How Employee Stock Options Work

*This article is not intended to be used as investment advice.

A few years ago, I was hired as the first U.S. employee for a Y Combinator-backed startup.

Before then, I had worked in companies of multiple sizes and industries, but I had never worked in an early-stage startup, so I was confused by much of the lingo in my job offer.

I wondered: What is a strike price? What is a normal vesting schedule? How likely is it that my stock options will be worth something? How exactly does an option differ from normal stock? Is an employee stock option similar to a derivatives option that you can buy on an exchange?

I’ve now had the chance to work in two startups and learn much more about how they work. Employee stock options can be a bit complex, but they’re definitely within your grasp to understand.

Here are some of the basics I wish I knew when I joined my first startup…

What Is a Stock Option?

Simply put, a stock option is the right to buy or sell shares of a company at a particular price, for a particular period of time.

Stock options are NOT actually stock. They just give you the right to purchase stock at a discounted (favorable) price.

Here’s a hypothetical example to explain how options work:

Let’s say Starbucks is trading at $100 per share, and you think there’s a good chance their shares will be worth much more than that soon.
You could purchase a “call option” on Starbucks that would allow you to buy Starbucks shares for a specific price on a specific date (for example, $105 in 2 months).
If Starbucks shares climb above $105 per share, you make money.
For example, if Starbucks rises to $115 per share in the next couple of months, you’d make $10 of profit for every share of your option contract. (The normal contract is 100 shares, so you’d make $1,000.)

Similarly, when you join a startup company as an early employee, you may be given free stock options that could be worth something (potentially a lot) if the company’s value goes up in the future.

How Do Employee Stock Options Differ from Standard Options?

Employee Stock Options (ESOs) operate similarly to standard call options (like the Starbucks example) except that ESOs have more restrictions. ESOs are specifically issued to employees and cannot be sold on the standard market. You can’t just go and sell them to someone else.

Another major difference between standard options and ESOs is that employee stock options generally come with a vesting period.

What Is Vesting?

Vesting is the company’s way of keeping you around. They don’t just want to give you a piece of the company now—they want you to continue to have a VESTED interest in the business for several years and continue to chip in to make the company more valuable over time.

To accomplish that, the stock options don’t actually become yours right away. They “vest” over a period of time, and your “vesting schedule” is the length of time you need to wait until you can actually access a chunk of your shares.

Companies can set whatever vesting schedule they want, but this is the standard one used by most startups:

4-year vesting schedule: It takes 4 years for you to be able to access all of your stock options.
1-year cliff: If you leave the company before your 1-year anniversary, you don’t get any stock options.

It’ll help if we walk through an actual example so you can see how this works.

Let’s say you just got a job offer to be a Product Manager for Richard Hendrick’s hot new startup Pied Piper. Your job offer says you’ll receive 10,000 stock options on the typical 4-year vest with a 1-year cliff.

Here’s what that means:

If you leave Pied Piper any time before your 1-year mark, you get ZERO stock options because none of them have vested yet.
After you hit 12 months with the company, you’ll vest 25% of your stock options (2,500 options). So even if you leave the company one day after your 1-year mark, you still have 2,500 options.
Every month after your 1st year, you’ll vest another 1/48 of your total options. (That’s because there are 48 months in your 4-year vesting period.) Note: Some companies observe other vesting schedules, such as a quarterly instead of a monthly vest. Read your option agreement for details.
So, after the first 2 years of your employment, you’ve vested 50% of your options (5,000 options).
If you stay the full 4 years, all 10,000 shares will be vested. Boo-yah!

That’s Cool, but How Much Are These Options Actually Worth?

This is where things start to get tricky. The answer to this question depends on multiple factors that we’ll unpack one by one:

The exercise price of your shares
The share price
Whether the company has a liquidation event

What Is an Exercise Price?

An exercise price (also called the “grant price” or “strike price”) is the price at which you can buy shares of the company.

Ideally, you want the exercise price to be REALLY LOW and the share price (how much the shares are trading for right now) to be REALLY HIGH. The difference between those two amounts is your profit per share.

Let’s go back to your Pied Piper job offer. Let’s say that the exercise price on your Pied Piper shares is $1 per share.

If the Pied Piper share price rises to $10 two years from now, you will be eligible to make $9 of profit for every option you hold.

Here’s the math:

Your total share grant = 10,000 stock options
How many will have vested in 2 years = 5,000 options
Profit per share = $10 share price — $1 exercise price = $9 profit/share
Total profit = 5,000 x $9 = $45,000

And just think…if those shares went up to $50 or $100 per share, you’d have some big money on your hands.

Plus, the calculation above is only showing how much you’d potentially make in 2 years—when only half of your options have vested. If you stick around for your full vesting period (4 years) and the share price is $10 at that point, your total profit would be $90,000 (10,000 shares x $9/share).

BUT…just because the share price is above your exercise price doesn’t necessarily mean you can physically make money right now. That depends on whether Pied Piper actually has a liquidity event.

What Is a Liquidity Event?

A liquidity event is a chance for founders and early employees to cash out their shares. This typically happens during an initial public offering (IPO), acquisition, or merger.

In these types of events, another entity is buying the company from its existing shareholders (that’s you!). So you have an opportunity to turn your shares into liquid cash.

But employees also sometimes get the chance to sell their shares in other rare events, such as if a “secondary market” forms for the stock. For example, the company could create a market for employees to buy or sell company stock. Or if an outside investor wants to buy into the company and the most recent funding round has already closed, the company could allow the investor to buy shares from existing employees.

Basically, you can think of profiting on company stock as similar to prosecuting a murder case on a TV show: you need both MOTIVE and OPPORTUNITY.

Motive: The current share price must be greater than your exercise price. (This is the only way the shares are worth something.)
Opportunity: There must be a market for selling those shares to someone else. Without that, there’s no buyer and your gains are just theoretical.

When Are Stock Options Worth Nothing?

Startups are inherently risky. There’s a good chance your ESOs won’t be worth anything, such as if either of these things happens:

The company goes under
The company never has a liquidation event (i.e., the owners never sell the business)

Some people talk about acquisitions like they’re a bad thing. They get bitter that their company was acquired by someone else who may run the business differently, conduct mass layoffs, or treat employees poorly.

And yes, there can definitely be drawbacks to getting acquired. (I know—I’ve been part of both “acquired” and “acquirer” companies before.)

But the ironic thing is that if you want your shares to actually be worth something someday, you should WANT to work at a company where the founders and board ultimately want to sell the company. If your company is run by one family for multiple generations and they never sell the business or IPO, your shares will be worth absolutely nothing.

So the best possible situation for you (if you’re looking to make money from ESOs) is to work for a fast-growing company whose founders ultimately have an exit strategy.

What Does It Mean to “Exercise” an Option?

The “option” part of stock option means you have the option of whether or not to exercise your ESOs. To exercise a stock option means to purchase the underlying asset at the exercise price.

If you decide to purchase the asset, your ESOs convert from being stock options to being actual shares of the company. Just like purchasing any asset, you have to pay money to buy those shares.

Let’s go back to our Pied Piper example…

Your first batch of shares will vest on your 1-year anniversary of working for the company. That’s the first day you’ll have the ability to exercise any shares (unless you have an early exercise opportunity, which we’ll discuss below).
At your 1-year mark, 2,500 of your 10,000 stock options will have vested, and you can exercise any amount of those shares you want up to a maximum of 2,500. Let’s say you want to exercise all 2,500 options.
The cost of exercising your ESOs will be the same no matter what the current share price is. You’ll pay $1 per share to exercise (your exercise price) times 2,500 shares, resulting in a total cost of $2,500.
Now you actually own 2,500 shares of Pied Piper. Whoop whoop!
From here on, those shares are YOURS—even if you leave the company. You will continue to benefit from the company’s value going up over time. But on the flip side, if the company tanks in value, your shares could end up being worthless, and you’re out the $2,500.
Note: Based on your strike price and number of shares, you could end up paying a lot of money to exercise your ESOs—even tens of thousands of dollars.

Generally, the only way to have a really low exercise price is to join a company in its infancy. If it’s an early-stage startup with no or little revenue, the shares won’t be worth much when you start. But if you join a later-stage startup, the exercise price could be quite high, meaning that your cost of exercising shares will also be high.

What Does It Mean to “Early Exercise” an Option?

Early exercise is when you exercise options (i.e., purchase shares) before they have vested.

Some companies give executives this privilege so the execs can lock in a lower taxable value on their shares. Other companies give all employees the opportunity to early exercise their shares.

You may be wondering: Why wouldn’t ALL companies allow employees to early exercise? The reason is that companies have to administer a lot more paperwork for allowing employees to early-exercise, and most startups are strapped for resources and can’t process a bunch of extra paperwork.

As an employee, the benefit of early exercising your options is that you can potentially save a bunch of money on taxes. But the downside is that you have to pay money today to buy those shares (unless your company offers a cashless purchase option), and there’s no way of knowing whether those shares will actually be worth anything down the road.

What Are the Tax Implications of Early Exercising?

You should definitely talk to an accountant to get help with any of your stock option tax questions. They know way more about this stuff than I do, but I’ll just give you a quick run-down on the basics.

In the same way that people have to pay capital gains taxes on the profits they make in the stock market, you have to pay taxes on the profits you make from your ESOs.

Early exercising is a chance to lock in a lower tax rate on those options. It’s often a good idea to early exercise if the following conditions are all true:

You expect the share value to go up over time.
You expect the company to eventually have a liquidation event.
You have enough money now to purchase your shares.

If any of those conditions are not true, consider holding off and just exercising your ESOs later.

Note: There are two different types of ESOs: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs or NSOs). The difference between these two options essentially comes down to taxes. If you hold ISOs and meet a bunch of different conditions, you don’t get taxed as much as NSOs. Learn more by reading here or here.

When Is the Latest Time to Exercise Your Options?

Generally, the only time you’re forced to exercise your options is if the company sells or you leave the company.

If you leave the company, you’ll have a window of time within which you must decide whether or not to exercise your options. Most companies have a 90-day post-termination exercise period, but you should check your option agreement to see exactly how long the period is at your company.

If you don’t exercise your options (i.e., buy your shares) within that post-termination exercise period, YOU LOSE THEM.

Read your option agreement carefully and speak to your accountant or any family friend who has familiarity with how options work.

What Else Should You Watch For?

ESOs can be confusing. Companies and investors can sometimes insert clauses into option agreements that will decrease your potential payout. Beware of things like the following:

Non-Traditional Agreements: Your company can essentially decide to write whatever kind of ESO agreement they want. That could include really long vesting schedules, unfair limitations on your ownership rights, or a host of other things.
Board Approval: Many companies include a clause in the option agreement that says your ESO grant is “subject to board approval.” That means the company’s board of directors gets to decide in their next meeting whether or not you will actually receive the ESOs you’ve been promised. At most companies, it’s taken for granted that the board will approve all of the recent option grants, but it’s not a 100% certainty.
Dilution: Companies can issue new shares if they want—thus increasing the total pool of options and diluting the value of every existing share. It’s common for companies to issue new shares when a new investor comes on board, and depending on how many new shares are issued, the value of your ESOs could drop significantly. It’s smart to mentally plan for some dilution, but there’s nothing you can do to prevent it.
Liquidation Preference: Some venture capitalists (VCs) insert clauses into their investment agreements that stipulate they’re entitled to receive a certain percentage return on their investment if the company sells. Essentially, they’re guaranteed the first $X million of any sale. And if that guaranteed value exceeds the company sale price, employees could get nothing. This doesn’t happen often, but it’s possible.

Conclusion

My best guidance to you would be to read the fine print of your option agreement. Study up on how ESOs work by reading other articles and watching YouTube videos. (I’ve included a few helpful ones below.)

If something in your option agreement smells fishy or doesn’t line up with some of the common standards I’ve written about here, ask questions.

When you work for a startup (especially an early-stage one), ESOs often represent a decent percentage of your overall compensation. It’s important you understand exactly what that compensation entails.

Best of luck at your startup, and I hope you make millions off your ESOs! 🙂

Where Else Can You Find More Info About ESOs?

Here are a few additional resources I’ve found to be helpful:

*Again, this article is not intended to be used as investment advice. Talk to your accountant or certified investment professional for recommendations about your personal situation.

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