In addition to a salary, your company may offer you compensation in the form of stock options. The stock options are often granted as a way to incentivize you to work towards a common company goal, which could range from a fundraising round to an IPO. Basically, owning stock options mean you have a financial stake in the company. Just like investing in the stock market, this means you are putting a lot of faith in the company, its leadership, employees, and products. It’s also important to remember that the valuation of a company, which will ultimately influence the value of your equity, depends on a large number of factors and not just on how well you perform in your role.
Stock options are often described as hypothetical money. This means, you will not receive any tangible income from your options until they are liquidated through some form of exit. Stock options are also often granted with a few stipulations. Some of the more common ones are:
- “Four year vesting schedule”— You will gradually accrue your equity and receive the total value of stocks when you reach four years of tenure in the company.
- “One year cliff” — You will receive the first 25% of your stock options after completing one year in the company. Companies do this to ensure that they are awarding equity to employees who plan to stay for the longer term.
- “Post-termination exercise” — If you decide to leave the company, you only have a period of time to exercise the stock options that you have vested. Most companies give about 90 days, although some may offer longer. If you don’t purchase your options at the strike price during this time, you will no longer own them and they will be returned to the company.
- “Assumptions of dilution” — If the company decides to issue new shares because of an upcoming fundraising round or IPO, your equity might get diluted, which means even though you own the same number of shares, the value of these shares will decrease, as the number is a smaller fraction of the total value of shares in the company.
To calculate the value of your equity, you would need to know a few things:
- Strike price: With ISOs/NSOs, you have a right to purchase your stock options at a certain price. This price tends to increase as startups mature. You will find this number on your stock grant.
- Total shares outstanding: This measures the total number of shares that has been issued by your company. You can ask your recruiter for this number or find them on sites like Forge, for most companies.
- Current value of company: This number is pretty straightforward, as it is literally the current valuation of your company. You can often get this number from your recruiter, news articles announcing your company’s recent fundraising round, or from sites like Forge as well.
After you have all of this information, the formulas are simple arithmetic:
Price per share: Current value of company/Total shares outstanding
Value of your equity: (Price per share x Total number of your stock options) — (Strike price x Total number of your stock options)
You can also calculate what percentage of the company you own:
Percentage ownership: Total number of your stock options/Total shares outstanding
The image below shows a hypothetical example of the output of the formulas above.
Remember that may not get the total value of your equity unless they have all vested following the vesting schedule on your grant. Dilution, as described earlier, may also occur, meaning as new shares are issued, the value of your shares may decline.
Depending on where you live, there could be significant tax advantages if you choose to early exercise your ISOs. Early exercising simply means that you decide to purchase your stocks at their strike price even before they have vested. By early exercising your shares, you benefit in the long-term because the capital gains holding period will start at the date of exercise.
People often ask me if they should early exercise their shares or not. While there may be tax advantages for early exercising, you should also consider the opportunity costs of your decision. Remember that in order to early exercise, you would have to allocate some of your own money to purchase the shares at their strike price. Are there any other ways you could spend this money (i.e. other stock or real estate investments)that would yield more returns than the amount you would save through the long-term capital gains tax?
People often ask me if they should negotiate for a higher base pay or equity package. Negotiating an equity offer is complex and ultimately depends on your own preferences and comfort level with uncertainty. Here are a few general things you may want to consider:
Would you prefer a higher base salary right now or more equity that may become very profitable in the future? There is no right or wrong answer to this question, it really depends on what would work best for your current lifestyle.
- What is your tolerance for uncertainty?
Like I explained earlier in the article, equity grants are hypothetical money. The value of your stocks and how much it grows over time depends on a myriad of factors that are outside of your control. How comfortable are you with this ambiguity?
- What are your other offers?
If you have other offers, evaluate how they compare against each other. The key here is to think about total compensation, not just base salary and stock options in isolation. Let’s say you have two offers at hand, one from a startup and another from a publicly traded company. The startup offered you a $150,000 base salary with 40,000 shares, with a strike price of $1 and a current price per share of $5. This means, at the startup’s current valuation and including your stock package, your total compensation would be $190,000 per year. The publicly traded company offered you a $160,000 base salary with $30,000 worth of RSUs per year, for a total compensation of $230,000.
Even though the base salary at the startup is higher, by including the value of your stock options and RSUs in the calculation, you can see that your total compensation in both scenarios are the same. Ultimately, your decision will depend on which of the two companies you think would grow more in the future, in a way where you would obtain the most return for your shares.
- When are you joining the company and for what position?
If you’re joining an early stage company (i.e. Seed or Series A), you may receive a larger equity package, relative to a later stage company (i.e. Series E or pre-IPO). This happens because you are being compensated for the highly uncertain future of early stage companies, compared to those that have proved its value and position in the market. You should also expect your equity package to increase as you get hired for more senior roles. Senior members of an organization are often awarded with a higher percentage of the company’s common stock. Again, this number differs depending on the maturity of the company.
- Do you believe in the company and its potential to grow?
Choosing to work in a startup is an investment and similar to how should be thinking about the other financial investments you make in your life, you should evaluate the growth potential of the company. If you are confident that the company will multiply its current valuation and become a leader of its industry, then it might be wise to negotiate a higher equity package in lieu of base pay.