What you’ll learn in this guide

This guide explains how to deal with the Big Uncertainty and the Big Decision.

Because option-wise, there should really just be two things that keep you up at night. They are the only aspects for which there is no definitive answer – two genuinely tough ambiguities with which you can’t avoid dealing.

The Big Uncertainty – and how to deal with it

How much money you make depends on how successful your company becomes, but this is inherently uncertain. What to do?

The Big Decision – and how to make it

Having options involves buying company shares. This is called exercising. Exercising potentially increases your profit, but you also risk losing any money you put in. How much should you spend?

Is that everything?

In order to understand the Big Uncertainty and the Big Decision, you should know about two basic mechanics of stock options: the Option Lifecycle and the Exit Pie. We fully cover them in this guide.

When it comes to essential knowledge, that's about it.

But you can go much deeper if you feel like it. We're creating follow-up guides for that stuff, and we'll link them here. No need to dive into those today. Just know that you can always come back for more whenever you're ready.

This article is for illustrative purposes only and is not necessarily indicative of future results. See the end of this document for full disclosures and additional information.

The Option Lifecycle

The purpose of stock options is to someday make you money. To do so, options need to pass four phases.

1. You start with unvested options

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:

2. Your options vest

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.

3. You exercise your options

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.

4. Your company exits

Finally! Your company goes public or is acquired.

When a company goes public, it sells its shares on the public stock market. This event is called an IPO for initial public offering, ✱ and it is what Slack, Uber and Lyft did.

IPOs are typically followed by a lock-up period during which employees can't sell their shares. You'll have to wait, for instance, another 90 or 180 days. Whenever we talk about the exit, we mean the IPO including the lock-up period.

When a company is acquired, it is bought by another company: GitHub by Microsoft for example, or Twitch by Amazon, or Whatsapp by Facebook.

The exit is your payday. It is the first moment at which you can sell your shares to make a profit. ✱ It’s the moment the founders of your company have been waiting for, and its investors have been, too – their business model is making money through exits. If it isn’t for the exit, your options would be pointless.

That’s assuming the exit is successful, meaning the exit value is high enough. We explain exit values in a bit.

The Exit Pie

The Option Lifecycle explains how stock options can make you money. But how much money? What are the factors that determine your profit?

When your company exits, a bunch of money is offered to everyone that owns equity: founders, investors, your colleagues – and you. Some key terms:

The exit value is the total amount of money offered.
Your payout
is the part of it that you get. But there are costs, such as taxes.
Your profit
is the net amount of money you make, after costs.

Let’s say the exit value comes in the form of a golden pie – the taller the pie, the higher the amount of money. Then you get a slice: that’s your payout.

Let’s go through it step by step.

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The more successful a company gets, the higher its exit value

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.

$1.1 billion
(in 2013)
$2.6 billion
(in 2005)
$17 billion
(in 2014)
$76 billion
(in 2019)

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.

Payout = exit value × diluted stake

When payday comes, the exit value is divided as you would expect it: the percentage of the company you own is the percentage of the exit value you get. In other words: to compute your payout, multiply the exit value by your stake at the time of exit.

Your stake today is your number of shares divided by the total number of outstanding shares of your company. For instance: if you own 100,000 shares and your company has 50,000,000 outstanding, your stake is 0.2%. Wait, how do I know the number of outstanding shares? 

Your employer should be able to provide you with the total number of outstanding shares. Some companies keep it a secret, but that’s like paying your salary without disclosing whether it’s in dollars or yen: you have no clue what it’s worth.

Your stake at the time of exit, unfortunately, is probably not your stake today. Throughout its lifetime, your company slowly decreases your stake to make room for new employees and investors. This is called dilution.

So to compute your payout, you multiply the exit value of your company by your diluted stake. The problem? It is uncertain by how much your stake will dilute. That uncertainty is part of the Big Uncertainty, which we’ll cover in a bit.

With dilution, what really happens is that your company creates new shares to give to new employees and investors. As a result, there are more outstanding company shares in total. So even though you still own the same number of shares, your stake – the percentage of the company that you own – decreases.

To continue the above example, if you own 100,000 shares and your company has 50,000,000 outstanding, your stake today is 0.2%. But if your company then gives another 50,000,000 shares to new investors, the number of outstanding shares grows to 100,000,000, diluting your stake to 0.1%.

This may feel bad intuitively, but it doesn’t need to be. Your stake has been halved, but if the new investments enable your company to quadruple its exit value in the end, your payout is doubled.

In Exit Pie terms: you'd get a smaller part of a larger pie, and end up with more calories down the line.

Profit = payout - costs

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.

Taxes when exercising on 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.

Taxes when exercising pre-exit

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​.

Secfi has a free tool that helps you do that. ✱ In order to use it, the only thing you need is an estimate of your payout – which we’ll make in the next chapter.

The tool is called Exercise Pre-Exit.

We'll introduce it in the last chapter, but in case you can't wait:
- Create a Secfi account and enter your equity details
- In the dashboard menu, click on Insights
- Click on Exercise Pre-Exit.

The Big Uncertainty

How much money will you make?

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.

Gaining exit intuition

You probably know the feeling of traveling in to a country with a different currency. For the first couple of days, it is hard to judge intuitively if items in shops are cheap or expensive: you're not familiar with the numbers that make up their prices. After a few days, you notice you'll feel the need to convert back to dollars less and less because you have internalized the currency.

It's the same for exit values. Before looking at your company specifically, it is helpful to get a feel for what sorts of exit values startups achieve in general. How rare are $1 billion exits? How wild is it to expect $500 million for your company? If your first mental reaction is 'I have no clue', you need to build exit intuition.

  1. Make it a habit to follow news outlets on startup exits. Search TechCrunch for 'acquired' for example, or look up lists of IPOs of the last couple of years. Focus on the exit values you see passing by.
  2. For each company you read about (of which the exit value was disclosed), research the company a bit. Get a feel for what it took them to get to that exit value. How many employees do they have on LinkedIn? In how many countries are they selling? Is their product wildly popular? Does their business model have a viral aspect, or do they need to work hard for their sales? Do you think they have a large profit margin, or are their costs per unit sold substantial? How many years ago were they founded, and how much capital did they need to raise?
  3. Now compare the maturity and levels of success of those companies with the company you work for – especially for those that operate in a similar market or under a similar business model. Do their situations still feel far off? Or are you getting close? Each company is unique, and companies can face very different outcomes despite following seemingly similar trajectories. Nevertheless, mental exercises like this can be a helpful starting point for building exit intuition.

Having some familiarity with exit values, the next step is to imagine the future of your company and make ballpark estimates of its exit value.

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Thinking in scenarios

Trying to come up with a single estimate is futile – it would almost certainly be wrong. Much more useful instead is to get an idea of the range of possible outcomes. That's why we're going to consider three scenarios.

Close your eyes and imagine one particular scenario for the future of your company: the one where you extrapolate how the company is doing today. The scenario is supposed to be slightly optimistic, but nothing crazy happens here – if it came to be true, you would be pleased though not surprised.

Think about where your company would be in that future scenario. Do this in broad strokes. Would it have 200 employees, or more like 1000? In how many countries would you be serving customers? How popular would your product get, or how effective would your sales team become? No need to answer those questions precisely – just make sure you have an intuitive idea of the level of success. Help me better imagine this scenario. ✱

In the base scenario, imagine your future company by extrapolating how it is doing today: continuing smoothly, growing gradually. No big losses, no surprising wins.

Hiring stays as easy or hard as it currently is. Is there a material competitor today? Then it will still be there in the future. Is your company searching for product-market fit at the moment? Then you will find it, but it won’t be an overwhelming success.

In short, imagine a scenario that is slightly optimistic, but wouldn’t surprise anyone if it were to come true.

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.

The next one, the dream scenario, is very optimistic. To imagine it, close your eyes again, and think what would happen if everything went better than you expect. It’s the scenario you told yourself not to lean on too much when you were considering the job offer here – the stuff you and your colleagues have been fantasizing about over Friday drinks, only semi-jokingly. Help me imagine the dream scenario some more. 

In the dream scenario, everything went better than you’d expect. That competitor you’re bothering with? Your company ended up winning the battle. That second product you’re thinking would be really cool to do someday? It became a revenue-making thing. Your reputation grew, which made hiring easier. A big investment round enabled smooth international expansion.

The specific critical wins that constitute the dream scenario differ from company to company, but you probably know what they are for yours.

Holding that mental picture of the dream scenario, intuitively forecast the exit value of your company again, and write it down.

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.

Discuss, refine, and account for dilution

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.

The Big Decision

Should you risk your savings and exercise pre-exit?

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.

Reason 1: to maximize your profit

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.

Reason 2: to avoid losing equity

Unimpressed by the potential tax savings? The second reason to exercise pre-exit: you get to keep a larger part of your equity in case you leave your company before the exit.

We have been discussing ‘exercising pre-exit’ as opposed to ‘exercising on exit’ – but that’s possible only if you keep working for the company until that very exit. If you leave beforehand, you’ll lose your options except if you exercise them within 90 days. ✱

There are two exceptions. Some companies go beyond the convention of 90 days, and have a deadline of e.g. 3 or 5 years. The other exception is that companies may decide to extend exercise deadlines in individual cases.

That means that unless you stay until the exit, you’re still faced with a pre-exit exercise. So why not just wait until that actually happens? The issue is that this 'forced pre-exit exercise' will probably be more expensive than if you'd deliberately decided to do it today.

That's because ​if your company is growing, the upfront costs per option increase over time. ✱ And the faster your company is growing, the worse it gets. If today an exercise budget of $5000 would cover the exercise costs of, for example, 50% of your options, you’re likely to get much fewer than 50% of your options for that same budget a year from now.

Our upcoming advanced guide on exercising explains why.

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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.

Hope that was helpful
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