Stock Option Starter Guide

You applied, nailed the interviews, accepted the offer and started working. Congrats! You now have options – but not really.

You get your options unvested. That’s jargon for: your company would like you to have options, but only if you keep working there for a while. Unvested options still need to vest (again, just jargon for you actually getting them), a process that takes years.

How many? That’s what your employer determines through the vesting scheme. The most common vesting scheme takes 4 years and has a 1-year cliff. That means you get nothing during the first year, then an instant 25%, and then a little bit every month. Why ‘cliff’? Well:

When the vesting scheme ends, you now truly have stock options! But what does that mean? What do you own?

An option is still not really anything, except the permission to buy a share: a tiny piece of your company. Buying shares is called exercising your options. Because here's the odd thing about stock options – they’re a form of compensation, but you incur costs before they make you money.

To exercise, you need to pay their strike price as well as income tax. The strike price is predetermined, but the amount of taxes varies. We’ll get to that in a bit.

Now you have shares. You own a part of your company. The percentage of it that you own is called your stake. It has potential future value, but since your company is private, you can’t sell it on the public stock market. Your shares won’t make you money until your company has its exit.

So when does exercising happen? It's up to you. As long as you work for the company, you can buy your shares whenever you like. And you don’t have to buy them all at once.

You could even wait with exercising until the exit, then cover the costs with the money you make, and have no upfront costs at all! But that strategy also has its drawbacks. Which strategy to follow is the Big Decision of Stock Options, and we’ll cover it in a bit.

The exit value is how valuable your company ended up becoming. In general, exit values range from tens of millions to billions. Outliers even reach the tens of billions.

To get an idea, here are some examples of well-known brands. Note that their exit values were on the high end of the spectrum.

The exit value is always a surprise. You can try to predict it, but until the exit actually happens, it’s unsure. It could very well be $0 if things go downhill. This is The Big Uncertainty, and we’ll explain how to deal with it in a bit.

Your profit is your payout minus your costs. Your costs have two components:

• The strike price
• Taxes
  

The strike price is the price of your shares. You pay it to your company when you exercise. The price per share was determined when you were granted the options. Multiply it by the number of options to get the total strike price. If your option grant was 100,000 options at $2 per share, your total strike price is $200,000.

Taxes are more complicated and depend on when you exercise: wait until your company exits to exercise on exit, or do it pre-exit.

When you exercise on exit, you enter the simplest tax scenario: what’s left from your payout after subtracting the strike price is taxed as ordinary income.

In this scenario, there’s just one moment at which you incur costs: the moment of exit. In that instant, you sell your shares, pay the strike price, incur the ordinary income tax, and keep your profit. There is no need to have cash at any point.

When you exercise before the exit instead, it gets complicated. Overall, your taxes may now be lower. But you pay them in two parts: the first part is due when you exercise, and the other part when you sell your shares on exit.

That means you now have ​upfront costs​, as you pay some of the taxes (and the strike price) before receiving any payout. That’s a cash requirement you may not be able to afford. And even if you do, you risk losing that money: a successful exit is not guaranteed.

Admittedly, that’s still all a bit vague. What will your exact tax bill be, and how is it divided between the moment of exercise and the moment of exit?

The bad news: it’s complex. Many factors determine it. The good news? While complex, it is not ambiguous. ​You can precisely compute your taxes beforehand​.

We discussed the formula for how much money you’ll make with your stock options: profit = payout - costs. That means that once you know your payout, you can use a free Secfi tool to help compute your costs, and then know your profit too.

The problem? Your payout is inherently uncertain​ – you won’t know it until the exit happens. This is the Big Uncertainty of Stock Options.

To an extent, dealing with the Big Uncertainty simply means accepting it as a fact of life. The reality is that your equity is a bit of a lottery ticket.

But there’s no reason to stay in the dark completely. You can get ​some​ idea of the possible outcomes, and that’s better than nothing.

Got it? Now intuitively, what exit value do you feel your company might achieve? Let's call that the base scenario. Write it down somewhere.

Lastly, the disappointing scenario. This one is slightly pessimistic – not bankruptcy per se, but not nice either. To imagine it, take a moment to think of the key hurdles still ahead for your company. Now think what would happen if you failed at overcoming the majority. Estimate once more.

Having written down three numbers, you can now move from company exit values to forecasts of your personal payout for each scenario. Figure out what your stake in the company is, multiply it by the exit values, and there you have it.

If this all felt very unscientific, then that’s because it is. You'll never reach accuracy, but the idea is that having some perspective is better than none. ‍

Additionally, your perspective will develop over time. Today’s forecasts only kickstart your intuition. Keep reading about other startups, especially those similar to your company, to become increasingly more familiar with how exits work.

Use the scenarios you envisioned – and the exit values you forecasted – as starting points for discussions with colleagues and leadership. Do they share your thoughts, or do they have different expectations for the future of your company? This helps you sharpen your view.

As the history of your company reveals itself month by month, try to make sense of the events that play out. Make a mental update of your future scenarios after major ups and downs.

Lastly, note that the above forecasts of your payout don't yet factor in dilution. As you discuss future scenarios with your leadership, ask them about their expectations of dilution still to come. While they won't be able to tell for sure, based on the amount of capital they're planning to raise they should be able to provide you with a rough idea.

To exercise pre-exit means buying some (or all) of your shares today, instead of waiting for your company to exit. You should consider doing so for two reasons:

• It potentially decreases your total costs, maximizing your profit
• You get to keep a larger part of your equity when you leave the company before the exit

The tricky part? Exercising pre-exit comes with ​upfront costs ​– money you pay before receiving any payout. That's money you risk losing: your company might fail to have a successful exit, in which case you never actually get that payout.

The more options you exercise pre-exit, the more you unlock the potential benefits – your potential tax savings grow, and you'll get to keep a larger part of your equity when you leave the company.

But on the flip side: the more options you exercise pre-exit, the higher the upfront costs. It's a classic risk-reward trade-off.

So you’ll have to make a choice: ​how much money do you want to risk exercising pre-exit​? This is the Big Decision of Stock Options.

The key is a two-step process:

1. Determine how large your potential benefits are exactly – it varies highly per situation.
2. If the benefits are worth it, decide on the amount you are willing to risk to unlock them. Risking more means unlocking more.

Step 2 is a personal one – in the end, no one can make that call for you. But to help you at least make it informed, we’ve got your back on step 1.

Exercising pre-exit can increase your profit because of ​tax savings​. Normally, your payout (minus the strike price) is taxed as ordinary income. If you exercise pre-exit, a part of it may be taxed as capital gains instead. That's a lower tax rate.

The key question is: how much of a difference does it make – and how high of an upfront cost does it take? If the difference is small, it might not be worth the risk.

The answer highly depends on your tax situation, income, and type of stock options. How they impact tax savings is complex, but ​Secfi offers Pre-Exit Exercise, a free tool​ that helps you crunch the numbers. Based on your details, it forecasts the difference in profit between exercising now vs. waiting for the exit.

There’s one caveat: Pre-Exit Exercise requires you to input the future exit value of your company – which, as we know, is uncertain. So that’s where your exit value forecasts come in. Here’s what you do:

1. Create a Secfi account and enter your equity details.
2. Navigate to the Exercise Tax Calculator to learn about your upfront costs.
3. Next, navigate to Pre-Exit Exercise.
4. Enter as exit value your base scenario forecast. See how exercising pre-exit affects your profit in this scenario.
5. Now enter your dream scenario forecast. Consider the difference again.

How did that make you feel?

If the differences in profit are small, but the upfront costs are high, it’s probably not worth it. Conversely, if the upfront costs are affordable, consider exercising all your options pre-exit.

It gets tricky when the differences in profit are substantial, but the upfront costs are too. You’ll then want to find a middle ground: decide on a budget to exercise some of your options now, leaving the remainder unexercised.

Deciding on that budget is difficult since it’s somewhat of a gamble. Say you budget $5000. Now if your company ends up having a very successful exit, you’ll wish you’d spent more than that, since you could have maximized your profit even more. If on the other hand your company fails, you lost $5000 and wish you’d spent nothing at all.

What’s the amount of money you can forgive yourself losing in a bad scenario? The choice is a personal one. But at least you now know what the potential benefits are.

So ask yourself two questions:

• Is there a fair chance you’ll leave the company before the exit?
• In case that happens, would you spend, say, $5000 to buy shares?

If the answer is a double yes, you might just want to spend $5000 today and leave with more shares for it.