The two problems with stock options

In your life as a startup employee with stock options, there are really only 2 things which don’t have a clear-cut answer: 

1. How to deal with profit uncertainty

You can’t know how successful your company will become, so how much money you’ll make is uncertain. What can you do to still get a realistic idea?

2. Deciding to exercise

Buying company shares potentially increases your profit but you also risk losing the money you put in. How much should you spend?

To get a grip on that uncertainty and make that decision, you also need to understand:

  • The four stages of stock options: how can stock options make you money? What things need to happen before options turn into dollars?
  • The Exit Pie: how do you work out how much money you might make? What are the things that affect that amount?

When it comes to the essentials, that’s about it. We explain it all in this guide, as simply as possible.

The four stages of stock options

The purpose of stock options is to someday make you money. No matter what type of options you have, they need to pass four stages to do so.

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 need to vest (again, just jargon for you actually getting them), a process that takes years.

How many? That’s what your employer chooses through the vesting scheme. The most common vesting scheme takes 4 years, with 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 – now you have stock options

But what does that really mean?

Well, an option still isn't really anything, except the permission to buy a share: a tiny piece of your company. Buying shares is called exercising your options. Although stock options are a form of compensation, you need to spend money before they make you money.

To exercise, you need to pay their strike price (the price your employer offers you to buy the shares for) as well as income tax. The strike price is set when you join the company, but the amount of tax varies. We’ll get to that in a bit.

3. You exercise your options and officially have shares

When you exercise your options, it really just means buying your shares. You now have a stake in the company – that's the percentage of it that you own. It has potential future value, but since your company is private, you can't sell it on the public stock market. Until your company exits (which means going public or getting bought by another company) your shares won't make you money.

When you decide to exercise is up to you. As long as you work for the company you can buy shares whenever you like, and you don't have to buy them all at once. If you leave the company, you'll usually have 90 days to exercise (a few companies extend this to 5, 7 or 10 years).

You could wait to exercise until the exit, then cover the costs with the money you make, and have no upfront costs. But that strategy also has its drawbacks. Which strategy you follow is a big decision we'll cover how to decide what's best for you later on.

4. Your company exits – finally!

When a company exits, it either:

1. Is acquired, meaning it gets bought by another company. Microsoft bought GitHub, Amazon bought Twitch and Facebook bought WhatsApp.

2. Goes public, meaning it sells its shares on the public stock market in an initial public offering (IPO for short). That's what Slack, Uber and Lyft did.

(There's usually a 'lock-up' period of 90 or 180 days after the IPO, where employees can't sell their shares. When we say exit, we mean the first date you can sell your shares, not the actual date the company IPOs.)

If the exit value of the company is high enough (more on that in a bit) then you can sell your shares to make a profit. Hello payday! This is the moment founders and investors have been waiting for – their business model is making money through exits.

Without an exit, your options wouldn’t be worth anything.

The Exit Pie

The Option Lifecycle explains how stock options can make you money. But how much money? What things affect your profit?

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

The exit value is the total amount of money offered to everyone who has equity.
Your payout
is the part of it that you get. But there are costs, like taxes.
Your profit
is money you make after costs – the net amount.

Let’s say the exit value is 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 the company, the higher its exit value

Exit values range from tens of millions to billions of dollars. A few companies even reach the tens of billions.

Here are some examples of well-known brands (they're nearer the top of the range).

Tumblr
$1.1 billion
(in 2013)
Skype
$2.6 billion
(in 2005)
WhatsApp
$17 billion
(in 2014)
Uber
$76 billion
(in 2019)

You can try to predict the exit value for your company, but until it actually happens, you can't know it for sure. It could be $0 if things go downhill. We'll talk about how to deal with this uncertainty in a bit.

Payout = exit value × diluted stake

When payday comes, the exit value is divided among everyone with equity. The part that you get (your payout) is the percentage of the company you own at that time (your stake).

Your stake today is the number of shares you own, divided by the total number of existing company shares. So if you own 100,000 shares and your company has 50,000,000, your stake is 0.2%. (Your company should tell you the total number of existing shares they have, otherwise it's impossible to know what yours are worth.)

Your stake at the time of exit, unfortunately, is probably not the same as your stake today. As your company creates new shares for new employees and investors, your stake slowly goes down. This is called dilution.

To work out your payout, you multiply the exit value of your company by your diluted stake. The problem? It's how much your stake will dilute by, but we'll cover how to manage that uncertainty later on.

Dilution isn't necessarily a bad thing

With dilution, your company creates new shares to give to new employees and investors. As a result, there are more 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 there are 50,000,000 existing company shares, your stake is 0.2%. If your company then creates another 50,000,000 shares for new investors, the number of shares grows to 100,000,000, diluting your stake to 0.1%.

This may feel bad, but it doesn’t need to be. Because if your stake is halved, but new investments let your company quadruple its exit value, your payout is actually doubled.

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

Your profit = payout – costs

Your costs have two parts: the strike price and taxes.

The strike price is the price of your shares which you pay to your company when you buy them. When the company granted your options, they set the price per share.

To get the total strike price, multiply the price per share by the number of options. For example,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, or do it before the exit.

Taxes when exercising on exit (the simplest tax scenario)

You’ll be taxed just like any other income on what’s left from your payment, once you’ve minused the strike price. 

The only time you need to pay is when your company exits. You sell your shares, pay the strike price, pay your ordinary income tax and keep the profit. There’s no need to have cash upfront. 

Taxes when exercising before the exit (a little more complex)

Overall, your taxes might be lower. But you pay them in two parts: at first when you exercise, and then when you sell your shares on exit.

That means you’ll have ​upfront costs which you might not be able to afford​, as you pay some of the taxes (and the strike price) before getting any payout. And even if you do, you risk losing that money because a successful exit isn’t guaranteed.

Our free tool called Exercise Pre-Exit helps you work out your exact tax bill, and how it’s split between exercising and exit. All you need is an estimate of your payout – we’ll explain more on that in a sec.

Or to access the tool straight away:

You can't know how much money you'll make

Your payout is uncertain because the exit value is

We know: your profit = payout – costs. Once you know your payout, our free Profit Simulator can compute your costs, and tell you your profit.

But there’s one big uncertainty: you won’t know what your payout is until the exit happens, since it depends on the exit value of your company and on how much you'll dilute. The reality is that your equity is a bit like a lottery ticket – sadly that’s just a fact of life. 

The good news is you don’t have to stay in the dark completely. You can get some idea of possible outcomes, and that’s better than nothing.

Building exit intuition

You probably know the feeling of traveling to a country with a different currency. For the first few days, it’s 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’ve internalized the currency.

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

  1. Follow news outlets on startup exits. Search TechCrunch for 'acquired' for example, or look up lists of IPOs in the last couple of years. 
  2. Research the companies where they’ve shared the exit value. Get a feel for what it took them to get there. How many employees do they have on LinkedIn? How many countries are they selling in? 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. Compare the maturity and levels of success of those companies with the company you work for – especially for those in a similar market or with a similar business model. Do their situations still feel far off? Or are you getting close? Every company is unique, and companies can have different outcomes despite following seemingly similar trajectories. Nevertheless, mental exercises like this can be a helpful starting point for building exit intuition.

Now you’ve got some context, the next step is to imagine the future of your company and make rough estimates of its exit value.

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Think about 3 scenarios

Coming up with a single estimate is futile – it would almost certainly be wrong. It’s much more useful to get an idea of the range of possible outcomes with 3 scenarios. 

1. The base scenario: based on how your company is doing today 

Nothing wild happens here – it should be slightly optimistic. If it came true, you’d be pleased but not surprised.

Think about things like: Would it have 200 employees, or nearer 1000? How many countries would it be in? How popular might the product be? You don’t need to answer these precisely, just have an intuitive idea of the level of success. 

Got it? Now write down what exit value you feel your company might achieve. 

2. The dream scenario: if everything went better than expected

It’s the scenario you told yourself not to lean on too much when you were considering the job – the stuff you and your colleagues fantasized about over Friday drinks, only semi-jokingly.

That competitor you’re bothering with? Your company ended up winning the battle. That second product you’re thinking about launching? It became a revenue-making thing. Your reputation grew, which made hiring easier. Or a big investment round helped you expand internationally. These dream scenarios will differ from company to company, but think about what it would look like for yours. 

Again, forecast the exit value and write it down.

3. The disappointing scenario: if everything went a little worse than expected 

This one is slightly pessimistic – not full-on bankruptcy, but not nice either. Think of the key hurdles still ahead for your company. Not sure how to make your product profitable yet? Will you need to raise more money soon? Is your ambition to expand internationally?

Now think what would happen if you didn’t overcome the majority of these hurdles. Estimate once more.

Using your 3 numbers, you can move from company exit values to estimating your personal payout in 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 that all felt very unscientific, that’s because it is. You'll never reach accuracy, but having some perspective is better than none.

Also your perspective develops over time. Today’s forecasts only kickstart your intuition. Keep reading about other startups, especially those similar to your company, to get more familiar with how exits work.

Use your scenarios and exit values as starting points for discussions with colleagues and leadership. Do they share your thoughts, or 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, or if there are any major ups and downs, make a mental update of your future scenarios.

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

Deciding when to exercise and how much to spend 

Should you exercise before your company exits?

You can buy some, or all, of your shares today, instead of waiting for the exit. As someone with equity, it's the one big decision you need to make. It’s worth considering for 2 reasons: 

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

The tricky part? You pay money before getting any payout. That's money you risk losing: your company might not have a successful exit, in which case you never actually get that payout.

The more options you exercise before the exit, the more you unlock the potential benefits – it’s up to you if you exercise them all, or just a part. 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 before your company exit​s?

This is a two-step process:

  1. Work out how big your potential benefits are – it varies per situation.
  2. If the benefits are worth it, decide on the amount you’re 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 make an informed decision, 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 – a lower tax rate – instead. 

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

The answer depends on your tax situation, income, and type of stock options. We offer a free tool called Pre-Exit Exercise, which helps you crunch the numbers. Based on your details, it forecasts the difference in profit between exercising now or waiting for the exit.

You’ll need to enter 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 to do:

  1. Create a Secfi account and enter your equity details.
  2. Go to the Exercise Tax Calculator to learn about your upfront costs.
  3. Next, go to Pre-Exit Exercise.
  4. Enter your base scenario forecast as your exit value. 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. 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 want to find a middle ground: decide on a budget to exercise some of your options now, leaving the rest unexercised.

Deciding on that budget is difficult because it’s a gamble. Say you budget $5000. If your company has a very successful exit, you’ll wish you’d spent more than that, since you could’ve maximized your profit even more. But if 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? This choice is a personal one. But at least you now know what the potential benefits are.

Reason 2: to avoid losing equity

If potential tax savings aren’t enough, there’s another reason to exercise pre-exist: you get to keep a larger part of your equity in case you leave your company before the exit.

We’ve looked at ‘exercising pre-exit’ versus ‘exercising on exit’ – but having that choice is only possible if you keep working for the company until the exit. If you leave before, you’ll lose your options unless you exercise them within 90 days. (There are two exceptions: sometimes companies have a longer deadline of up to 10 years, and some companies extend 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? Well, this 'forced pre-exit exercise' will probably be more expensive than if you decided to do it today. If your company is growing, the exercise costs per option increase over time. And the faster your company is growing, the worse it gets.

If today, $5000 would cover the exercise costs of 50% of your options for example, you’re likely to get much fewer than 50% of your options for that same budget a year from now. (That's due to the rising 409A valuation – learn more in our complete guide to exercising).

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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