How Should You Think About Your Options (Stock Options, That Is)

After finishing the post on anti-dilution, it occurred to me that maybe I had the cart before the horse since I’ve never really discussed the basic mechanics of option grants. Since the blog is targeted at senior managers, I should note that this post is for a more general audience. My further ulterior motive is that I’ve got a presentation coming up on this topic and this will help me arrange my thoughts.

So the first thing that seems pretty important to point out is that stock options, at least in the technology world, are remarkably standard. You don’t need to spend a whole lot of time trying to figure out whether or not your company has a better option plan than another company…they are pretty much all the same. Which is NOT to say that you don’t need to worry about the details. You absolutely do. As you’ll soon see, it is not always easy to recognize value from an option grant.

First let’s cover the basics, including why plans are so similar: 1) VCs have worked to standardize governance documents across portfolio companies and option plans have fallen into this vortex, and – this is the more important one – 2) in order for grants to qualify for favorable tax treatment, they need to conform to certain guidelines. When those guidelines are met, the grants are called “Incentive Stock Options” or “ISOs.” Those guidelines drive uniformity.

Three basic concepts tell you most of what you need to know about the mechanics of option grants:

• Strike price: the strike price is the price you will pay, per share, when you exercise your grant (i.e. – buy the underlying shares). The option only has value if the value of the shares exceeds the strike price. In order to be an ISO, the strike price needs to be at the fair market value for the stock on the day of the grant. This may come as a surprise to you…your manager may have suggested to you that the stock was worth more than the strike price. Generally, what’s happening is that they are comparing the price of the company’s preferred stock (what the VCs buy) with the price of the common stock (what your option converts into). Why would VCs pay a higher price for their stock than you pay? Because they get additional rights. Should you care? No. You are going to exercise your grant and probably sell your stock relatively quickly so those extra rights are not valuable to you. There is a bit of a sleight of hand going on here that is part of the magic of options.
• Vesting schedule: Almost all employee grants have what is called a 4/1 vesting schedule. This means that the grants vest over 4 years with a 1 year cliff. The cliff means that nothing vests until you get to the first year anniversary of the grant. Why? Because it is very annoying to have to fire someone or have them quit in the first year. The idea of having itinerant workers become shareholders is excruciatingly painful to managers. Once over this threshold, the rest of the grant will usually vest quarterly or sometimes monthly.
• Expiration Date: Most employee grants expire either seven or ten years after the grant date. Generally, this is irrelevant. Something else will happen in the intervening period, including: a) there’s a liquidity event which causes you to exercise, b) you leave, which forces you to make a decision on exercising, c) the company fails or is sold at a low price, leaving the option worthless.

Some advanced concepts to further flesh out some scenarios:

• How do I realize value: The best way to maximize value from an option grant is to be employed at the company when a liquidity event (IPO or sale, otherwise known as an “exit”) occurs. At that point, the value of the underlying shares becomes known and you should be able to sell the shares quickly and realize the excess value. Note two reinforcing factors: a) any finance major can tell you that the value of any kind of option derives from not exercising until the last possible moment (see below for an exception), b) venture backed companies (the analysis is different for public companies) grant options to encourage you to help them reach a successful exit. Everything, even the tax laws, makes it difficult for you to realize that value if you aren’t around at the ultimate event.
• How can I enjoy favorable tax treatment: If, after you’ve exercised your option you hold the underlying shares for at least a year, the gains on those shares will be taxed at capital gains rates. Otherwise, the gains are taxed at ordinary income rates, which for now are roughly double capital gains. On the one hand, this can be economically meaningful. On the other hand, as noted above, the best way to realize value from an option is to hold it as long as possible and once you do exercise, quickly sell the stock and realize the gain. Holding the stock for any period of time exposes you to principal risk (i.e. – the money you put up to buy the stock). The intrinsic value (current price minus the strike price) may be compellingly high, but this is a dangerous game to play and you should understand the risks.
• Can I exercise if I leave my company before the liquidity event: Two things will happen on your last day of employment: a) vesting will stop, b) the clock will start ticking and you will have no more than 90 days (except in cases of death or disability) to exercise whatever has vested. The 90 days, by the way, is an IRS requirement. Your challenge will be that: a) you probably won’t know if there’s any intrinsic value unless the company has been raising capital at rising prices and b) even if that’s the case, you generally won’t know if or when a liquidity event is going to occur. In the meantime, you’ll be at the bottom of the capitalization table having paid cash for common shares with no rights (remember that from above?). In some cases, companies even put in buy-back provisions so that if the value starts to rise and an exit looks probable, they can buy back your shares at a “fair market value” price determined by the board. If it feels like the game is rigged against these types of exercises, well, it is. Regardless, I’m always surprised at the number of people who say, “I exercised my options when I left that company.” Then there’s always a pause as I wait for the rest of the story. “And I made a tidy little sum!” or “And now I’m pretty sure I’m never going to see a nickel.”

Now, I never say this, but I feel compelled to here: I’m not a lawyer and I’m not an accountant. I don’t even do my own taxes. Please do not depend on this post for legal or tax advice. The rules on options are constantly changing. Use this to make yourself smart enough to ask the right questions but consult a professional before making any decisions.