Let’s start with the first principles: stock is fractional ownership in a company. That means, as a shareholder, you have a proportional claim to the profits that company generates. This is why stock prices are driven by earnings in the long run.
So the fundamental questions you need to answer are:
The more clear the profitability path becomes, the more investors are willing to pay for the shares.
To state the obvious, Profits = Revenue - Expenses. Revenues are simply the volume of sales multiplied by the price per sale. Finally, expenses are all the inputs it takes to make those sales. Some expenses are variable, like the cost of the materials to produce a product. And some are fixed: you have to pay the rent on the office building no matter how much you sell or don’t sell.
With this simple framework and understanding of what drives profits, you can more clearly think about the viability and potential value of your company shares.
If you’re uncertain about your exercise decision, it’s likely that you’re concerned about the downside. So let’s talk through some potentially negative signals that you should consider when exercising stock in an individual company.
You can’t sell a dollar for $0.50 and make up for it with volume. Unit economics is about the sales price of your product minus the variable cost of producing/selling that product. If it’s costing you an incremental dollar to generate an incremental $0.50 of revenue, you may have a problem unless you can increase the revenue per sale or decrease the variable costs.
In short, unit economics is about understanding how much it costs your company to generate new revenue, and how much it will cost in the future.
Over the past two years, the market has shifted from a historically low interest rate environment — where growth was rewarded with little regard for the costs incurred to generate that growth — to now, where investors are rewarding capital efficient companies who demonstrate their business model can produce profits. By nature, many venture-backed startups are not profitable starting out, so if you’re at an early-stage company, it’s likely the company is unprofitable. That’s okay and normal! It’s why startups are often called “venture-backed.”
That does mean the risks of exercising options at a young company are higher, however. But the total costs are also significantly lower than mature companies due to a lower valuation for the company (and to taxes owed). If you’re optimistic about your company and are comfortable risking some of your money on your company’s future, exercising a portion of your option grant could make sense.
If you’re at a late-stage (Series C and beyond) company, and for every $1 of new revenue your company generates, the variable costs are > $1, this is a signal that your company may have a difficult time increasing their valuation going forward and could be a reason to hold off on exercising your options.
In the current market environment, many businesses have taken a closer look at where they are spending money and are seeking opportunities to reduce expenses and become more capital efficient. “Nice to have” products are being eliminated as companies determine they are non-essentials for operating their business. As a result, a lot of companies that sell B2B solutions have seen this trend reflected in their revenue over recent quarters.
One of the most reliable methods to tell if your product is truly indispensable is if customers continue renewing their contract despite being forced to reduce spend across the business. A quarterly revenue miss is not fatal, nor a reason to give up on your stock options. However, you should be aware that if your company has missed revenue targets or has experienced higher than normal customer attrition, it is unlikely that the business valuation will be increasing until these trends are reversed.
There are a variety of reasons for why someone chooses to leave a company. We’ve seen many individuals involuntarily leave as many companies have reduced headcount to lower their burn rate to preserve runway. I have also spoken to many employees who have voluntarily left their company due to burnout, cultural shifts, or stifled personal and business growth over the past year.
An exodus of talent takes a toll on any business and can erode value creation, especially if top performers are leaving to join a competitor that they believe is better positioned to capture market share. If you notice this trend at your company, it could be a cautionary signal to hang tight on exercising your options until you are able to evaluate how these changes are impacting the business.
The term “underwater” means that your strike price > current 409A (aka FMV). In this situation, exercising options would not be favorable because you are paying a higher price than the current value to acquire your company’s stock. Unless you’re extremely confident that your company’s valuation will rebound or you’re on a tight deadline to exercise your options, it’s better to not exercise underwater stock options.
If you find yourself in this situation, I would recommend that you inquire with your company about reissuing your option grant based on the current fair market value.
For example, if you were granted 20,000 ISOs at a $1 strike price and your company’s current 409a is $0.80, the same economic value would now be 25,000 options. If you’re optimistic about your company’s future prospects and want to financially participate in any upside created from this point on, it’s in your best interest to request that your options grant to be reissued.
Ultimately, these red flags could mean the company may have a hard time increasing the valuation of the business going forward but it's not a cut-and-dry rule. Also look at the current environment — nearly every company is cutting valuations and has done layoffs. Even the good ones!
That’s why, in some situations, it might still make sense to exercise options in the presence of these red flags. Even if you’re uncertain about your company’s ability to increase the business valuation going forward, if you have a wide “margin of safety” between your strike price and the company’s current FMV, now may be a great opportunity to consider exercising your options.
For example, if your strike price (i.e. price you pay to acquire one share in your company) is $0.25 and the company’s current FMV is $15, your margin of safety is $14.75 per share. Even if your company does not IPO, there could be a variety of other opportunities, such as tender offers and secondary sales for you to receive liquidity for the value of your shares.
Exercising your options positions you to pursue these liquidity opportunities and retain additional upside upon holding these shares for beyond 12 months. For employees with a large “margin of safety” and/or at promising companies, NOW is an incredible opportunity to consider exercising your options.
Taking a multi-year approach can result in saving taxes upon exercise, more time to accrue cash to put towards exercising options, and any future increase in the company's valuation being taxed at a lower rate upon sale.
These are just a few of many factors to consider prior to exercising stock options. For some startup professionals, lower valuations can be a great opportunity to start obtaining equity in your company and setting yourself up for expanded financial possibilities in the future!
If you have questions about your own situation, feel free to put some time on my calendar. Navigating equity can be complex, so John, myself, and our team are always happy to help. Feel free to put time on my calendar here.
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