How do people get rich from their employee stock options?

Editor’s note: A version of this question originally appeared on Reddit.‍

How do so many regular tech employees get rich from startup stock options? How is it beneficial for startups to give vast amounts of potential money to employees as stock options? What are stock options, and how do I get rich if my startup offers stock options?‍

- Anonymous‍

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Dear Anonymous,

In the past 30 years, technology startups have created tens of thousands of millionaires in Silicon Valley, largely from stock options. A 2016 report estimated that there were more than 76,000 millionaires and billionaires living in the region alone.

This is largely due to the incredible value that private technology startups are capable of generating through software.

You asked a good question around why startups are willing to give their early employees so much equity as stock options. The answer is equal parts practical, competitive, and cultural.

First, the practical reason: For cash-strapped early-stage startups, they’ll offer competitive stock option packages to employees to get access to top talent while potentially paying slightly-less-than-industry-average salaries.

Similarly, stock options give startups a competitive advantage when they’re creating job offers for top candidates — if all things are equal, candidates will take the job offer with the more attractive stock options package.

Finally, stock options are cultural: Silicon Valley is built on a long-standing belief that it exists as a meritocracy, where founders share in the success of their startups with the employees who generated the most value on the path to get there. Technology companies began granting employee stock options in the 1960s, and they’ve become a defining characteristic of the industry since then.

So what is a stock option, and how does it work? In basic terms, a stock option gives you the ability to buy (or earn) shares in your company at a predetermined price and/or a predetermined timeline.

There are three common types of employee stock options — incentive stock options (ISOs), non-qualified stock options (NSOs) and restricted stock units (RSUs).

Depending on how successful the company eventually becomes, your pre-IPO stock options can end up being worth a lot.

For example, in the year 2000, early Google employees exercised 17.7 million shares at an average price of 30 cents per share — spending around $5.3 million to do so. The company went public in 2004, and closed its first day of trading at $100 per share — making those shares exercised just four years before worth $1.77 billion.

Collectively, the Google shares that employees exercised in 2000 are now worth tens of billions of dollars.

Very few technology startups become the next Google, and most stock options that are granted each year eventually end up worthless, because the vast majority of startups fail. Exercising stock options can also carry tax liabilities, depending on what type of shares you’re vesting, and when you decide to exercise.

However, for the small handful of startups that survive, grow, and eventually exit, stock options can represent a life-changing financial opportunity for early employees.

- Vieje Piauwasdy, Director of Equity Strategy, Secfi

Do you have a question about your stock options? Email us at ask@secfi.com