is. If the shares are being offered at a strike price of 10 cents per share, they’re earning an estimated $1,550 in equity over the next four years. If they’re being offered at a strike price of $20 per share, the shares are worth an estimated $310,000.
There is no widely accepted template for offer letters. In some cases, we’ve seen offer letters where employee equity is instead listed as a total dollar amount, rather than as a total number of shares.
If you are evaluating multiple offers, keep in mind that two different companies might offer two different types of stock options — RSUs vs. ISOs, for example.
Make sure you’re comparing apples to apples: $10,000 worth of equity at Startup A might seem like it’s worth more than 500 shares at Startup B, but it’s impossible to measure relative value without knowing the strike price on Startup B’s stock options. In this example, you’ll need to gather more information to make an informed decision.
Before signing your offer letter, make sure you understand:
- What type of stock options am I earning?
- How many shares am I earning, and what is my vesting schedule?
- What is the company’s current strike price?
- What is the company’s post-termination stock option exercise window?
Can you negotiate for more employee equity?
Employee equity is similar to employee salaries — if you’re unhappy with how many shares you’re being offered, the best time to negotiate for more equity is during the job offer stage.
Some employers are open to offering people more equity in return for a lower base salary. Sometimes, simply asking for more equity during negotiations is enough to get more.
Building a plan for your stock options
Once you start at your new job (congratulations by the way!) you should build a plan for how, when, and if you’re going to exercise your employee stock options.
Start by understanding your vesting schedule, and figuring out when you can begin to exercise your stock options.
Next, calculate how much it will cost to exercise your stock options now, versus waiting to exercise at some point in the future. You might be surprised to find that the taxes you owe on your stock options make them virtually impossible to buy in full.
For example, in 2021, the average Secfi customer needed $543,000 to exercise their stock options — with the majority of that money going to taxes.
There are ways to minimize your stock option-related taxes, depending on the type of stock options you’re earning and when you decide to exercise them.
Finally, make a plan for how you’d like to pay for your stock options. That could mean setting aside money each month, taking out a loan, applying for stock option exercise financing, selling a portion of your stock options in a tender offer or secondary marketplace, or some combination of the above.
If you’d like help calculating how much it will cost to exercise your stock options, try Secfi’s free Stock Option Tax Calculator.
We want to wish you the best of luck on your job search, and if you’ve already started, we want to wish you the best in your new role.
We hope this article helped you understand how stock options work, and why it’s important to build a plan for them. If you’d like to delve deeper into any of the subjects we touched on above, we’ve built in-depth articles on every aspect of employee stock options at Secfi Learn.